Employee Share Participation Plans

Employee share ownership and participation is often an effective way to retain and motivate employees. Many public companies have some form of stock option plan which usually entitles the employee or director to purchase shares at a fixed price (generally current fair market value) for a period of time. As the shares appreciate in value so do the value of the options. At some point the employee can exercise the option, sell some or all of the shares and use the proceeds to pay the option price, any tax and pocket the difference. Often some of the large compensation payments received by executives are the result of stock options. Many companies have a logo, "Today's stock price is $X, tomorrow's stock price depends on you!"

Stock option plans are also attractive for private companies although at the outset they have the drawback of no liquidity and sometimes difficulty in valuation. In other words, generally speaking shares of a private company are not tradable, so unlike a public company the source of funds to purchase the shares (or pay tax on the share purchase) cannot come from the shares themselves.

In British Columbia there are two basic ways to structure employee stock compensation: 1) various private plans including employee stock option plans, employee share purchase plans (including loans from the company to employees to buy shares), phantom stock purchase plans (where value accrues to the employees based on the appreciation of the value of the company), and creating special shares for employees; and 2) the Employee Share Ownership Program under the British Columbia Employee Investment Act which provides a 20% B.C. tax credit of the amount an employee invests under a registered ESOP (maximum $2,000 per year and $10,000 lifetime). The Province of British Columbia provides cost sharing assistance of 50% (up to $5,000) of eligible costs to establish an ESOP.

One of the most important considerations of any type of plan is to make sure that the employees fully understand it and have some input into its design and operation - i.e. so that the employees truly understand the cause and effect relationship between what they do, the performance of the company they work for, and ultimately the value of the shares of the company.

From a legal perspective it is important that a plan be properly authorized by the shareholders and for a British Columbia company that the existing shareholders waive their existing pre-emptive rights to be issued the same number of shares and at the same price as the employees under the plan. Issuing shares to employees (particularly at a discount price) does cause dilution to the other shareholders of the company, but hopefully this dilution is more than offset by the added value to the company.

Income tax considerations are also very important. Generally where shares are issued to someone who is at arm's length with the company (does not own 50% or more of its shares) there are favorable tax consequences in that no tax arises until the shares are actually disposed of. Absent this provision, and in the case of a public company, tax arises immediately on the exercise of the option. An employment benefit equal to the difference between the strike price and the fair market value at the time the option is exercised is included in income. In certain cases this is eligible for a 50% deduction to equate to capital gains treatment.

Special care should be taken when loans are granted to employees to purchase shares as negative tax consequences can occur if the shares fall in value and the employee is unable to repay the loan and some or all of the loan is forgiven.

Shares of a private company that are held for two years or more and that meet other criteria of using all or substantially all of their assets in an active business may be eligible for the enhanced $500,000 capital gains deduction and may also be eligible investments for RRSP's. There is also an election that can be made when an eligible Canadian private company elects to go public on a Canadian stock exchange where the gain can be triggered (hence utilizing the $500,000 exemption) without actually selling the shares. Once the company ceases to be a private company the shares are no longer eligible for the exemption.

If a private company anticipates going public it should also be cognizant of the policies of the various stock exchanges on employee stock options to make sure that the company's plan or recent grants under the plan do not run afoul the stock exchange's policy. Similarly the terms of the plan should deal with such matters as what happens if the company wishes to go public (e.g. to ensure that the options are exercised or expire before that time).

Kim Johnson is accredited under the British Columbia ESOP program and has had experience establishing employee compensation plans for private and public companies.