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Stock Compensation - how to attract and retain your exec team

Updated: Mar 23, 2023

(Newsletter: tsCFO.004 v1 202.03.21)





















Stock Options - Introduction


Stock option compensation is one of my favorite areas to work in because there are a lot of moving legal, tax, and accounting parts - fertile ground for a Fractional CFO to add value. It is a complex area where I have seen legal professionals set tech startup executives up for hundreds of thousands of dollars in avoidable future T4A employment benefit taxes (assuming a future successful CCPC tech startup exit) by glossing over CRA tax consequences that only show up when the underlying shares are sold for cash far into the future.


While it is possible to have full option terms in a separate legal document for each employee, the normal practice is to have standard option terms approved by the Board of Directors in an Option Plan, supporting simple (~2 page) option agreements covering terms specific to each employee. Option Plans are sometimes referred to as an ESOP (Employee Share Ownership Plan). Technically an ESOP can also be a direct share purchase plan (no option grants involved) for employees in a big tech company, but in the world of tech startups, the terms “Option Plan” and “ESOP” generally refer to the same thing.


Founders (typically 1-3 people) get fractional penny shares on or around the date of incorporation to split the starting equity pie that option holders and other shareholders subsequently participate in. The founder share agreement should include a time limited buy-back clause to deal fairly with any unexpected early founder exit. If the tech startup can ultimately manage a successful exit (including a liquidity event such as an M&A (Merger & Acquisition) transaction or an IPO (Initial Public Offering) on a public stock exchange, each founder should be fairly rewarded for their early risk taking, sweat equity and creative thinking. Over the financial life of the Company the Founders inevitably watch their initially large %ownership of the equity pie get diluted down with new treasury shares issued to investors on a financing raise, and new shares issued to employees as their option grants are exercised on vesting.


CEO’s and other founders of a tech startup are always cash constrained in their journey to develop a new product or service and sell it in sufficient volume to finally achieve positive cashflow. Compensation (gross salary) is inevitably the dominant cost for tech startups - so how do CEO’s attract and retain talent with limited cash resources in the early days? While some management talent will prefer a tech startup environment to the politics and bureaucracy of a big tech corporation, the large compensation and benefit packages offered by big tech can be a barrier to tech startups competing for the same talent pool. Sharing the tech startup equity pie through a Stock Option Plan is a normal response to attract and retain management talent while keeping the ongoing cash hit from salary and benefits affordable. With a compelling tech story, early stock options are the best way for non-founders to get involved in helping to build a tech startup powerhouse, and get a meaningfully early share of the equity pie as a reward. Founders should not be dipping into the limited option pool. Founders should use the option pool to attract the talent they need to fill management holes and grow the company, and (at least in theory) make their penny founder shares worth millions.


There is often no legal limit to how many options a tech startup can reserve in the option pool with Board approval, but typically existing shareholders and potential investors don’t want to see a tech startup with an option pool that exceeds 20% of issued shares. As the tech startup matures the option pool size tends to shrink as a % of issued shares. If a tech startup is engaged in an exit transaction (liquidity event) such as an M&A or IPO, the option pool is normally reduced to a maximum 10% of issued shares. This is not as limiting as it may appear at first glance. The option pool room increases each time a tech startup issues new treasury shares during a financing round. This means the overall size of the option pool can still increase with new financing rounds even though the option pool as a % of issued shares may be decreasing from ~20% as a new startup attracting talent, down to ~10% after a liquidity event.


When offering options to attract new management talent, the CEO needs to be careful not to share confidential cap table details except on a “need to know” basis (as discussed in tsCFO.002), so the CEO has to walk a fine line between offering a reasonable number of options to attract talent while disclosing as little cap table detail as possible during negotiations with the prospective employee. Generally it is best to avoid any discussion of %ownership of equity, especially in written form on employment agreements. The %ownership of every shareholder is continually diluted with each new share issued from treasury. Instead of thinking in terms of %ownership, employees who are option holders should focus on increasing the value of the tech startup by executing effectively on the business plan (growing the pie).


It is the Fractional CFO’s job to track %ownership of all shareholders with each change in share capital. On an exit transaction %ownership determines each shareholder’s share of the “exit pie” - so it is an important number, just not the right number for option holders to focus on when there will be much further dilution before any exit in the distant future. Bottom line, managers with options should focus on growing the total equity pie, and not %ownership. Owning 100% of a company worth nothing isn’t very satisfying. Owning 1% of a company worth $100M puts $1M in your jeans.


Non-management employees in a tech startup are generally compensated with cash only. Recent graduates from university or technical college should be partly motivated by getting real-world experience in their chosen field, in addition to their starting salary. For other “rank and file” staff below the senior management team, salary levels are generally affordable for a tech startup. I have seen progressive tech organizations “share the pie” with all employees who pass a one year probationary period, regardless of the employee’s level in the organization hierarchy. I admire this “share the pie wide” philosophy, and have seen it contribute directly to a strong and cohesive corporate culture. However, only larger tech organizations (>100 employees) can afford the legal and admin effort required for this “share the pie wide” philosophy. The tech startups I now work with as a Fractional CFO (all well under 50 employees) would be overwhelmed by the legal and administrative overhead associated with offering options beyond the management team.


There are a couple of advantages to keeping the number of shareholders in a tech startup to a minimum by limiting access to option grants. It reduces the risk of having to manage a rogue shareholder (eg. disgruntled former employee) who may distract management at an Annual General Meeting, or refuse to sign an all-shareholder legal document (which can be solved using a compulsory Shareholder Agreement with a “drag along” clause). Another reason to limit the number of shareholders in a tech startup is that under BC Securities legislation, the level and complexity of financial reporting by a private company goes up (read increased legal and accounting fees) once you have over 50 shareholders (not counting active BC resident employees, but counting former employees who are shareholders).


Stock Options - Legal Structure and Vesting


The legal side of option compensation is fairly straightforward. Most share purchase options provide a right (vesting over time) to purchase common shares from treasury at a specific strike price per share on or before the option expiry date. It is not uncommon for employee option expiry dates to be 10 years from the option grant date, while Directors generally have expiry dates up to 7 years from the grant date.


The Board of Directors (Board) of a tech startup has to authorize the Option Plan and the details of any individual employee option grant issued under that plan. This legal authorization is generally done through a Board resolution.


In the USA, the IRS (US Federal Internal Revenue Service) punishes options that have longer than a 10 year expiry, so by osmosis this 10 year expiry has become a common limit in Canada as well, even though CRA has no corresponding tax restriction. If you plan to attract and retain US employees as your tech startup grows, you should have your lawyer select an Option Plan template designed to comply with IRS Incentive Stock Option (ISO) requirements, including a declaration that the Option Plan is intended to qualify as an ISO for IRS tax purposes. Other ISO tax related requirements for US employees are not detrimental to Canadian employess, so a single comprehensive Stock Option Plan can be used by the tech startup to attract and retain both Canadian and US employees. Any lawyer experienced with Canadian tech startups should be familiar with how ISO requirements fit into their Option Plan template.


Only vested (or “earned”) options can be exercised. Options can vest immediately if the Board wishes to recognize a prior contribution, but generally tech startup options vest over a period of 3 or 4 years to reward employees for their contribution to growing the tech startup’s valuation over that time period. It is possible for the Board to structure option vesting based on milestone achievement as an incentive. While this sounds intuitively appealing, it is quite rare because it is difficult to anticipating every possible scenario to determine when a milestone is achieved. The last thing you want a valued manager to be preoccupied with is an internal dispute with the Board over whether or not their options have vested. Options suck enough legal, tax and administrative oxygen out of the room as it is, so keeping the vesting simple and time-based is a good choice. Time based vesting doesn’t mean an option grant is forever committed to a specific individual. If an employee is terminated or quits for any reason, their unvested options expire immediately and their vested options expire unless exercised within a short period following the termination date (typically 30-45 days).


As a best practice, option vesting over time is typically monthly after a “one-year-cliff”. Assuming the option vests over 4 years (48 months), then 12/48 of the option grant vests on the first anniversary (1 year cliff) of the option vesting start date, and 1/48th vests on the last day of each following month until the 4 year vesting period has been completed. The theory behind the 1 year cliff is to establish a “probationary employment period” before any options vest. Once the year has passed, there is an immediate catch-up on 12 months of option vesting.


An employee can exercise all or a portion of their vested options to purchase shares by serving notice and paying the option strike price per share. No share can be legally issued until the full share price is deposited in the Company bank account (ie. the Board isn’t legally permitted to authorize the issue of shares today, and have them paid tomorrow). Even for option exercises with a trivial strike price, it is important to record the share purchase deposit accurately in the QBO / Xero accounting record with the individual shareholder’s name and number of shares issued in the GL transaction detail.


To reinforce this point from a legal perspective, each individual Director on the Board is personally liable to pay for any shares authorized to be issued before the company has received the share proceeds. In my experience, lawyers rarely ask to confirm share proceeds deposited to Company bank accounts before they push the legal share paperwork through, which can lead to a situation where the lawyer’s legal share register shows shares being issued at a premature date, because the share proceeds were deposited on a later date. This is an area for a Fractional CFO to review in detail, and try to correct any legal oversights. For example, a “better late than never” cash deposit can cover missing proceeds from previously unbooked founder shares in the QBO / Xero accounting record. The Share Capital GL account should always match the lawyer’s legal share register perfectly.


Warrants are effectively options issued to investors or financing partners as an incentive. They look and behave exactly like options, except that warrant holders don’t enjoy the preferential tax treatment that CCPC tech startup employees (and directors) enjoy. CRA deems legally registered Company directors of a CCPC tech startup to be “employees” for tax purposes (sharing the same generous tax advantages), even though the directors don’t show up on payroll.


Stock Options - Tax Consequences


CRA’s tax rules on option grants to Canadian Controlled Private Corporation (CCPC) employees are very generous with deferrals and reduced tax rates, as long as employees (including directors) are being rewarded for their contribution to company growth from a strike price that is at least equal to the common share FMV (Fair Market Value, as determined by the Board) on the option grant date. CRA’s tax treatment is far less generous if the option strike price is set at any value lower than common share FMV on the grant date, because the employment benefit portion of the option grant will no longer be eligible for the 50% 110(d) deduction.


In contrast, CRA’s tax treatment of otherwise identical options granted to Contractors (such as a Fractional CFO like myself) or a Board Advisor (instead of a legally authorized Board Director) is so hostile, it is almost impossible to imagine a scenario where they could be considered. I am left to conclude that CRA is aggressively protecting shareholders against CEO’s and other Founders (who control private company voting) from using options as a tool to reward friends and relatives (at the cost of diluting other shareholders including themselves) in exchange for the kind of “consulting” contract one might award to the close relative of a Saudi oil prince in the process of securing a large purchase order from a Middle East company. The bottom line is that Contactor / Board Advisor options are off limits - you have to find a different way to compensate.


If a tech startup Board is following best practices to minimize future tax on option holders, it will set the option strike price = FMV of a common share at the option grant date. This requires the Board to value the Company at the option grant date, given the FMV of a common share = Company valuation / number of shares issued. Private company valuation is a grey area requiring judgement.


The valuation of any company is theoretically equal to the discounted net present value of its future cashflows, but in a tech startup that gets you nowhere because future cashflows are completely unpredictable. For larger tech companies in specific segments, comparable data is sometimes available as a valuation guide, but in practical terms no two tech startup companies are alike, and tech startups never share private financial data, so trying to work with industry comparable data for tech startups is generally not effective. Valuation professionals earn significant fees to document assumptions and methodologies appropriate for each specific company situation, in arriving their best possible 3rd party valuation estimate. Thankfully CRA does not generally require 3rd party valuation studies for tech startups. Big tech companies may find themselves in a situation where the numbers get large enough to require a formal valuation for tax purposes. The only time I have seen a professional valuation study undertaken by a tech startup was during an M&A negotiation to support their argument for a higher valuation.


The question becomes, what valuation guidelines remain for a tech startup Board to work from? There are fairly simple rules of thumb and patterns to follow which CRA will accept as long as the Board acts diligently and competently. For example, if there was a recent investment in the Company’s common shares by a 3rd party investor, that sets the FMV per share. If the last 3rd party share investment was a within 18 months, and no dramatic event (either positive or negative) has occurred, that same last share price will likely serve. If years have gone by and the company has made steady progress towards its business plan (product commercialization, revenue growth) that progress has to be reflected in an increased valuation using a logical foundation such as a simple calculation based on financial statement ratio analysis. If a significant event has occurred (either positive or negative), the Board should document an assessment on how it impacts valuation, including clearly stated assumptions. In most cases, employee option grants are not very material, so CRA has little motivation to question reasonable efforts by the Board to come up with a FMV share price (= strike price at the option grant date), as long as these standard valuation rules of thumb are respected. What CRA will not tolerate lightly is option strike prices at an “artificially low FMV” for a few privileged employees (or directors), and set a higher FMV for everyone else during the same time period. In the same manner, shares must always be sold at a consistent FMV price to all shareholders within a similar period of time, or immediate and negative tax consequences will be triggered.


In terms of tax consequences, it is important to note that there are no constraints on the Board altering vesting terms at the grant date, or accelerating vesting at any point after the option has been granted. The Board can also set any option expiry date it chooses at the option grant date, or extend an option expiry date about to expire, without any tax consequences. For the purposes of minimizing accounting, legal and admin costs the Board should apply option terms as consistently and fairly as possible, but it can be helpful to know that tinkering around the edges is tolerated by CRA. In contrast, there can be both negative tax consequences and shareholder approval restrictions on efforts by the Board to reprice underwater options, so it is best not to wade into those murky waters.


There are two sets of tax rules at play related to an option exercise, and the subsequent sale of the underlying shares. The first set of tax rules relates to a T4A taxable employment benefit based on any difference between the option strike price set at the grant date, and the FMV of the common share price on the date of the option exercise (only available for the vested portion of any option grant). The tax on this “pregnant” T4A employment benefit is generously deferred for employees (and directors) of a CCPC tech startup, until the underlying shares are sold, which can be many years after the options were exercised and the “pregnant” tax liability was determined.


The second set of tax rules relates to capital gains tax on the eventual sale of shares that were issued from treasury as a result of an employee option being exercised. Normally 50% of a capital gain is taxable on the sale of any shares (public or private). However virtually all CCPC tech startup shares will qualify for the LCGE (Lifetime Capital Gains Exemption), which means any capital gains tax on qualifying CCPC shares can often be eliminated.


The best way to demonstrate the employment benefit tax treatment of an option exercise, and the capital gains treatment on the sale of the underlying shares, is by way of a simplified example (see the detailed table below - with apologies for the fine print). Note that for demonstration purposes I have assumed identical option grants to two Executives, except that the strike prices are different (one at $.50 FMV, and the other at $.01).




The table above reflects a simplified scenario (if the reader craves financing logic, it assumes a combination of shareholder loans, founder sweat equity and SRED proceeds have carried the tech startup along until its $500k Angel financing in Year3.)


Option holders are not founders, so logically they should pay something for their CCPC tech startup shares (CRA expects it to be FMV at the option grant date). The total after-tax investment cost for the option holding Executive is the amount paid to the Company to exercise their options, plus CRA’s 2 levels of tax (deferred T4A employment benefit triggered by the option exercise, and capital gains tax triggered by the eventual sale of the underlying shares). The results are:


Executive1 retains 78% of their $50k share sale proceeds in Year5 (total cost = $5k paid for shares + $11k T4A tax + $0 capital gains tax). Executive1 has had to personally pay $5k FMV to exercise their options in Year2. The Company receives $5k FMV for the treasury shares issued on option exercise.


Executive2 retains 36.6% of their $50k share sale proceeds in Year5 (total cost = $100 paid for shares + $31.6k T4A tax + $0 capital gains tax). Executive2 paid a trivial $100 for their option exercise in Year2, which is a good thing of the company ultimately fails. The Company gave a discount of ($5,000FMV-$100paid=) $4,900 on the FMV share price at the time of option exercise, receiving only $100 for the treasury shares issued on option exercise. Executive2 pays a punishing level of T4A employment benefit tax to CRA in Year5.


Selecting a $.01 strike price at the option grant date might be a seductively appealing shortcut to the Board in the near term, but like not bothering to change your car’s engine oil, there is a long term price to be paid for disqualifying the option holder from CRA’s 110(d) deduction of 50% on the T4A taxable “pregnant employment benefit” triggered by the option exercise. Due to CRA’s generous tax deferral for CCPC tech startup employees, the T4A slip is not required to be issued by the Company until Year5 when the underlying shares are sold, and the shareholder has the resulting cash proceeds to pay the taxman.


The Board’s best practice is to always set the option strike price = FMV of a common share at the option grant date, as both nature and CRA intended. This means the executive only benefits from the rise in company valuation (read FMV share price) that they directly contributed to. In the long term, the Board isn’t doing option holders any favour with simplistic but convenient $.01 strike prices, unless the Company fails. The Board has no business structuring option terms around an anticipated Company failure, they should be minimizing long term tax consequences for the option holder.


It is instructive to note that the 50% reduction to the T4A employment benefit enabled by the 110(d) deduction puts the employment benefit on the exact same tax footing as regular capital gains, where only 50% is included in taxable income. Despite this 50% tax reduction similarity, the remaining taxable portion of the T4A employment benefit should not be confused with regular capital gains, which have special characteristics like being available to be offset by any capital loss carryforwards. The 110(d) deduction has a few other quirks - it is not available to founders (who should not be dipping into the option pool anyways), and it is only available if the option grant is for a common share, which I have assumed throughout this Newsletter.


The second level of tax on the Year5 sale of shares involves capital gains tax, applicable on the sale of any public or private shares. When selling CCPC shares of a tech startup, there is an opportunity to avoid capital gains tax through the Lifetime Capital Gains Exemption (LCGE). The LCGE is only available if the CCPC tech startup shares have been held for at least 2 years prior to their disposal. This is the motivation behind tax savvy option holders exercising shortly after they vest, if there is any potential for an exit shortly after 2 years. The LCGE is very generous with a $913.630 lifetime limit for 2022 (indexed with inflation). That should be sufficient to completely eliminate any capital gains tax that would otherwise be paid in Year5 when the shares are sold. If $913k is not sufficient, the taxpayer should throw a big party to celebrate. The blue font lines in the above table highlight how the LCGE behaves to cancel out capital gains tax.


To be perfectly clear, in the example above the Executives holding CCPC options of a tech startup have no tax consequences at any point in time until the underlying shares are sold in Year5. The CCPC “tax deferral glow” is retained even after an exit event where the tech startup shares become publicly traded, or they get converted into the shares of a NASDAQ acquirer. In Year5 when the related shares are sold, the taxpayer has the cash proceeds to cover the long deferred but “pregnant” T4A employment tax burden triggered by the option exercise in Year2, and any capital gains tax that might be applicable on the sale of shares in Year5.


A dramatically different tax treatment occurs if otherwise identical options are granted to a Contractor/Consultant or Board Advisor. The full FMV of those Contractor / Advisor options (as valued by a Black Scholes model) must be assessed as an immediate T4A employment benefit in that grant year, despite the options likely not having even begun to vest given the 1 year cliff. Regardless of where the option strike price is set relative to common share FMV, the Contractor / Advisor pays full tax on the T4A employment benefit out of pocket in the year of the option grant. With any tech startup there is a good chance that the options will never be exercised, or if exercised the shares will become worthless because the Company is prevented from executing on the business plan for a wide variety of reasons. So the Contractor / Advisor pays tax immediately, but any future offsetting benefit remains at risk. To twist the knife a little further, CRA requires any options granted to a Contractor / Advisor to be revalued annually using the same Black Scholes model, and if that results in an increase in option value there is an additional T4A taxable benefit to be assessed. Speaking personally as a Fractional CFO faced with this punishing option tax treatment from CRA, I find CCPC tech startup options issued to a Contractor / Advisor to be completely toxic. CRA could hardly make Contractor / Advisor option tax treatment more painful, in sharp contrast to CRA’s generous discounted and deferred employment benefit tax treatment for CCPC tech startup Employee / Director options.


Given employees can leave the Company years before they sell the shares underlying their original option grant, and they may conveniently “forget” to advise the Company when they sell the underlying shares at a future date, I am at a bit of a loss in trying to understand how CRA expects the compliance logistics to work in requiring the Company (per the example in the table above) to issue Year5 T4A slips for the “pregnant but deferred employment benefit” triggered by the Year2 option exercise. While the T4A employment benefit deferred tax rules strike me as problematic from a corporate compliance perspective, they are fair to the taxpayer. In terms of the Company’s duty to track underlying share sales of potentially long departed employees for ongoing tax compliance, the task is clearly difficult. However, CRA has a long arm, a long memory, and a big hammer. I wouldn’t mess with CRA, if I had to make a tax compliance choice.


Stock Options - Accounting Treatment


We aren’t done yet. Generally Accepted Accounting Principles (GAAP) rules require options to be valued using a Black Scholes model, or another acceptable option valuation methodology (I have never seen an alternative method used). During the early 1990’s large Silicon Valley tech companies (NASDAQ size) were granting valuable stock options to executives in the .com bubble era, allowing them to reduce salary compensation because rapidly rising tech share prices made the option grants both liquid (after vesting) and lucrative, right up to the bubble crash. This left their Income Statements with artificially reduced salary expense, and unrecorded option compensation expense. The Black Scholes valuation of options was widely incorporated into GAAP at this time to report the hidden option compensation expense. The Black Scholes model is a statistical algorithm that produces an option valuation figure based on a set of variables that are well documented in any set of tech startup financial statement notes prepared by an accounting firm doing an Audit or Review Engagement. Briefly, the variables used as input into the Black Scholes model include: number of options granted, current FMV of a common share, estimated option life (amortization period), risk free rate (eg. 1yr treasury bill rate), and share volatility (presumed to be high, but subject to a bit of negotiation with any accounting firm reviewing the financial statements).


The value of an option grant is amortized over the estimated life of the option, which is typically assumed to be the vesting period in the absence of better information. The amortization of the value of an option grant over time is recorded as a debit to “Stock Compensation Expense” on the Income Statement, and it accumulates as a credit to “Contributed Surplus” in the Equity section of the Balance Sheet. You can think of the amortization of option value over time as a twist on fixed asset depreciation. Over a period of years, depreciation expense (aka fixed asset amortization) which runs through the Income Statement as a debit, will accumulate as a credit in "accumulated depreciation" on the Balance Sheet, until the asset becomes fully depreciated over its estimated useful life. Similarly, the Black Scholes option valuation figure gets amortized as a debit to Stock Compensation Expense on the Income Statement over several years (the estimated life of the option) and accumulates as a credit in Contributed Surplus on the Balance Sheet, until the Black Scholes valuation is fully amortized. Woo Hoo! Isn’t accounting exciting?


GAAP requires heavy financial statement note disclosure for all share and option transactions. I won’t provide guidance on those details in this already lengthy Newsletter because the information is widely available. Any tech startup financial statements prepared by an accounting firm engaged in an Audit or Review Engagement will have a full set of financial statement notes with detailed share and option note disclosure.


The Board can help simplify financial statement note disclosure and reduce legal fees by batching option grants for Board approval. There is nothing wrong with the Board approving a batch of option grants with consistent terms (same strike price FMV, 4 year vesting period with 1 year cliff, 10 year expiry date, option grant date) covering all option grants during a six month period, except for different vesting start dates which can depend on the lapse of a probation period (typically 3 months) following each individual employee’s date of hire.


There is a debate about where to disclose option compensation on the Income Statement. Some accounting firms push for it to be disclosed beside cash based compensation expenses like salary. I agree this can make sense for NASDAQ public companies, and big tech companies reporting in Canada. However, I find the Black Scholes option valuation model to be aggressive in valuing private company options (no matter how you skew the input variables within an acceptable range, the option value ends up being 75-90% of common share FMV), to the point where hundreds of thousands of dollars in stock compensation expense can run through the Income Statement of a money losing tech startup that goes bankrupt a few years later. I wonder how valuable that stock compensation information is to financial statement users prior to the tech startup flaming out. I prefer to de-emphasize tech startup stock compensation by showing it below cash based operating expenses on the Income Statement, because the option value comes from a statistical model based on a range of input variables, and doesn’t carry the same decision making weight for management or investors as a cash based expense like salary.


Underwater stock options (where the common share FMV has dropped below the option strike price) can happen because management dropped the ball, or because the tide has gone out on equities in general, dragging the tech sector along for the ride. This happened dramatically during the 2008 financial crisis when tech valuations got squeezed. In general, disinterested shareholders (those not holding options) are very reluctant to see options repriced at a lower value when the Company is suffering a valuation hit, because that rachets up the option benefit for management at a time when the Company has not performed well, and all shareholders are suffering with a depressed share price. If the tide has gone out on equity investments during a financial crisis (management not at fault), it will inevitably rise again in time, at which point the underwater options have at least partly recovered. If management performance was an issue in the valuation decline, the underwater options are behaving correctly. On the flip side, management can be concerned that deeply underwater options have lost their value as an incentive to attract and retain talent. However, in a low tide situation all tech companies suffer, so there are fewer landing spots for employees looking to jump ship. In addition to these ethical arguments suggesting the repricing of options is a bad idea, the legal path to cancel underwater options and issue repriced options is complicated not only by Board and/or shareholder approval requirements, but by punishing CRA tax treatment if new options have a higher “in the money” value than the old underwater options they replace. In short, it is best to ride out the storm with the underwater options in place.


Conclusion


For a tech startup, stock options are a complex area involving legal, tax and accounting issues, and no shortage of acronyms. They are also a vital part of enabling a tech startup to attract and retain the management talent needed to plug organization holes that Founders (including the CEO) can’t cover, either because of a lack of training in a specialized area, inexperience, or time constraints.


A surprising number of tech startup lawyers set up option grants with $.01 strike prices. This is seductively appealing in the short term because it costs the option holder almost nothing to exercise options as they vest, and there are no immediate tax consequences for employees / directors of CCPC tech startups. However the long term tax consequences of a $.01 option strike price are punishing, as the 110(d) 50% deduction on the T4A “pregnant employment benefit” is denied if the option strike price is below the common share FMV at the grant date.


While CRA’s tax hit is long in coming (no impact until the underlying shares are sold years into the future), it lands hard (potentially hundreds of thousands of dollars in avoidable T4A employment tax) when it comes. The best practice is to respect CRA’s very reasonable logic that employees receiving option grants should only benefit from valuation growth that occurs after they joined the company. That CRA logic is reflected in the requirement that options qualifying for the 50% 110(d) deduction must have a strike price greater than or equal to the common share FMV at the grant date. CRA assumes (quite reasonably) the option grant date aligns with the start of the employee’s contribution to the CCPC tech startup’s valuation growth.


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