Employee Stock Option Plan (ESOP) in Canada

An employee stock option plan is the master document that lets a corporation reward people with the right to buy its shares later at today's price. Each option gives the holder the right, but not the obligation, to buy one share at a fixed exercise price, also called the strike price, after the option vests and before it expires. If the company grows, the holder buys at the old price; if not, the option lapses and the holder has paid nothing.

In Canadian startup practice, ESOP almost always means this kind of option plan. The directors adopt the plan by resolution, and individual grants are then made by the board, or by a committee acting within authority the board has delegated, through a written option agreement with each participant. Section 27 of Ontario's Business Corporations Act allows a corporation to issue options to acquire its securities. If the articles limit the number of authorized shares, the corporation must reserve enough shares to cover every outstanding option. Most Ontario articles authorize an unlimited number, so the reserve is usually a board decision: the option pool shown on the company's cap table.

No statute requires a corporation to have a plan, and a private corporation files nothing with the government to adopt one. A shareholder agreement or investor rights agreement, however, often requires shareholder or investor consent to create or enlarge the pool.

The acronym causes confusion because it means something different in the United States. A US ESOP is a tax-qualified retirement plan: a trust acquires company shares, sometimes with borrowed money, and allocates them to employees' retirement accounts. It is a product of US pension and tax law and has no direct Canadian equivalent, so US plan templates rarely fit.

The closest Canadian counterpart to a US ESOP is the employee ownership trust, a separate tax regime for selling a business to a trust held for its employees; our guide to employee ownership trusts in Canada explains it.

The plan sets the outer limits; each grant agreement fills in one holder's numbers. A well-drafted plan covers:

• Eligible participants. Employees, officers, directors and consultants of the corporation and its affiliates, matching the securities exemption discussed below.
• Pool size. The maximum number of shares issuable under the plan, sized for planned hires and often negotiated with investors before a financing.
• Exercise price. Not less than the fair market value of a share on the grant date, as determined by the board.
• Vesting. Usually time-based and set grant by grant; see vesting schedule for cliffs, acceleration and leaver terms, and model a schedule with the free vesting calculator.
• Term. A maximum life, often ten years from grant, after which unexercised options lapse.
• Leaver terms. Unvested options typically end when service ends, vested options can be exercised for a short window, often 90 days, and everything lapses on a termination for cause. Following the Supreme Court of Canada in Matthews v. Ocean Nutrition Canada Ltd., 2020 SCC 26, wording that removes a dismissed employee's incentive rights during the reasonable notice period must be absolutely clear and unambiguous, so these clauses should be drafted together with the employment agreement.
• Change of control. Whether a buyer must assume, substitute, cash out or accelerate options, using a definition consistent with the company's other change of control clauses.
• Joinder. Anyone who exercises must sign the shareholder agreement, so new holders are bound by its transfer restrictions and drag-along terms.
• Transfer. Options are usually made non-transferable, except on death.

Every grant should be approved by a resolution recording the holder, the number of options, the exercise price, the vesting start date and the basis for the price. Lamba Law's cap table and stock option practice prepares plans, resolutions and grant agreements.

Pricing options at fair market value on the grant date matters for two reasons. The option has no built-in gain when granted, and an exercise price at least equal to that value is one of the conditions for the employee's one-half deduction under paragraph 110(1)(d) of the Income Tax Act. The deduction also requires the option to be over a prescribed share, which broadly means an ordinary common share without capped dividends or a holder's redemption right. An option priced below value can lose the deduction; an arm's length employee of a Canadian-controlled private corporation (CCPC) can still claim the alternative deduction in paragraph 110(1)(d.1) by holding the shares for at least two years after exercise. The full mechanics are in our entry on stock option taxation in Canada.

The Income Tax Act does not prescribe a method for valuing private company shares for option grants. The board determines value and should record how. Common evidence includes the price paid in a recent arm's length financing, adjusted where investors bought preferred shares with rights the common shares lack, and, for larger or later-stage grants, a business valuation report from a chartered business valuator. Grants made just before a priced round closes, at a price well below the round price, are the hardest to defend.

An option is a security, so granting one is a distribution that needs a prospectus exemption. Section 2.24 of National Instrument 45-106, which applies in Ontario, exempts a distribution by an issuer of its own securities to its employees, executive officers, directors and consultants, to those of a related entity, and to their permitted assigns, such as a holding entity, RRSP or TFSA, if participation is voluntary. Participation is not voluntary if the person is induced to take part by the expectation of being hired, appointed or engaged, or of keeping that role. The exemption does not cover making staff buy shares to get or keep a job.

The consultant branch is narrower than it looks. A consultant qualifies only if engaged under a written contract and spending, or expected to spend, a significant amount of time and attention on the business. A casual adviser with no written agreement does not fit; the private issuer exemption in section 2.4 may be available instead.

Section 2.24 is not among the exemptions that require a report of exempt distribution, so grants under it need no report and no filing fee. Shares issued on exercise are also exempt, under section 2.42, but a private company's shares generally cannot be resold without another exemption or a sale of the whole company.

Kestrel Labs Inc., a Toronto software company incorporated under the OBCA and a CCPC, has 9,000,000 common shares held by its founders, Sana Qureshi and Liam O'Connor, and one angel investor who bought common shares at $0.25 three months ago. Before its first hires, the board adopts a stock option plan with a 1,000,000-share pool, 10% of the 10,000,000 shares on a fully diluted basis, and resolves that a common share is worth $0.25, recording the angel round as the basis.

The board grants Hannah Lee, a senior engineer, 60,000 options at $0.25 with a ten-year term and four-year vesting after a one-year cliff, then 1,250 options a month. It also grants 20,000 options to Rafael Ortiz, a designer who works three days a week for Kestrel under a written consulting agreement, relying on the consultant branch of section 2.24.

Thirty months later, Hannah resigns. She vested 15,000 options at the cliff and 22,500 more over the next 18 months, for 37,500 in total; the other 22,500 return to the pool. Within the plan's 90-day window she pays $9,375 to exercise and signs a joinder to the shareholder agreement. Because Kestrel was a CCPC when it granted the options and Hannah dealt with it at arm's length, she owes no tax until she sells the shares. The company issues the shares and updates its securities register and cap table.