THE EQUITY INCENTIVE CANADIAN STARTUPS NEED (HINT: IT IS NOT STOCK OPTIONS).

AuthorTingle, Bryce C.

Growth companies contribute disproportionately to Canada's job creation, economic development and innovation. Most growth companies can match neither the salaries nor the security of more established competitors for executive talent. This makes their only advantage--the growth prospects of their equity--particularly important part of their compensation arrangements. Canadian growth companies (and Canadian businesses generally) make less use of equity incentives than their American peers and the kind of incentive they use almost exclusively, stock options, are strongly criticized by politicians, academics, institutional shareholders, and corporate governance experts.

Stock options are accused of contributing to income inequality and creating incentives for value-destroying behaviour in large established corporations, but it is not clear these critiques have much to do with their use by growth companies. As well, it is not clear why these companies should be restricted to the use of stock options as the only equity incentive scheme available to them without adverse tax effects. For example, there are good reasons American growth companies make extensive use of share grants. As Canada enters its fourth round of amendments in this century to the tax rules relating to equity incentives, it is time to consider a tax regime that begins to differentiate between growth companies and their larger, more established counterparts, and that ceases to differentiate between issuing an option to acquire shares and simply issuing shares.

Table of Contents INTRODUCTION I. THE DEBATES AROUND STOCK OPTIONS II. THE USE OF STOCK OPTIONS BY CANADIAN STARTUPS III. THE PROBLEMS WITH STOCK OPTIONS IV. ARE CORPORATE GOVERNANCE FAILURES THE EXPLANATION FOR CANADIAN EQUITY COMPENSATION PRACTICES? V. THE IMPACT OF CANADIAN TAX POLICY ON THE USE OF STOCK OPTIONS VI. THE EQUITY INCENTIVE CANADIAN STARTUPS NEED VII. CONCLUSION INTRODUCTION

The fastest growing companies in Canada contribute disproportionately to the country's economic and employment growth. (1) They labour under many disadvantages, such as the much-discussed scarcity of institutional capital focused on the earliest stages of their development. (2) Some of the disadvantages faced by Canadian startups seem almost intractable, such as the small size of the Canadian market and the paucity of experienced executive talent outside the natural resource sector. This paper, however, is about a problem that is comparatively easy to fix: Canadian growth companies (and Canadian businesses generally) make less use of equity incentives than their American peers and the kind of incentive they use almost exclusively, stock options, are almost universally regarded as inferior. Stock options set up perverse managerial incentives, fail to operate at all in certain conditions such as the current down-market, and make it very difficult to attract badly-needed managerial talent, particularly if already employed in other countries. (3)

The explanation why Canadian startups continue to use an equity incentive that many of their executives, directors and investors regard as less than ideal, is connected to Canadian tax rules. The federal government is in the midst of its fourth attempt to reform the tax regime around stock options in less than twenty years. (4) It is difficult to think of any set of technical tax rules that has received such constant attention. Since the tax treatment of options was extensively revised in 2000, the importance of this form of equity to startups has occupied the center of the debate. (5) But no one is asking: why stock options? Why should the government decide which compensation structures are used by startups?

  1. THE DEBATES AROUND STOCK OPTIONS

    Stock options provide their holder with the right to buy a certain number of shares at a price that is set at the time the option is granted. The number of shares that may be purchased vests over time and the option, itself, expires five to ten years after it is issued. Once vested and prior to its expiry, the holder of an option can pay the exercise price to acquire the shares. This is only done when the share price of the issuer has increased above the exercise price, and nearly always only when there is a liquid market for the underlying shares, because the option holder must sell some of the shares to cover the price of exercising the option and, as we will see, to pay the tax owing from exercising the option. The value of the option at the time of exercise is the difference between the exercise price and the then current market price.

    There are two different debates about stock options in Canada: one involving the corporate governance of large, mature companies; the other around income inequality. Neither has much to do with the use of stock options by startups, but startups are adversely impacted by the outcome of these debates all the same.

    The corporate governance debate is the oldest. Corporate managers are in the decision-making business: committing investors' resources to corporate projects and then effecting a multitude of adjustments, large and small, over the course of many years to ensure the organization succeeds in these projects. These decisions can be skewed by managers' prejudices, inertia, failures of character, indifference, foolish disregard for risk, too extreme fear of risk, self-interest, and inattention. If a corporation can improve the decision-making of its managers in a broad and systematic way, it will achieve materially better returns from its opportunities. Properly calibrating executive pay structures has generally been seen as the best tool available to do this.

    Economics is predicated on the idea that people respond to incentives and so a great deal of the debate about corporate governance has revolved around the proper structure of executive compensation. (6) This has not been considered a simple task and executive compensation packages have grown increasingly complex over the past several decades. (7) An executive compensation advisory industry has grown alongside the changing compensation norms and very few boards now set executive compensation without input from specialized consultants. (8) For their part, the advice provided to institutional shareholders by proxy advisory firms such as Institutional Shareholder Services and Glass-Lewis on the subject of executive pay is so complex that it won't fit in their proxy voting guidelines, requiring separate detailed treatment. (9) Even these stand-alone executive pay guidelines don't include many of the models required to actually evaluate pay practices and generate voting outcomes. (10)

    For reasons we will discuss later, since the dot-com collapse and the Enron era frauds, stock options have been a major issue in arguments amongst managers, boards, proxy advisors, compensation consultants, and the various third parties that concern themselves with corporate governance. (11) Well-coordinated shareholder proposal campaigns have been launched against Canada's largest companies demanding the curtailment of their use of stock options. (12) An article in the (usually staid) Canadian Chartered Accountant's professional publication, can, without much further elaboration, refer to "Shareholder and political controversy over lavish salaries, perks and dubious compensation tools, such as stock options ...", suggesting that their continuing use is a function of managerial intransigence. (13) Similar sentiments can be found in Canada's national newspapers, (14) the reports issued by think-tanks, (15) and statements by the tribunes of good governance in Canada such as the Shareholder Association for Research and Education (SHARE) and Canadian Coalition for Good Governance. (16) In every case the arguments against stock options are couched in terms that suggest the continuing use of options represents a failure of governance. (17)

    The second argument about stock options has revolved around the growth of income inequality in the West over the past forty years or so. The most prominent advocate of the view that stock options are central to this story is Thomas Piketty, who pointed out in Capital in the Twenty-First Century, that stock options are "a form of remuneration that has played an important role in the increase of wage inequality...". (18) Other observers have noted that "The staggering increases in the compensation of corporate executives of US Stock-exchange listed companies stems particularly from stock options and other forms of compensation that are linked to the value of the corporate stock." (19)

    The politicians have noticed. The 2015 national election included pledges by the Liberals and NDP to increase the taxation of stock options. (20) There was an aborted attempt by the Liberals to do so in 2016, that was withdrawn because of protests from Canada's startup community. (21) However, in June 2019, the government introduced a Notice of Ways and Means Motion to effect changes to the taxation of stock options with the express goal of reducing inequality. (22) The Department of Finance's press release noted the benefits of the tax treatment of options, "are disproportionately going to a very small number of high-income individuals." (23) The release goes on to note that six per cent of stock option deduction claimants accounted for almost two-thirds of the cost of the deduction to taxpayers. (24)

    The most recent federal government proposal is well defined, except around the treatment of startups. This is surprising, because, as the 2019 federal budget notes, "The public policy rationale for preferential tax treatment of employee stock options is to support younger and growing Canadian businesses." (25) Canadian-Controlled Private Corporations (CCPCs), the conceptual workhorse of tax policy when it comes to entrepreneurs, would be excluded from the changes, but the government is not sure what to do about "non-CCPCs [that] could be...

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