Equity compensation – three traps for the unwary

For most technology and emerging growth companies, equity incentives (including stock options, restricted stock and stock purchase plans) are an essential tool to attract, motivate and retain key employees. Equity compensation plans need to address a complex interplay of employment, tax, securities, corporate or accounting issues. This articles covers three traps for the unwary.

(i) Vesting after termination of employment

Management and investors often assume that if an employee is terminated, the employee’s options or restricted stock grants will cease to vest on the date of notice of termination or notice of resignation. This expectation, however, does not reflect the current state of the law in Ontario. Ontario courts have taken the position that, unless a plan or option agreement provides very clear wording to the contrary, in the event of the termination of employment of an option holder, vesting will continue through the employee’s notice period. As described above, if a terminated employee is entitled to common law notice, this can result in unintended lengthy periods of additional vesting after the employee has ceased to work for the company. It is possible to limit vesting to the period of actual service if a plan or option agreement contains a properly worded provision which provides that vesting ceases on notice of termination or on the last date of active employment. However, the wording that is necessary to effect this result is constantly subject to challenge in Ontario courts, so it is important to ensure that your plan reflects the most up-to-date state of the law. Similar issues arise with post-service exercise periods. That is, to the extent an option is exercisable after termination of employment, the clock on the exercisability period should “start ticking” on the last day the employee works for the company, not at the end of his notice period.

(ii) Corporate law restrictions

Holders of equity incentives are not just employees, they are also current or potential minority stockholders, and should be treated as such. From an investor standpoint, it is important that shares acquired under an equity compensation plan are subject to appropriate contractual restrictions. These include a right of first refusal, a drag-along, a “buy-back” of vested and/or unvested shares on termination of employment, and a post-IPO market stand-off agreement. In some situations, we have seen a number of companies attempt to take a short-cut to some of these restrictions by imposing a “voting trust” that purports to transfer voting power over the shares to an officer of the company. In our experience, even if these voting trusts are enforceable, they can put management in a conflict of interest position, and should not be relied upon as completely effective replacements for traditional drag-alongs, powers of attorney, share escrows and other restrictions.

(iii) Securities law compliance

A company must comply with the securities laws of each jurisdiction in which it has executives, employees or consultants who receive securities under an equity compensation plan. There is a requirement that an employee’s participation in a trade must be “voluntary”, that is, an employee cannot be induced to purchase securities by expectation of employment or continued employment. For this reason, among others, serious securities law (and employment law) concerns apply to schemes in which startup companies purport to compensate employees with shares “in lieu of” salary. The consequences of failing to comply with securities laws can be severe. Ontario has administrative penalties for non-compliance with securities laws of up to CA$5 million and/or imprisonment for up to five years per infraction, which can potentially apply not only to companies but to directors and officers who authorize, permit or acquiesce to the non-compliance. Other additional penalties may also be levied depending on the offence.

Questions? Email us at startups@dentons.com.