How do I set up an employee option plan?

What a stock option is

A stock option is a right to buy shares of the company later at a fixed price, called the exercise or strike price. The person doesn’t own shares until their options vest and they pay that price to exercise them. A stock option plan is the document that sets the rules for every grant.

Options are different from founder shares. Founders usually own their shares outright, subject to a buyback (see founder vesting). Option holders own nothing until they exercise.

The documents you need

A typical plan for a Canadian private company has three parts:

• The plan itself, which sets the size of the option pool, who can receive options, how vesting and exercise work, and what happens when someone leaves or the company is sold.
• Board approval adopting the plan and reserving shares for it, usually by a written directors’ resolution signed by all directors (section 117 of the CBCA, section 129 of the OBCA). Shareholders often approve the plan too, and your shareholder agreement may require it.
• A grant agreement for each person, stating the number of options, the exercise price, the vesting schedule and the expiry date.

Check that your articles authorize enough shares of the class the options will convert into. Most startup articles allow an unlimited number of common shares, but it’s worth confirming.

Decisions to make before you draft

How big should the option pool be?

There’s no legal rule. The pool is a business decision about how much of the company you’ll set aside for hires over the next stage. Investors in a priced round often ask for a pool of a particular size, and whether it’s created before or after their investment affects who bears the dilution. Model it on your cap table before you agree to a number.

What vesting schedule?

A common schedule for employees is four years with a one-year cliff, then monthly or quarterly vesting. You can choose something else, as long as the plan and grant agreements say it clearly.

What exercise price?

Usually the fair market value of a share on the grant date. This matters for tax: one route to the stock option deduction requires the exercise price to be at least the fair market value when the option was granted. Record how the board set the value at each grant.

What happens when someone leaves?

Plans usually say unvested options end when employment ends, and vested options must be exercised within a set window. In Ontario, termination language needs care. Courts look closely at whether a plan clearly and unambiguously limits what a dismissed employee would otherwise be owed during their reasonable notice period, including options that would have vested in that time. The Supreme Court of Canada set out this approach for incentive compensation in Matthews v. Ocean Nutrition Canada Ltd., 2020 SCC 26. Generic wording copied from a US plan may not do that. See employee or contractor for the employment side.

What happens on a sale?

Decide whether unvested options accelerate, are assumed by the buyer, or are cashed out. Double-trigger acceleration, which needs a sale and a termination, is common.

Securities law: options are securities

Granting an option is a distribution of a security, so it needs a prospectus exemption. Most private companies rely on section 2.24 of National Instrument 45-106, which covers distributions to employees, executive officers, directors and consultants of the issuer and its related entities. The exemption only applies if participation is voluntary: nobody can be told to accept options as a condition of getting or keeping their job.

Section 2.24 isn’t one of the exemptions listed in section 6.1 of NI 45-106 that require a report of exempt distribution, so option grants under it don’t usually need an Ontario Securities Commission filing. The private issuer exemption can also apply. If option holders live outside Ontario, the securities rules of their province apply too, so check them before granting.

Tax: why CCPC status matters

Under section 7 of the Income Tax Act, an employee who exercises an option generally has a taxable employment benefit equal to the value of the shares at exercise, less the exercise price.

• If the company is a CCPC when the option is granted, section 7(1.1) generally defers that benefit until the employee sells the shares. That avoids a tax bill on shares that can’t yet be sold.
• If it isn’t a CCPC, the benefit is generally taxed in the year of exercise.

The stock option deduction in section 110 can reduce the taxable benefit by half if its conditions are met. For CCPC shares, one route is holding the shares for at least two years after exercise. For options granted after June 30, 2021, section 110(1.31) limits the deduction where the employer isn’t a CCPC and its annual gross revenue (or its group’s consolidated revenue) is over $500 million: only $200,000 a year of vesting options, measured by the shares’ value at grant, qualify. CCPCs and smaller employers aren’t subject to that limit.

The section 7 rules apply to employees. Options granted to independent contractors are taxed differently, so get tax advice before granting options to a contractor or advisor. A change of control, such as a US investor taking control or a reorganization under a US parent, can end CCPC status and change how future grants are taxed.

Alternatives to options

Some companies use phantom equity or share appreciation rights, which pay cash tied to share value without issuing shares. Others issue restricted shares. Each has different tax and securities consequences, and options remain the most common choice for early-stage Canadian companies because of the CCPC deferral.

What investors check

In due diligence, investors check that the plan was properly approved, that every grant has a signed agreement and a board approval, that the exercise price was set sensibly, and that the cap table counts every option. Promises of “1% equity” in an offer letter that were never granted under the plan are a common gap. See getting investor-ready.

What to do next

1. Decide the pool size, vesting schedule and leaver terms with your cofounders.
2. Have the plan and grant agreement drafted for a Canadian corporation and approved by the board.
3. Get tax advice on your CCPC status and how you’ll value shares at each grant.
4. Keep a grant register that matches your cap table.

We prepare stock option plans, including board and shareholder approvals and a standard grant agreement, at a fixed fee shown on our fees page. Fees are in Canadian dollars and exclude HST; government filing fees and other disbursements are charged at cost. See also hiring and equity and our legal budget planner.

This guide is general information about Ontario and Canadian law, not legal or tax advice for your situation. To talk through your plan, book a free 15-minute consult.