Employee stock options vs warrants

This article discusses the pros and cons of stock options vs shares for employees of Canadian — private and public — companies. The taxation issues are poorly understood and can be very confusing. Current tax regulations can make it difficult for companies to bring new employees options partners in as shareholders.

Stock options are a popular way for companies to attract key employees. They are the next best thing to share ownership.

Options are also a key part of a compensation package. In larger companies, options contribute substantially — often many times the salary portion — to income. In a recent survey of executive compensation see www. Most of the compensation came from stock options — no wonder the CRA Canada Stock Agency wants to tax them! Unfortunately, tax law can turn stock options into a huge disincentive in attracting key employees. For exampleif an employee of a company private or public exercises options to buy shares, that employee may have a tax liability even if he sells the shares at a loss.

If the company fails, the liability does not disappear. The tax treatment is not the same for Canadian Controlled Private Companies CCPCs as it is for public or non-CCPC companies. CCPCs have an advantage over other Canadian companies. This discussion is applicable to Canadian Controlled Private Companies CCPCs.

It addresses how a start-up can best get shares into the hands of employees while being aware of possible tax issues. To give employees an ownership stake and stock in the company, the best solution is to give them founders shares just like the founders took for themselves when the company was formed. Companies should issue founders shares from treasury as early as possible.

Some companies issue extra founders shares and hold them in a trust for future employees. Sometimes, the founders will transfer some of their own founders shares to new partners. This is a HUGE benefit.

This benefit is the difference between what the employee paid stock the shares and their FMV Fair Market Value. This benefit is taxed warrants regular employment income. For CCPCs, this benefit may options deferred until the shares are sold.

However, if the shares are later sold or deemed to have been sold by virtue of a liquidation at a lower price than the FMV at the time of acquisition, the tax on the deferred benefit is STILL DUE.

And, although this loss i. It may be possible to claim an Warrants Allowable Business Investment Loss to offset the tax owing on the deferred stock, i. This may work well if the company is still quite young and has not raised substantial sums from independent investors.

In the case of publicly-listed companies, options grants are the norm since FMV can be readily determined — and a benefit assessed — and because regulations often prevent the issuance of zero-cost shares.

But for pubcos and non-CCPCs, the tax on these benefits may not be deferred. It is payable in the year in which the option is exercised. This is a real problem for smaller public, venture-listed companies insofar as this tax forces the option to sell some shares just to be the tax! Getting cheap shares into the hands of employees is the best way to go for a CCPC. The only downside risk arises if the company fails in less than two years.

See Bottom Line below. If shares instead of options are given at a very low e. To avoid the risk of employee to pay the tax on the deferred benefit if shares are issued to an employee below the FMV, options are often granted. This is only a risk if shares are ultimately sold below the FMV, as may be the case in a bankruptcy.

Stock options, if unexercised, avoid this potential problem. An option gives one the right to buy a certain number of shares for a stated price the exercise price for a given period of time. The is no liability at the time that options are granted. Only in the year that options are exercised, is there is a tax liability. For CCPCs this liability can be deferred until the shares are actually sold. For example, giving shares at a penny instead of granting options exercisable at 50 cents means that more warrants must be granted which means greater dilution later when an employee is realized.

That amount will go right back to the new owner of the company meanwhile diluting all shareholders participating in the exit! Action item for investors: Give shares instead that are notionally equal to the Black-Scholes value of the option. Example, Joe Blow holds an option to buy K shares at 60 cents.

The shares are warrants valued at options cents based on recent investments. The value of stock options is determined to be 35 cents i. The 35 cents is based on the value of the option say 20 cents plus the employee amount of 15 cents. This is better than showing K shares as options on the cap table!! Employee employee is given an option to buy shares for a penny each. If the employee exercises the option immediately and buys shares, then he is deemed to have received an employment benefit of 99 cents which is fully taxable as income BUT both a DEFERRAL and a DEDUCTION may be available.

Employee, the tax options this income can be deferred until the shares are sold if the company fails, they are considered to be sold.

He can mitigate this by claiming an Allowable Business Investment Loss ABIL. In this example, Caution — claiming an ABIL may not work if the company has lost its CCPC status along the way. Their attitude is let CRA challenge it. To determine the number of shares, start by arbitrarily setting the price per share. This could be the most recent price paid by arms-length investors or some other price that you can argue is reasonable under the circumstances.

However, he can defer payment of stock tax until the shares are sold. This is why it makes sense to own shares as soon as possible to start the 2-year clock running. He can offset this warrants by claiming an ABIL. This is the situation that must be avoided. Make sure you let 2 years pass before liquidating if at all possible. Why bother with options options the benefits of share ownership are so compelling?

And the only possible financial employee to an employee getting shares instead of stock options arises in d above if shares are sold at a loss in less than 2 years. If the company fails that quickly, the Options was likely never very high and besides, you can stretch the liquidation date if you need to.

Contractors and consultants are not entitled to the benefit of stock deferral. Consequently, contractors and consultants will be liable to pay tax upon exercise of any options. Never underestimate the power of the Canada Revenue Agency. One might expect them to chase after the winners — those with big gains on successful exits but what about the folks that got stock options, deferred the benefit and warrants their shares for zip?

In the case of public companies, stock option rules are different. The main difference is that if an employee exercises an option for warrants in a public company, he has an immediate tax liability. Up until the Federal Budget of March 4th,it was possible for an employee to defer the tax until he actually sells the shares. Furthermore, CRA now wants your company to withhold the tax on this artificial profit. This discourages the options of shares for future gains.

If the company is a junior Venture-Exchange listed company, where will it find the cash to pay the tax — especially if it is thinly traded? It is also wrong in that stock options will no longer be an attractive recruiting inducement. Emerging companies will find it much harder to attract talent.

It will also be a major impediment to private companies that wish to go public. In the going-public process, employees usually exercise their stock options often to meet regulatory limits on option pools.

This could result in a tax bill of millions of dollars to the company. Before the March 4th budget, you could defer the tax on any paper profit until the year in which you actually sell the shares that you bought and get real cash in hand. This was a big headache for those who bought shares only to see the price of the shares drop. The stories you may have heard about Nortel or JDS Uniphase employees going broke to pay tax on worthless shares are true.

But when the shares tanked, there was never any cash to cover the liability — nor was there any offset to mitigate the pain. The only relief is that the drop in value becomes a capital loss but this can only be applied to offset capital gains.

In the meantime, though, the cash amount required to pay CRA can bankrupt you. CRA argues that the new rule will force you to sell shares right away, thereby avoiding a future loss. You are the CFO of a employee tech company that recruited you from Silicon Valley. So much for being an owner! As part of the March 4 changes, CRA will let the Nortel-like victims of the past i.

I guess this will make people with deferrals pony up sooner. The mechanics of this are still not well defined. Interestingly, warrants similar to options given to investors are NOT taxed until benefits are realized.

Options should be the same. Investors get warrants as a bonus for making an equity investment and taking a risk.