In a context of labour shortages, where close to 40% of Canadian small and medium-sized businesses are already having difficulty hiring new employees, stock-based compensation with a vesting schedule could help with employee recruitment and retention.
A useful tool to attract and retain employees
With stock-based compensation, employees in an early-stage business are offered stock options in addition to their salaries.
The percentage of a company’s shares reserved for stock options will typically vary from 5% to 15% and sometimes go up as high as 20%, depending on the development stage of the company.
For example, in a company worth $5 million with a 15% option pool, you have $750,000 in stock options to allocate to employees. The amount of stock options offered to employees will usually depend on their responsibilities and seniority.
A senior engineer earning $100,000, for instance, might have an additional 10% to 30% of his or her annual salary in stock options initially worth $10,000 to $30,000.
What is a stock option?
A stock option gives an employee the right to purchase a share at a fixed price for a specified period of time. For the senior engineer mentioned in this article, let’s assume that the company’s options are priced at $5 per share, then the engineer has the option to purchase 2,000 shares at $5 each, worth a total of $10,000.
Typically, employees in early stage companies only get to exercise their options upon a liquidity event such as an acquisition by a strategic buyer of the company or an initial public offering (“IPO”). Let’s say that the share price grows five times over the next several years, then the engineer can exercise his or her options at the time of the liquidity event and would buy shares at $5 to resell them at $25 for a profit of $40,000 on the initial option grant. The value of the employees’ stock options is linked to the value of your company upon a liquidity event.
What is vesting?
You don’t want your employees simply exercising their options and leaving the company. As a result, entrepreneurs who offer stock-based compensation usually set a vesting schedule that determines when an employee gets the stock options.
When you use a vesting schedule, a portion of the shares are granted to an employee on a yearly basis for a specific number of years, the stock usually has to be purchased within four years with a one-year cliff.
A one-year cliff means that an employee doesn’t vest (get shares) during the first year of employment. If an employee leaves or is fired before the one-year mark then they get no stock.
For example, an employee could be awarded options to acquire 10,000 shares, with 25% of the shares vested after the first full year of employment and then monthly vesting for the remaining shares over a 36-month period.
Some companies use a three-year vesting period, which can be used as a recruiting tool in a competitive field to grant employees their stock more quickly.
When setting your vesting schedule, it’s a good idea to check how your peers and competitors do it. You also need to check with your accountant to understand how stock-based compensation will affect your financial reporting.
Who can get stock options
One decision you should make early on is whether stock-based compensation is only for management and the senior team or for all employees.
If it’s available to all employees, in differing amounts based on responsibility, it makes everyone in your start-up an owner working toward success. Stock options also can be given in lieu of or in addition to a salary increase.
There are no guarantees of eventually getting rich, but there are well-publicized stories of how some early employees at Google, Facebook and Microsoft all became millionaires when they cashed in their stock options.
However, it’s important to let your employees know that if your company folds, the stock options become worthless. Therefore, exercising the options and paying for the shares prior to a liquidity event comes with significant risk.
Best practices for stock-based compensation
Employees at start-ups routinely get stock options in addition to their salary. You and your founding team need to clearly explain how they work and what are the advantages for employees, as well as the risks when they are exercised if not at the time of a liquidity event.
- Explain the vesting schedule to employees and any changes that are made.
- Explain what employees who leave after a longer period need to do with their options—an employee who leaves the company after five years and has $10,000 in stock options may have to exercise his or her options and pay for the shares.
How to avoid tax headaches for your employees
- Get a proper valuation done by a firm that specializes in equity valuations for private companies to determine the fair market value of the stock options being offered. In the U.S., the report is called a 409a and many firms do them for Canadian companies as well.
- You want stock-based compensation not to be considered as a taxable benefit. It should be tax neutral until exercised and sold. Read more on the Canada Revenue Agency’s (CRA) website.
- You only want employees to pay capital gains tax when they sell the shares, although if they hold their shares for over two years, they could be entitled to the capital gain exemption on small businesses that are Canadian Controlled Private Companies (CCPC). Read more on the CRA’s website.
Can founding employees take some profit?
You and your employees have bills and mortgages to pay. The trend in start-ups is increasingly to allow the company’s founders and some of the early employees, during a fundraising event, to exercise some of their options before a company is sold or goes public.
The idea is to let employees feel they can afford to stay at their start-up. They see the value of their options and understand with their bank accounts that the value of the company is growing.