Apr 24, 2021
Employee Stock Options (ESOs) provide an employee with the right, but not the obligation, to purchase shares of the employer’s company at a set price within a defined timeframe. The terms are documented in a contract and include the number of shares, exercise price, and timing (vesting schedule and expiry date).
There are several methods of exercising the options, including:
Not all options may be available to an employee and it will depend on the plan. It’s helpful to know the options available as the cash outlay to exercise can be substantial and some methods generate the liquidity required, so that the employee doesn’t have to pay “out-of-pocket”.
Employee stock options that meet certain requirements qualify for a deduction that results in the benefit being effectively taxed at capital gains tax rates. One of these requirements is that the exercise price cannot be less than the fair market value (FMV) of the shares when the ESO is granted. The implication is that if the company’s share price does not appreciate, the ESO will expire worthless. However, a significant appreciation in share price can be very lucrative for an employee. Important decisions will need to be made in terms of exactly when to exercise these options and what to do with the resulting common shares. Individuals may benefit from collaborating with an independent financial planner to determine the best path for their unique situation.
The value of a stock option primarily consists of two parts.
Intrinsic Value: Calculated as the difference between the fair market value (FMV) of the shares and the exercise price.
Time Value (or Extrinsic Value): The potential benefit of the share price moving favourably in the time remaining before expiration. The time value is based on the expected volatility and time remaining before expiration. When options are granted they are “out of the money” and their value consists only of time value (extrinsic value).
The benefit an employee receives when exercising an employee stock option (ESO) is the intrinsic value. As a result, the most common reason to exercise the options before expiry (and forgo the time value) is when the plan is to sell the resulting shares. However, there may be reasons for early exercise of the options with the intention of holding the shares. These motives include tax planning opportunities and the benefits of share ownership.
Employees with ESOs from a non-Canadian-Controlled Private Corporation (non-CCPC) must account for the benefit in the year that the ESO is exercised. It may be beneficial to spread out the tax impact by exercising the options over a number of years. This can reduce the marginal tax rate applied to the income and is referred to as income spreading.
There are advantages in owning common shares that are not available to option holders, including voting rights and the entitlement to dividends. When the intrinsic value is very high (FMV is significantly greater than exercise price), the time value of the options could become insignificant compared to these benefits of share ownership.
The decision on when to exercise is greatly influenced by the employee’s plan for the resulting shares. Employees will be influenced by their own expectations of the future share price. Due to the large upside potential of stock options, in cases where the company is very successful, an employee’s resulting equity ownership may comprise a very large portion of their total wealth. This is referred to as a concentrated position. The risks presented by these positions should be considered in the context of an individual’s overall financial plan.
Employee stock options often contribute to an employee’s larger concentration in the employer’s stock. Employees may have stock options that are still vesting as well as other forms of equity compensation, such as Restricted Share Units. After factoring in this exposure, employees may be surprised by the total weight of their overall financial wealth that’s allocated to the company. There is no universally accepted definition of what constitutes a concentrated position. In practical terms, a concentrated position is one that makes up a significant portion of an individual’s net worth.
Individuals should assess this concentration in terms of their total wealth which is comprised of human capital as well as financial capital. Human capital is the net present value of an individual’s expected income from their future labor (employment).
The inherent risk is that if the employer’s business is unsuccessful then both the financial capital and human capital of the employee may be simultaneously impacted. The overall risk of an individual’s total wealth can be reduced by holding investment assets that are weakly (or even negatively) correlated with their human capital.
Individuals need to consider the risk that is specific to the company’s operations, reputation, and business environment. Having a concentrated position can expose an individual to an unacceptably high level of company-specific risk that could be eliminated by holding a well-diversified portfolio. Company-specific risk can range from relatively low to high for some small and unprofitable companies.
An individual may have objectives that support retaining the risk of the concentrated position. For example, an executive may have received the options with the expectation or mandate that the resulting shares be held for a long period of time. Another example would be a private company that elects to go public, but the owner wishes to maintain effective voting control. In this situation, more complex tools such as derivatives could be used to hedge the risk.
If the employee anticipates needing to access the shares, then liquidity should also be considered. This will be relevant in cases where the trading volume of the company’s shares is small relative to the number of shares held. Liquidity can also be an issue for employees that are designated as insiders and subject to blackout periods.
An individual’s exposure to the risks of holding a concentrated position should be consistent with their overall risk tolerance. The overall risk tolerance of an individual is a function of both ability (capacity) to take risk and willingness to take risk.
Ability to Take Risk: Refers to an individual’s ability to withstand potential losses and considers objective factors, including time horizon, age, and the need for income.
Willingness to Take Risk: Refers to an individual’s risk aversion and considers subjective factors, such as personality and reaction to real or potential losses.
Individuals with unsuitably risky investment assets may sell the investments after a major decline in value and realize the losses. This was common in the market collapse of 2008-2009 when many investors had overestimated their ability to stomach the downside risk of their portfolio and sold at the bottom of the market.
Regardless of the circumstances that resulted in a concentrated position, thoughtful planning should be undertaken by individuals that decide to sell the position.
Selling shares of a publicly traded company is a very straightforward endeavour. However, when transacting in amounts that are significant relative to the individual and/or the trading volume, additional planning may be needed.
The proceeds from selling an individual stock can vary significantly based on the exact timing of when it’s sold. This is due to the price volatility of individual stocks which can be considerable even over short time periods. The degree of this volatility varies between companies and depends on a number of factors such as size, industry, and profitability.
Selling a stock only to see it increase in value shortly after can cause considerable frustration and regret for the seller. These feelings are magnified when the stock is a concentrated position and the “missed opportunity” may have had a material impact on the individual’s total wealth.
One strategy to mitigate this concern is to divide the shares into tranches to be sold over a set period. The sell transactions will net to an average price, reducing the risk of selling at the worst time. The trade-off for this downside protection is the average price will also reduce the chance of selling at a great time.
Although an employee may live and work in Canada, the shares of their employer’s company may trade on a US stock exchange. If these shares are sold in a CAD denominated investment account, the proceeds will be automatically converted to CAD at the exchange rate set by the financial institution. However, if these shares are sold in a USD denominated investment account, the proceeds will remain in USD. This will enable the seller to confirm they are receiving a competitive rate before converting to CAD. The individual will also control the timing of when to convert to CAD, allowing them to be patient if the foreign exchange rates are not favourable at the time.
Determining if the shares constitute a concentrated position depends on their value relative to the individual’s total wealth. However, for higher net worth individuals, the shares may also be significant in a general sense. This can lead to liquidity issues if the trading volume of the company’s shares is relatively small in comparison to the shares being sold. A trading strategy implemented over several days may be required to avoid driving down the price.
This article is meant to provide a general overview and is not intended to provide tax or legal advice. You should consult with professionals to ensure that your own unique circumstances have been considered and any action taken is based on the latest information available.
The most overlooked area of financial planning for business owners and incorporated professionals is the lack of integration between corporate and personal assets. When the majority of your assets are in your corporation you need very specific, specialized and personalized financial advice.
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