What are employee stock options?

Employee Stock Ownership Plans (ESOPs) are a benefit program allowing employees to own shares in your business and profit from their appreciation over time. They are qualified plans with contributions that meet CRA standards to get special tax exemptions and benefits. Employee stock purchase plans allow them to accumulate company stock during their tenure and exchange it for cash value when they leave or retire. Business owners can then reallocate these shares to other employees or use them to create new ESOPs for their recruitment strategy.

These plans only use a portion of the company’s total stock offerings, aligning an employee’s motivation with financial success without affecting company management, voting power based on shares or administrative structure. However, owners can also use an ESOP to redistribute shares that control the business, choosing when and if they want to transfer certain shares to employees.

How do employee stock option plans work?

When you create an ESOP, you can set up a trust as a separate entity to hold company shares. The company can fund this trust by depositing money, taking out a loan or combining both. The trust then buys a specified number of shares from the company or external or public sources. After the trust acquires company shares, it distributes them to employees based on factors like their contributions to the company, pay grade, length of service or another fair formula. Employees can accumulate more shares over time, like a traditional retirement fund that grows with every employer contribution. When an employee leaves the company or retires, they sell back their shares to the trust. The trust then reallocates these shares to other employees eligible for the stock option plan, keeping company ownership within a select group of employees over time.

Benefits of employee share plans for employers

Employee stock option plans have many benefits for employers, such as:

Lower turnover

A long-term benefit of ESOPs is that they financially incentivize employees to stay with the company. By having employees and management involved in share ownership, you give them a reason to stay with your organization and let the value of their shares grow. ESOPs can increase loyalty and reduce turnover, saving your company money on recruiting and training new staff.

Business preservation

Having an external trust manage the shares only for employees can ensure your business will continue to run smoothly even after company leadership retires. This strategy can promote continuity, as shares are constantly reallocated to employees when others leave. Since employees care about the company’s success because it affects their shares, they will typically act in its best interest.

Tax benefits

Employee stock purchase plans can give your company the following tax deductions:

• stock contributions to the ESOP, providing company leadership with a cash flow benefit from new share issuance
• cash contributions to the trust, whether to repurchase shares or keep them as cash reserves for future needs
• dividends and loan repayments through ESOPs

Create a share market

You can use an ESOP to stabilize the share market. This model allows your company to issue new shares to employees for fundraising or repurchase shares using tax-deductible cash and loans. Owners can also transfer business control to employees by increasing employee ownership.

Employee savings plan

Employers can offer stock option shares as part of an employee savings plan. By matching employees’ savings contributions with shares from the ESOP rather than cash, you can contribute more and conserve your cash flow for other purposes.

Benefits of Employee Stock Ownership Plans for employees

Being part of an Employee Stock Ownership Plan has many benefits for employees, including:

• Empowerment: An ESOP can boost employees’ morale and motivation by giving them direct ownership and a stake in the company’s value growth. This strategy can encourage your employees to invest more in their work and your company’s success.
• Deferring taxes: Like an RRSP (Registered Retirement Savings Plan), Employee Stock Ownership Plans allow employees to defer taxes on the value of their ESOP contributions until they retire or withdraw funds from their plan.
• No fees for retirement planning: There are generally no employee fees when accumulating company stock shares.

ESOP drawbacks

While many companies find great benefits in offering employee stock options, some risks and consequences may make these plans unsuitable for your business.

• Giving equity in your company can dilute your ownership and potentially limit your future profits.
• Reduced ownership and equity can make attracting investors for business growth more challenging if you need more capital.
• Limited liquidity means employee stock options may not be enough when you want to attract top talent.
• ESOPs align with your company’s performance, so the benefit will decrease if your stock price decreases.

Types of ESOPs

There are different types of employee stock options to choose from:

• Leveraged: Companies use borrowed funds, partially or entirely, to buy shares from retiring or leaving employees. Instead of making cash contributions, the company repays the loan over time and manages ownership transition and debt repayment simultaneously.
• Non-Leveraged: An unleveraged or direct share purchase plan involves the company making cash or share contributions to the ESOP trust without borrowing. The ESOP then allocates the shares to employees based on a predetermined formula or criteria.
• Combined: This structure incorporates elements of leveraged and non-leveraged ESOPs. The ESOP can buy shares through company contributions and borrowing. This hybrid approach gives companies flexibility in funding and allows them to tailor the ESOP structure to their financial situation and goals.
• Issuance: This structure involves increasing the number of shares in the trust by adding new shares of stock. Rather than making cash contributions, the company dilutes the value of existing shares to expand the pool of shares for new and current employees.

Should you invest in an ESOP?

Before committing to an ESOP, check if it’s right for your business by considering these factors:

• Value: If your company’s stock value is already high, implementing ESOPs can be expensive. The cost of buying highly valued stock for an ESOP is higher than that of stock with a lower market value.
• Size: ESOPs are generally more suitable for medium-sized businesses that can manage the high upfront costs of setting up a stock ownership plan. Setting up an ESOP starting at $40,000 or more for smaller companies can be impractical. Small businesses might also need help with logistical challenges, especially those with few employees. Fair distribution of shares to all employees can be complex in large companies.
• Exit strategy: If you plan to sell your business for profit, ESOPs may discourage potential buyers since they need to buy out the trust. ESOPs are typically more suitable for companies not planning to sell as their exit strategy.
• Ownership structure: Although ESOPs are good for transferring ownership to employees, they may not be suitable for companies with existing succession plans, such as family businesses planning to transfer ownership to a relative.

Starting an employee stock option plan

Following these best practices can create a more motivated and aligned workforce invested in your company’s growth.

• Tax research: CRA has rules on contribution limits, administration and vesting requirements. Know these rules to reduce your liability and keep your tax info current.
• Cost analysis: Research the costs involved before deciding on an ESOP. Setting up an employee stock option can cost over $80,000, with a minimum of $40,000.
• Choose a trusted provider: Look for different plan providers to help set up and manage your trust. Hiring an external provider can ensure compliance and ongoing support for the plan.

Employee stock options can reward long-term dedication and encourage team retention. These perks can also allow employees to purchase company shares at a discount, benefiting your business and their finances.