More Valuable Than Money? The 5 Most Common Equity Compensation Plans
April 2, 2018
By Morganne Foley, at McInnes Cooper
Equity compensation plans are a valuable and versatile tool for many corporations, from early-stage startups to established blue-chips. Corporations can use them to attract new talent, to motivate employees to achieve performance milestones or reward them for long service, and to retain employees for the long haul. An equity compensation plan is a way for a corporation to make payment to another – usually an employee – with an ownership stake (or a valuable asset that mimics an ownership stake), instead of with cash. These plans come in several forms; the one that’s the best fit for a particular corporation will depend on its unique circumstances and on what it hopes to achieve.
Here’s a quick look at the five most common types of equity compensation plans.
- Stock Option Plans
A stock option plan offers the promise of equity at a set price at a future date, typically on meeting certain conditions. An option gives the holder, often an employee, a right to purchase a certain number of shares at a point in the future at a pre-determined price (the “exercise price”). This right is often tied to the option-holder’s commitment to remain with the corporation for a certain period of time.
Stock option plans are particularly attractive to startups that often lack the cash to entice and keep top talent (like employees, directors, consultants and advisors) to help the corporation grow, and is one of the considerations founders should think about when incorporating their startup. There are some disadvantages of stock option plans. The main one for the corporation is the possible dilution of other shareholders’ equity when option-holders exercise their options. The main one for the option-holder in a private corporation is the lack of liquidity compared to cash bonuses or greater cash compensation. Until a corporation creates a public market for its shares or is acquired, the options won’t be the equivalent of cash benefits; and if the corporation – and its stock value – doesn’t grow, the options and underlying shares could ultimately prove worthless. The option-holder’s motivation is, generally, that the exercise price will be lower than the potential fair market value of the shares at a particular time in the future such that the option-holder both has a stake in the corporation’s future and can acquire that stake at a discounted price.
Stock option plans typically contain some or all of the following terms (among other standard terms):
Option Pool. The Board of Directors determines the size of the “stock option pool”: the number of options reserved for award. The stock option pool diminishes every time the corporation awards options; if the plan isn’t well organized, the options can run out. Plans typically give the corporation discretion to ensure it can retain its outstanding shares in the event of employee departures by giving it rights to cancel options in exchange for a specified financial value.
Stock option agreement. Plans typically require the corporation and the person to whom it will grant the options to sign a written option agreement specifying the date the options are granted, the total number of shares subject to the option, the exercise price, the vesting commencement date and schedule, the expiry date, and any unique terms.
- Exercise Price. Typically, the Board of Directors determines the exercise price, often at the shares’ fair market value when the options are issued.
- Vesting Schedule.The option-holder can only exercise their options once they’ve “vested”. Vesting conditions vary, but (particularly in startups) they are often tied to the option-holder’s continued involvement with the corporation according to a pre-determined “vesting schedule”. The vesting schedule outlines the percentage of options the option-holder can exercise after a specified amount of time.
- Expiry. Once vested, an option stays vested until it expires. Exercising the options is voluntary; there’s no obligation on the option-holder to exercise their options and purchase the shares. If an option-holder doesn’t exercise their options before the expiry date, their unexercised options are cancelled and returned to the corporation’s option pool. For example, if the current market value is less than the exercise price and therefore, the option-holder doesn’t exercise the options before they reach their expiry date, the options will be forfeited and the option-holder won’t be able to exercise them. Stock option plans also typically set out what happens to vested and unvested options if the option-holder is removed (or removes themselves) from their role or becomes disabled, retires or dies.
Shareholders’ Agreement. Once the option-holder exercises their option and purchases the shares, they typically enter into a shareholders’ agreement with the corporation and the other shareholders that governs the ownership of shares and management of the corporation.
- Restricted Share Unit Plans (RSU Plans)
In an RSU Plan, participants are granted notional units called “restricted share units” rather than actual shares. The RSU value mirrors the market value of the granting corporation’s common shares and fluctuates with their rise and fall. The plan participant then receives the shares underlying the RSUs according to a vesting schedule after achieving required milestones, such as remaining with the corporation for a specified length of time. RSU Plans typically contain these terms (among other standard terms):
Administration. Normally, the corporation’s Board of Directors will administer the RSU Plan, including granting of RSUs, determining the terms of the grant, interpreting any matters arising from the RSU Plan and making any other determinations necessary for the plan’s administration.
Shares Reserved for Issuance. The plan sets out the maximum number of shares the corporation can issue upon the vesting of any RSUs granted under the plan. This can be an absolute number or a rolling number based on a percentage of the total outstanding shares.
RSU Grant Agreement. Upon the grant of the RSUs to the plan participant, the corporation and the participant enter into a grant agreement containing the terms and conditions the plan requires and any other terms and conditions the corporation’s Board of Directors determines in respect of the plan participant at the time of the grant.
Vesting. Vesting of the RSUs can be based on time, performance, or both. RSUs that vest based on performance are sometimes called “performance share units” or “PSUs”. Once the plan participant meets the vesting conditions, they can settle their RSUs in shares of the corporation, cash, or both. Assuming the RSU Plan is structured properly and the Income Tax Act’s salary deferral arrangement rules don’t apply, the value of the shares received on settlement of the RSUs is added to the participant’s income and taxed as such in the year of settlement (as opposed to the year of grant). Typically, the corporation withholds a portion of the shares to pay income taxes and the participant receives the remaining shares. RSUs settled in cash must vest no later than three years after the grant to avoid the salary deferral arrangement rules; if caught by those rules, the plan participant will be taxed in the year of grant.
Employment. Typically, the plan requires that the participants’ entitlement to the RSUs depends on their continued employment with the corporation. Upon the participant’s employment termination, retirement or death, their RSUs are typically forfeited or a portion immediately vests.
Share Capital Adjustments. RSU Plans usually include standard provisions about the adjustments to the outstanding RSUs on the occurrence of certain events, such as any change in or reorganization of the granting corporation’s capital structure.
Change of Control. An RSU Plan customarily also deals with participants’ rights if there’s a “change of control” of the granting corporation.
- Share Appreciation Right Plans (SAR Plans)
Under SAR Plans, the corporation grants plan participants share appreciation rights. Each SAR entitles participants to receive, on vesting, the net value of the increase in the market value of the corporation’s share between the grant date and the vesting date. Share Appreciation Right Plans are similar to stock option plans in some ways, and to RSU Plans in others:
Value. Share Appreciation Rights function much like stock options in many ways – but unlike stock options, participants aren’t required to pay the exercise price when they exercise the SAR. Share Appreciation Rights start with a nil value at the time of grant, so will have no value at vesting if the market value of the shares has decreased between the dates of grant and of vesting.
Plan Terms. Share Appreciation Right Plans typically contain provisions similar to those of RSU Plans in respect to plan administration, maximum shares reserved for issuance, grant agreement, market value, employment, share capital adjustments, change of control and shareholder agreements.
Vesting. Like RSU Plans, vesting provisions in SAR Plans can also be based on time, performance or both. Performance-based SARs are sometimes called “performance appreciation rights” or “PARs”. Once vested, the plan participant can settle the SARs in cash or in an amount of shares that equals the amount payable to the participant divided by the per share market value.
- Deferred Share Unit Plans (DSU Plans)
Deferred Share Unit Plans are used as a way to defer compensation to the granting corporation’s directors since they will be taxed on the DSUs only in the year in which they are settled rather than the year of grant – assuming the plan is properly structured so that the Income Tax Act’s salary deferral arrangement rules don’t apply. Deferred Share Unit Plans function very similarly to RSU Plans:
Grant. The corporation grants plan participants notional units, in this case called “deferred share units”.
Value. The value of DSUs mirrors the market value of a class of the corporation’s shares.
Plan Terms. In other respects, DSU Plans are also similar to RSU Plans with a key exception: DSUs typically vest only upon employment termination, retirement or death. They are therefore designed to be longer term in nature and vesting isn’t linked to performance criteria.
- Restricted Share Plans & Deferred Share Plans
Under Restricted Share Plans and Deferred Share Plans, the corporation issues shares to plan participants at no cost. But there’s a catch: the shares are awarded conditionally, and are only released to the participant upon satisfaction of the condition(s). The conditions might be time-based, performance-based, or both. These types of plans aren’t typically used in Canada primarily due to the adverse tax consequences to participants: they are normally taxed on the award at the date of issuance.
Please contact your McInnes Cooper lawyer or any member of the Corporate Finance & Securities Team @ McInnes Cooper to discuss this topic or any other legal issue.
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