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Using stock options to motivate and retain employees

27 September 2010 by National Bank
employee stock options

Want to retain your best employees and motivate them to outperform? Consider offering stock options. These may lead to complex tax issues for your employees, however, so here’s what you need to know to create a “win-win” solution.

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Offering your employees a chance to become shareholders in your company can be a very wise move. In a highly competitive job market, stock options are a compelling form of employee benefit to help retain your best personnel. Many Canadian companies – like Canadian Tire and CGI – rely on this type of incentive compensation to keep their top players and drive the organization’s growth.

How do stock options work?

A stock option plan lets you offer employees the right to acquire a set number of shares in the company at a predetermined price and for a defined period of time. The goal is to retain key personnel by letting them profit from the company’s growth, regardless of their position within the organization.

What are the advantages and disadvantages?

Generally speaking, this type of compensation plan can be negotiated just like a salary.

For the employer, the costs are lower than a salary expense: The stock option does not directly entail a cash outflow, but administration costs associated with the program must be taken into account.

When negotiating the agreement, the employer can not only determine the number of stock options, but also divide those options into monthly or annual blocks that the employee can buy progressively, starting on a predetermined date. In this way, the employer is protected against a premature departure and ensures that the employee will be happy to contribute to the company’s bottom line for years to come.

For the employee, there are no tax implications until the stock option is exercised. At that point, it’s a whole new ball game, because tax issues related to stock options are quite complex.

Let’s suppose your employee buys a block of 1,000 shares at $3 each, for a total of $3,000. As long as he or she does not redeem these shares, there is no tax impact. If, after four years, the shares are worth $5 each and the employee decides to sell them, the tax authorities will consider that the employee has a taxable benefit of $2,000, i.e. the difference beween the starting share price ($3) and its value at the time of sale ($5).

In the case of a publicly traded company, this taxable benefit is added to the employee’s income for the year when the stock option is exercised and not when the shares are sold. The shares constitute a liquid asset whose value is set by the market. When the employee sells the shares, he or she may be taxed a second time if the sale price is greater than the adjusted base price of the shares.

In the case of a privately held, Canadian-controlled company, selling the shares will be more difficult for the employee. The tax system takes into account this lack of liquidity. Employees who keep their shares for at least two years after exercising their options can defer declaring the taxable benefit until the year that the shares are sold.

The taxable benefit from exercising stock options is considered employment income, but it is taxed as a capital gain rather than as salary. In fact, the employee can benefit from a 50% deduction from the federal and provincial governments. In 2017, Quebec increased this deduction, which was formerly 25%. [supprimer cette mention dans la version anglaise?]

In other words, if stock options, for instance, are being used to compensate for an otherwise unattractive salary, eventually, down the line, they will turn out to be a solid deal for the employee. That is, of course, assuming the stock price has risen.

Other ways to retain employees

There are other types of incentive plans based on stock options, such as ones where employees can purchase stocks at a discounted price; and stock ownership bonus plans, which allow the employer to reward employees with stocks when certain performance objectives are reached.

Whatever method you choose, keep in mind that stock option plans offer quite a bit of flexibility: As an employer, you are free to set the terms. The options are generally valid for a period of three to five years.

In certain cases, the employer can allow an employee to take a cash payment – rather than stocks – in exchange for his or her stock options. In other words, the employee will waive the stock options in exchange for a sum of money (or other benefits in kind), and not buy the company stock.

Who can benefit?

Stock option plans can be just as advantageous for large corporations as for small and medium businesses or small startups with major growth potential. In addition to motivating your team, this formula gives you a degree of financial flexibility, since any sums that don’t go toward salary or bonuses can be kept in the company coffers.

Turning employees into shareholders has many advantages, but make sure that your employees do their homework and fully understand the implications of the compensation you’re offering before they accept it.

Stock options can be very attractive, but employees are not always accustomed to taking on shareholder risk. With that in mind, don’t hesitate to offer other programs at your company to keep your most valuable resources motivated.

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