Employee Stock Options: Get Them Right

By Christopher Ferguson and Stephen Acker

In 2010, Jen-Hsun Huang’s salary was $1. No, he’s not a fresh-faced intern. Rather, Huang is the CEO of Nvidia Inc., the graphics and mobile chipmaker with Intel-sized ambitions.

In that context, $1 seems like a meager reward. You would imagine that out of the firm’s $844 million in revenues, the board of directors could have found some cash to pay Huang minimum wage. Of course, the Nvidia CEO earned much more than $1: He is the 10th highest paid CEO in corporate America, with $34.4 million in total compensation. The extra $34,399,999 came from stock options. His story is similar to another, better-known tech executive: Steve Jobs. The Apple CEO is famous for drawing a $1 salary to keep him on the company’s health plan.

Stock options have long been part of a top executive’s compensation package. But they are often available to lower-level employees as well. While there are valid reasons to use equity compensation — stock options preserve cash, and there is a widely held view that they align employee interest with company growth — options carry extra complexity relative to ordinary salaries.

This is true with respect to taxation, securities law, and most important for our purposes, Canadian employment law.

If judges were financial analysts, they would be financial analysts
The last thing employers want is for employee stock options to find their way into a wrongful dismissal claim. But it happens regularly. Case law from across Canada is littered with decisions that include employee stock option plans in calculating the compensation owed for a wrongful dismissal.

From the outset, this presents problems as damages are always paid in cash. This means that one of the goals of equity compensation — conserving cash — is thwarted when employee options find their way into claims decided in the courtroom. Worse, case law acknowledges that there is no standard way to calculate damages arising from lost equity compensation. But if an option plan is a significant part of an employee’s compensation and is part of a claim for wrongful dismissal, the court has little choice but to try to assess the damages.

Courts diverge greatly on methodology. In one case, a panel of the Ontario Court of Appeal agreed with the trial judge’s decision to value lost options profits based on what would have been a nifty investment strategy. One best applied with hindsight. In another case, the courts used the employee’s previous options exercise and trading strategy as their guide to valuation.

Prevention is preferable
The best way to avoid this uncertainty is to make sure that employee option plans are shielded from a wrongful dismissal claim. Thankfully, the language of the employee plan, if carefully drafted, can do just that.

To avoid judicial sleight of hand (often weighted in employees’ favor), employers must do two things:

• include provisions that make it clear that the option plan is apart from ordinary compensation and that it doesn’t increase damages from wrongful termination; and
• make it clear that the option plan expires precisely when an employee is terminated in practice (the last day of work) and not at the end of the reasonable notice period, whatever that may be.

Accomplishing the above should be simple. But, as is often the case in law, doing the straightforward can be complicated. While the language of the option plan guides its interpretation, there is an assumption that its language complies with lawful dismissal. This is because a reasonable notice period is an implied term of all employment contracts. So, it’s assumed that the language of the option plan will conform with the language of the employment contract. Therefore, if an option plan provides that an employee’s rights under the plan cease on the date of “termination” or the “effective date of termination,” courts will interpret such language as the end of the reasonable notice period.

To avoid an unfavorable interpretation of the option plan, its language must make it absolutely clear that vesting, and the ability to exercise options, cease at a time before the end of the notice period despite the legal obligation to provide a notice period. Canadian case law suggests that the best clauses include language like “on receiving notice of dismissal” or “when the employee ceases to perform services.” The potential problem for employers is easily fixed by proper wording and a little foresight. Neglecting to do so could end up turning a judge into a reluctant financial analyst, keen to use the benefits of hindsight.