Written by: Paul J. Leedham
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The issuance of incentive stock options in lieu of payment in cash continues to be an attractive means for technology companies to compensate their workforce, especially when available cash resources are tight or need to be reinvested in the business. Recipients of stock options (“optionees”) are granted the right to subsequently acquire a security from the issuing enterprise at a pre-established exercise price for a set period of time.
A significant benefit realized from issuing stock options is the alignment of optionee interests with those of the issuing enterprise. Optionees have an incentive to contribute to the growth of the enterprise in order to maximize their potential compensation – as the value of the underlying security increases relative to the exercise price of the option, so does the potential return to the optionee. The inherent value of an option in a private enterprise may not be extracted by the optionee until the private enterprise undertakes a liquidity event (such as an initial public offering). When it comes to publicly traded enterprises on the other hand, optionees can take advantage of accessing the public markets in order to realize liquidity through exercising their options to receive shares and then immediately disposing of them on the applicable stock exchange at prevailing market prices.
As mentioned, optionees have the right to acquire a security from the issuing enterprise for a set period of time (referred to as an option’s term), which is commonly two to five years but can sometimes be as far out as 10 years. The issuing enterprise will typically assign a vesting period to options when granted which requires the passage of time before the options can be exercised.
As an example, let’s say an issuing enterprise grants an employee 1,000,000 stock options which have a term of five years and a vesting period of 25% every six months. Under this scenario, no portion of the grant may be exercised until six months from the date of issuance, at which time 250,000 of the options become vested and can therefore be exercised. All 1,000,000 of the options will have vested and be exercisable 24 months from the date of issuance. Any unexercised options after five years have elapsed will become expired and can no longer be exercised.
The optionee will consider various factors in determining when it is most advantageous to exercise their vested options prior to expiry. An optionee may wish to achieve an element of personal income smoothing so as to not generate all income derived from exercising stock options in the same year but rather have it apportioned over two or more years. Incorporating the same facts as in the example above and assuming the issuing enterprise is publicly traded and the optionee desires to immediately dispose of their acquired shares upon exercising their options, this staggered option exercise would be beneficial if the optionee would otherwise have been taxed in the highest marginal tax bracket by exercising all options in the same year.
Of course, prevailing market prices could significantly change on a daily basis, and therefore it might be wise to consider a staggered option exercise strategy over a relatively short period of time straddling a particular taxation year-end (perhaps in December of one year and January of the subsequent year) in order to mitigate the chance of unfavourable market price changes. Additionally, an optionee may consider holding their options through to the end of their term under the presumption that the value of the issuing enterprise will steadily increase over the long-term and become more valuable as the company grows. While this demonstrates the alignment of optionee interests with those of the issuing enterprise, the optionee also exposes themselves to the risk of unforeseen adverse circumstances which might detract from the value of the issuing enterprise, such as those related to product obsolescence, environmental regulations, and government policies.
Overall, while the utilization of stock options allows technology companies to conserve cash resources and align the interests of their workforce with those of the company, it is important for the optionees to consider various factors when deciding when to exercise their options in order to maximize value.
If you require additional information on this topic, please feel welcome to contact Manning Elliott Partner Paul J. Leedham for assistance at 604-714-3685.
The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.