Silicon Valley North #22 August, 2000

The Way I See It… by Michael C. Volker

There are Better Options than Stock Options

Stock Options are seen by many as a way for employees to participate in the ownership of a company. That is, they appear to serve as a surrogate for actual equity participation but, in fact, they discourage stock ownership.

For public companies, options are an essential part of an executive compensation package, with the potential to handsomely augment a manager's salary. They work well as an income - not as an investment - component.

As a company evolves, we'd like to be able to bring in new management as additions to the founding team. Unfortunately, even a year or two post-startup, it is no longer possible to simply issue more founders shares because they are immediately subject to a tax on the difference between the so-called fair market value of the shares and their cost. In the case of a Canadian Controlled Private Corporation (CCPC), this tax assessment can be deferred until the shares are actually sold but for non-CCPCs, such as smaller public companies or many startups funded with off-shore capital, the tax must immediately be paid.

No wonder stock options are popular. There are no tax implications until the options are exercised. However, when the options are exercised, the holder is immediately subject to income tax, not a capital gains tax. This tax is payable whether or not the shares are actually sold. Sure, as per the recent Federal budget, up to $100K per year can be deferred until the gain is realized but there are other problems, too. Suppose that the shares acquired under option decline in value. In this case, you get no tax relief.

Let's look at an actual scenario: Jill joins a company and gets 10,000 stock options at $1. In 5 years, the shares hit $100. Jill scrapes together $10,000 and invests in the company, now holding $1 million in shares. Subsequently, the market tumbles and the shares decline to $10. She decides to sell, making a $90,000 profit. She believes that she owes taxes on $90K. In fact,she owes taxes on $990k of income ($1M minus $10K). She does have a capital loss of $900K but that doesn't help her unless she has other capital gains. She now has a tax bill of more than $300K (i.e. 50% marginal rate applied to 66% of the $990K) - not a great way to treat an employee-investor!

Obviously, the Canada Customs and Revenue Agency sees income from options strictly as employment income. Mixing income with investment can backfire. Investors generally do not want employment income. They prefer capital gains especially with the new rollover provisions which permit re-investment in new ventures on a tax-deferred basis.

What other "options" are available? For non-CCPCs there are two viable alternatives: 1)do a corporate reorganization under which you freeze current values in preferred shares and issue new zero-cost founders shares to all shareholders, or 2)implement a stock purchase plan. For a CCPC, a third option exists, i.e. employees can be receive shares with the tax on any deemed benefit being deferred until the time of disposition.

The reorganization approach can easily cost up to $10,000 in accounting fees and can be inconvenient except in cases where major new players need to be accommodated. But, the company may be in the same situation another year from now when new folks again enter the scene. The stock purchase plan offers the simplest solution for getting employees on board as investors. The company can provide an interest free loan (this is a taxable benefit but because the loan is for investment purposes, the deemed benefit is deductible). Employees thus become, and are treated like, real investors for the long haul.

The way I see it, an employee stock ownership plan is a much better way of facilitating true equity participation. Options, under our current tax rules, discourage ownership and should be relied upon only on the income side of the equation.

Michael Volker is a high technology entrepreneur and director of Simon Fraser U's University/Industry Liaison Office. He is a former executive director of the BC Advanced Systems Institute and is chair of the Vancouver Enterprise Forum. He may be reached at mike@risktaker.com.