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Question from reader: What should I do with my employee stock options?

Answer from Benjamin Felix, an associate portfolio manager with PWL Capital in Ottawa.

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Ben Felix helps Canadians invest their money, and writes about it at csinvesting.ca.

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An employee stock option (ESO) is the option for an employee to purchase their employer’s stock for a fixed price - referred to as the strike price or grant price - which is determined when the options are granted to the employee. ESOs typically have a vesting period and an expiry date.

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ESOs cannot be exercised until they have vested, which is the period of time that an employee must wait before being able to exercise their options. Vesting can happen over various time periods and follow various structures. Leaving a company with unvested options means foregoing the remaining unvested benefit. This is one of the reasons that employers offer stock options – it can improve employee retention. Stock options also allow start-ups to attract top talent despite being unable to pay large cash salaries. Realizing the value from an employee stock option plan requires exercising the options. Exercising means buying stock from the employer at the strike price set in the employee stock option contract.

Tax implications

If the employer is a Canadian Controlled Private Corporation (CCPC) when the options are granted, then there are no tax implications on exercised options until the shares are sold.

If the employer is a publicly-traded company, the taxable benefit is triggered at exercise whether or not the shares are sold. This makes exercising employee stock options to hold public company shares risky from a tax perspective.

The taxable benefit arising from ESOs is equal to the difference between the strike price and the market value of the shares at exercise. If options granted by a public company with a $5 strike price are exercised to purchase shares currently worth $15, the employee will have a $10 taxable employment benefit added to their T4 income for that year.

If certain conditions are met, the employee will receive a deduction for a half of the taxable benefit under paragraph 110(1)(d) of the Income Tax Act.

How to think about employee stock options

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If your employer’s share price continues to rise, the benefit of having the option to purchase shares at a fixed strike price continues to grow. If the share price falls, the benefit falls, potentially falling to zero if the market price falls below the strike price.

The risks specific to any individual company make it very difficult to say that its share price will increase over the long term. Based on this uncertainty, it would be sensible to use the proceeds from employee stock options to diversify into a portfolio with a more statistically reliable long-term outcome or to achieve an immediate financial goal.

While holding on to employee stock options may not be sensible, employees are subject to many biases that might affect their approach. Being aware of these biases may help in making sensible decisions.

Regret aversion: Employees will often fear missing out on future gains if they exercise their options. This is especially salient when their co-workers also have ESOs. Being the first one to exercise and sell could mean being left out of the millionaire club, as unlikely as that outcome may be.

Illusion of control: Employees may feel that their actions at work will have a direct impact on the share price. While engaged employees are an important part of any company, it is highly unlikely that any individual employee will directly affect the price of their company’s stock. If an employee is able to have this type of immediate impact, they are likely in possession of material non-public information and would not be able to legally sell their shares.

Optimism: People in general tend to believe that they are less likely than others to be subject to negative outcomes. From 1994 to 2017, a portfolio of global stocks returned 8 per cent annually, in U.S.-dollar terms. Removing the top 10 per cent of performers each year reduces the annualized return to 3.6 per cent. It is unlikely that most companies will produce market-beating stock returns. Diversifying will lead to a more reliable outcome.

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Mental accounting: Employees will often treat their stock options as distinct from their other assets. Comments like “these aren’t real money” or “I didn’t really do anything to get these so I don’t care if I lose them” are common. The reality is that vested employee stock options are as good as cash, assuming that there are no restrictions on selling company shares. It may be helpful to think about the dollar value of your vested options and ask yourself if you would use that cash to purchase shares in your employer as opposed to buying index funds or paying down your mortgage. In most cases the answer is no.

Anchoring: Employees who watch their company’s share price may become anchored at a recent high price and feel unwilling to sell their shares for less. This is of course problematic because stock returns are random and will not necessarily return to a previous high point.

While it may be rational to diversify, regret from missing out on potential wealth could have a real psychological impact. The right decision for any person will come from understanding what is rational, checking their biases, and making a decision that they can live with in both a best-case and a worst-case scenario.

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