Employee Stock Ownership Plans with Justin Rousseau from KRP
Hi friends! Welcome to the blog recap of our Entrepreneur Education Series. Today, we’re sitting down with Justin Rousseau (JR) from KRP to talk about ESOPs, or Employee Stock Ownership Plans.
Kingston Ross Pasnak LLP is the largest, local, independent full service accounting firm in Alberta. Justin has been with KRP since 2003, and focuses on assurance and advisory, working with clients in the startup, construction, real estate development, manufacturing, technology, professional and financial services and not-for-profit sectors, providing audit, taxation and business advisory services.
So let’s get down to business and recap the Education Session for you. Spoiler alert, we talk about a variety of different accounting and legal paths regarding ESOPs, so hang on!
TNT: Hey Justin! Thanks so much for joining us today.
JR: No problem!
TNT: So first off… ESOPs! What does it even stand for?
JR: Yeah! So ESOPs are Employee Stock Ownership Plans. ESOPs are essentially plans that allow employees to have ownership of your company. There are a ton of different ways to structure the plans, but at the end of the day, the goal is to benefit your employees, and give them motivation and a feeling of ownership in the company and its growth.
Before we talk about the plans, I’m going to give you a quick 101 on a few terms that we’ll be using today.
The vesting period is the time between the grant date and the vesting date, and is the period of time before the employee gets the ownership of the stock/option that you’re granting to them. As an example, today you agree with the employee that they should have ownership of 40,000 shares. You say that they need to stick around for 12 months to get the first tranche of 10,000 shares. Then another year for another 10,000, etc. While the stock/options are granted and the employees know how much they’re entitled to in the future, employees haven’t really earned them yet - if they leave tomorrow, they actually got 0 shares. It’s basically a no-fly zone that encourages retention while also providing the employee with the upside of participation.
You can offer the ESOP as part of a recruitment tool, or as a benefit/bonus once they’re already working with you. It’s common for employees to be working for you for at least a year before the ownership vests so that the fit for both you and the employee has been proven out before the employee has ownership of the company (which is trickier to unwind than the relatively simple employment termination - more on that later).
Options vs shares - shares are obvious. They’re the pieces of ownership of the company that you probably have. Options are contracts between the company and the holder of the contract (here, the employee) to purchase shares of the company for a predetermined price on or before a predetermined date.
E.g. an options contract to purchase 40,000 shares for $1/share on or before June 30, 2032.
We’re going to be talking about the most common stock ownership plan, which is the stock option plan (ESOP from here-on-out refers to the option variety unless otherwise stated). Here’s some option-specific lingo:
The strike price (that $1/share that we mentioned above) is the predetermined price that you will sell the shares of the company at, to the employees. You’re giving the employee the upside on the stock above this price, with the benefit of not having to pay that price today. (More on how to determine the price below, and also on how to communicate the value of the options to the employees).
For options, they also have an expiry date, which is the date on or before which the employee has to exercise the options and purchase the shares. You typically don’t want the employee to actually have to outlay cash for your shares, and if the options bump against expiry before an exit, they’ll have to exercise the option and pay the strike price. In the example above, they’d have to pay you $40,000 for the shares if you don’t liquidate before June 30, 2022. Instead, forecast an exit timeline for the company, plus 3 or 4 years, just in case anything happens that extends the exit period. As an example, 10 years (but talk to a lawyer on this topic and many others in here!). If you don’t set the expiry date far enough into the future, it’s generally tricky to change it, and you’ll often have to cancel and re-issue the options (and re-price them..! More on that below).
TNT: Great, thank you for outlining the basics! Let’s dig into strike prices. You hear sometimes of startups having a 1 penny strike price. But you and I have talked before, and that often ends up harming the employees.
JR: Yeah, 100%. So the penny price. It LOOKS like it’s great, because it’s so cheap. But the truth is that when you issue the options, you need to have the strike price be the current value of the company or higher. If you set the price lower than the value of the company, that gain that they get, will be treated like regular income and TAXED like regular income.
If the strike price is set properly, only half the gain is income (like capital gains), which means they only pay half the amount of tax (or less, depending upon the graduated tax rates). Granted, this is a good problem to have because there’s definitely income and cash happening here, but it’s an avoidable and sometimes considerable amount of tax.
TNT: Oh man, so that’s a big hit when tax time comes. So can that be changed by the company?
JR: Technically yes. Two situations:
If an option has been issued and not exercised (regardless of whether they’re vested), the options can be canceled and new ones can be issued with the strike at or above fair value so that tax consequences are minimized for the employees. That said, they’d need to be reissued with the strike at/above today’s fair value, which may be materially different than when they were issued previously.
But if the options have been issued and exercised (i.e. they hold shares and paid for them), then it can’t be changed.
This is a situation where if you’re in this position it’s likely worth a conversation given the impact to value of the options (i.e. difference between issued and potentially reissued strike prices) and the tax implications (i.e. whether paying full tax or 50% capital gains-like tax).
TNT: So how do you set a strike price?
JR: If you’ve done a recent raise, that makes it a lot easier, because you can base it off of that. But if you haven’t, especially with tech startups, it can be a lot harder. You can either look at previous financing or fundraising rounds, the potential revenue of the tech, number of users, increase in revenue, etc., OR you can have a formal valuation done. Another area worth a conversation, but you want to have the basis for this written down so that when CRA comes asking upon unicorn status, you have the back-up and your employees don’t have to pay full-tax.
TNT: So going back to vesting periods and the expiry dates - can a company unilaterally change the expiry date if you need to?
JR: Typically what we suggest, if you have a plan in place to sell or exit the company, you work that into the option life period, and then extend it by 3 or 4 years.
And in answer to your question about changing expiry dates - the answer is a maybe. It really depends on how the options are drafted initially. Make sure you have a lawyer involved, so you can add in that type of extension. And if you don’t have an extension option outlined in the draft, then you can’t just add on years. You’d have to cancel and reissue the options.
TNT: And why don’t you just set a long expiry date, like 100 years, so you don’t have to extend it, if your plans change?
JR: There are no real negative consequences to a long expiry date, but if you have a super long life period, it’s hard to expect employees to continue to be motivated by the options. The ESOPs will essentially lose their purpose of being available to employees to give them ownership and accountability for the company.
TNT: Gotcha. Ok, let’s nerd out some more. Let’s talk about lifetime capital gains exemptions.
JR: For sure. So with the lifetime capital gains exemption, it applies to individuals who hold shares of a private company, and who have the majority of their assets tied to the operation. Gains of roughly $900K (this changes for inflation each year), would be tax free. An example of when they wouldn’t qualify for this, would be if the employee doesn’t exercise their options until right before the sale. An example of when they would, is if they exercise their options and hold ownership for about 2 years, they would qualify then.
TNT: Makes sense. So going back to kinda how we started the conversation, why should companies or startups consider incorporating an ESOP?
JR: Well, it’s a great low-current cost (higher long-term cost) option to retain good talent. This is a great way to incentivize someone to continue to work for you, and grow the company, because they’re going to receive the benefits in the future.
I say that it’s a low-current cost, because it doesn’t really cost anything to implement, other than the professional fees. I say that it can be higher long-term costs, because you’re essentially diluting your ownership of your own company. That’s a factor you have to take into consideration when putting in place an ESOP.
TNT: Is there a right time in your company life to introduce an ESOP? Like at what point in the journey should a founder consider it?
JR: The answer is tricky. There’s no 100% correct answer, there’s no one right time to introduce an ESOP. You need to look at your specific situation, and figure out if it will really motivate your staff the way you want it to. If your staff doesn’t care about the options, then the incentive doesn’t really work.
I would strongly advise against doing it too early, because so much can change in a startup, so quickly. You’ll see founders set up the option plan, and within 6-8 months, because it doesn’t take long for a startup to change, the thought process of what was going to be beneficial to getting the options to the employees and the actual process is completely different, and the entire plan has to be amended.
It’s always good to have something percolating in the back of your mind, and have an idea of how you want to include an ESOP, but I wouldn’t go ahead and actually execute it.
TNT: Let’s quickly talk about terminated employees.
JR: Totally. So typical, when an employee holds options and the termination happens, there is an employment agreement and option agreement that says on the termination date, all options are forfeited.
We also strongly recommend drafting a USA (unanimous shareholders agreement), that can help deal with these types of situations. USA’s usually have a formula that outlines how the company will buy back shares from the terminated employee, if the shares have been exercised. And so effectively, if an employee has exercised their options, the company buys back the shares at a pre-agreed upon price.
TNT: Great, thanks. And before we head to the audience questions, let’s talk about financial statements. What’s the accounting impact of an ESOP?
JR: It does hit the financial statements. Once you calculate the cost associated with the options, that will show up as an expense in your company. The off-setting side will be reported as an equity.
TNT: So if I issue options today to an employee, does that cost hit my statements when I issue them or when the vesting period is up?
JR: Only on the vesting date, but you calculate it on the grant date. You do the calculations on the day it’s issued, and keep it in your back pocket, and then once the vesting date has passed, you record the related expense.
TNT: Ok, and now a question from our audience. They ask, “For awarding stock/options, we are looking at a combo of years of service plus % compensation + long term bonus. Is there a formula we should use to calculate this?”
JR: Honestly, there’s no formula, and no right way or wrong way to do this. The focus on awarding stocks and options should be on who you want to retain and what roles do you want to retain? For example, do you need the options to retain a top developer? Do you need the options to entice an engineer to work with you? Those are the considerations you need to make.
And I also tend to hesitate to issue shares to anyone who hasn’t been with the company for a significant amount of time… like a year or so. Unless you’re a very early startup and you’re using it as an enticement to get a key co-founder, developer, etc. on board to help you execute your company’s vision.
TNT: Good point. And another question here. They say, “What are some key options agreement characteristics that typically differ when issuing stock options for C-suite (like hiring talent that you can’t fully compensate yet) vs employees (motivating them to increase the growth of the company)?”
JR: Quantity is usually the key difference between the shares you issue the C-suite and other employees/staff. With the C-suite, you’re usually working it into their overall compensation package, and they’re typically voting shares. Whereas with other staffs, it’s typically a lower amount of shares, and they’re usually non-voting shares.
TNT: Makes sense. Especially because you don’t usually want all of your employees to have a vote on your operations or all the in’s and out’s of the business.
Ok, looks like we have one last question from the audience. They ask, “Have you seen anyone get creative with structuring options agreements with C-suite talent to make sure their reward is aligned with the company's best interest? For example, can you add some performance metrics into the options agreement?”
JR: Yes, you definitely can, and you would typically tie it to other metrics that you’re evaluating. It would be the same kind of metrics that you would issue regular cash bonuses on - revenue targets, customer acquisition targets, etc. If we hit goal X, then you receive Y in shares.
TNT: Well, this has been super informative. Thanks for all your advice and for breaking down ESOPs for us, Justin.
JR: Anytime! If anyone needs help with ESOPs or other items, they can contact me at jrousseau@krpgroup.com.
TNT: And if you need other resources, this is a great article that we found on Medium that can help break down ESOPs, option calculations, etc.