Established companies as well as start-ups use long-term incentive plans ("LTIPs") to attract talent, retain key employees, directors and executives (collectively, the "Beneficiaries"), and align their interests with those of shareholders. LTIPs are particularly relevant amid high competition and labour shortages. One of the most common types is the stock option plan ("SOP"), which sets out the terms and conditions of this performance incentive tool. An SOP also enables a company to retain cash to invest in its growth.
Though SOPs are usually complex and the rules governing them vary depending on whether the entity is a private or a reporting issuer (i.e. a public company), an overview of the key aspects will shed light on how these plans work and the various issues they raise.
Difference between stock options and restricted share units
While SOPs are the most common, there are other alternatives, such as restricted share unit (RSU) plans, which are also widely used, particularly by public companies.
Under an SOP, which may be approved by a company's shareholders, the company's Board or a compensation committee grants options to the Beneficiaries. All relevant details are set out in an agreement or on a form indicating the number of options granted, the vesting period, the vesting conditions, the strike price per option and the options' expiration date. When options are granted, the Beneficiaries do not immediately become holders of the company's shares. Instead, they must wait until the end of the vesting period. They only become shareholders once they have paid the strike price and met certain other conditions. In other words, when options are granted, the Beneficiaries do not obtain any immediate value. The value of their options is only created by the potential increase in value of the company's share price.
Under an RSU plan, Beneficiaries are granted a number of restricted share units, with each unit corresponding to one share in the company. One unit thus has the value of one share. As with stock options, RSUs are subject to a vesting period, but they differ in that the Beneficiaries do not have to pay a strike price to become company shareholders. Instead, they become holders of the shares when the vesting period ends, subject to certain conditions. The term "restricted" refers to the fact that the granted units are subject to a vesting period or to certain transfer/selling restrictions.
Beneficiaries
Although SOPs are usually geared towards a company's key employees, certain plans stipulate that consultants or other service providers who can be characterized as self-employed are also eligible. This point may also arise when determining their legal status as an independent contractor or as an employee under applicable employment and tax laws. Directors or officers may also be granted stock options under certain plans.
Some SOPs may set out that an option grant does not entitle the Beneficiaries to any future option grants or give them a right to continue in their role as employees, directors, officers or consultants for the company.
Option pool
When adopting an SOP, companies must select the class and percentage of shares that will be set aside for the plan. This information is sometimes included in the SOP. Though option pools are typically 10%, they can range from 5% to 20% and may be adjusted by the company over time. Shareholder dilution is naturally a consideration when determining this percentage.
Strike price
When granting options to Beneficiaries, the company must set a strike price for each option. This normally corresponds to the share's fair market value on the grant date.
The strike price is the amount that the Beneficiaries must pay to the company when they exercise their options.
To account for potential cash flow issues, SOPs may allow for cashless exercise. Under this mechanism, the Beneficiaries do not have to pay anything to exercise their options, but will, for instance, end up with fewer shares in relation to the number of options they hold.
Right to purchase shares
Since SOPs are prospective, the options only vest once a certain time has passed, e.g. after several years or at certain intervals during that period. These details are set out in the SOP or the option grant agreement. Once the options vest, Beneficiaries may exercise them and become company shareholders. In some cases, options vest when Beneficiaries meet certain performance targets.
Some plans stipulate that options will only vest if certain events occur, e.g. the company is bought out or goes public through an IPO. Similarly, some plans state that options will vest if there is a change of control. Sometimes, these same events may allow Beneficiaries working for a private issuer to sell their shares.
Additionally, SOPs may set out restrictions on transferring options or shares issued after options are exercised.
They may also stipulate that Beneficiaries will be bound by a shareholders' agreement if they exercise their options.
Loss of rights
Given that SOPs often involve significant monetary considerations, the specific wording used to govern the loss of stock option rights is crucial.
Firstly, SOPs typically specify that options will expire some time after they are granted, generally within five or ten years. Beneficiaries who do not exercise their options at the end of that period thus lose their right to do so. This deadline is designed to ensure a degree of predictability with respect to options granted.
In addition, a key feature of SOPs is that they must clearly state what will happen to any options that are not exercised as at a Beneficiary's termination or retirement date, or if a Beneficiary goes on extended leave or becomes disabled.
To limit Beneficiaries' rights when their employment ends, SOPs may clearly state that stock options are exceptional in nature, are not part of the Beneficiaries' regular compensation and do not compensate the Beneficiaries for services rendered. SOPs may also indicate that any options that are unvested as at the termination date, regardless of the reason for termination, are automatically cancelled. This means Beneficiaries would have no stock option rights in the post-employment period, including during any subsequent period in lieu of the termination notice they would have been entitled to.
For terminations without a serious reason, e.g. a layoff for economic reasons, SOPs typically include a limited window, for example 90 days, and usually less than one year, so employees can exercise any options vested as at their termination date.
Given the various issues raised and to minimize the risks of litigation when granting options, companies would be wise to make all Beneficiaries specifically aware of the SOP's wording with respect to the loss of rights upon termination of employment.
Language of the SOP
Since Québec's Bill 96 amending the Charter of the French language came into force in June 2022, all documents related to working conditions must be available in French. This requirement applies to all SOPs adopted by companies subject to the Charter, including any SOPs adopted prior to Bill 96, since the grace period granted by the legislation expired on June 1, 2023.
Other considerations
Needless to say, SOPs also raise other legal issues, including tax considerations. If an organization is a Canadian resident corporation and an employment relationship exists between it and the option's Beneficiaries, the gain realized when the options are exercised may be deemed employment-related income. In that case, the company may be responsible for deductions at source relating to the option exercise benefit.
It is also important that SOPs give companies some latitude for adapting to changing circumstances as they grow or dealing with certain specific cases. SOPs should therefore specify that the company reserves the right to modify or terminate the plan, as well as under what conditions.
Finally, SOPs could include a provision stating that by participating in the plan, Beneficiaries authorize the company to use their personal information for plan administration purposes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
