Employee Stock Options for Startups: Canada and US
Stock options let early employees share in the company’s success. They only work if people understand them. Here is how pools, vesting and cliffs work, and the main tax rules in Canada and the US.
How do startup stock options work?
An option is the right to buy a share later at today’s price, the exercise or strike price. Options vest over time, commonly four years with a one-year cliff: nothing vests in the first year, then a quarter vests, then the rest monthly or quarterly. If the company grows, the shares become worth more than the exercise price.
Vested share by quarter: nothing until month 12, then 25%, then monthly to 100% at month 48.
How big should the option pool be?
Many startups set aside 10% to 15% of shares at seed and top up at later rounds. Size it for the hires in your plan, not a round number. Investors usually want the pool created before their money comes in, which affects founder dilution; see how to raise a seed round. Grants are approved by the board under a written option plan. What happens to unvested options when someone leaves is covered in letting an employee go.
How are stock options taxed in Canada?
For employees of a Canadian-controlled private corporation (CCPC), the taxable benefit, the difference between the share value and the exercise price, is taxed when the shares are sold, not when the option is exercised. For other employers, it is taxed on exercise. Eligible employees can deduct 50% of the benefit. A $200,000 annual vesting limit on the deduction applies to options granted after June 30, 2021 by non-CCPCs with revenue over $500 million, not to CCPCs (CRA on employee stock options). CCPCs don’t withhold tax on non-cash option benefits.
Protecting CCPC status therefore matters for employees as well as for R&D credits; see CCPC status and SR&ED.
How are stock options taxed in the US?
US startups grant incentive stock options (ISOs) to employees and non-qualified options (NSOs) to others. ISOs can get capital gains treatment if holding rules are met, but only $100,000 worth of stock (at grant-date value) can first become exercisable in a year; the rest is treated as NSOs (26 USC 422). US companies set the exercise price at fair market value, usually supported by an independent 409A valuation.
| Canada (CCPC) | United States | |
|---|---|---|
| Main types | Employee stock options | ISOs and NSOs |
| When the benefit is taxed | When the shares are sold | ISOs: on sale if rules are met; NSOs: on exercise |
| Key limit | $200,000 vesting limit applies to large non-CCPCs only | $100,000 ISO limit per year |
| Exercise price | Fair market value at grant | Fair market value, usually a 409A valuation |
Explain the options, don’t just grant them.
An option nobody understands motivates nobody. A clear explanation is part of the compensation.
What should founders do?
- Adopt a written option plan with a lawyer.
- Size the pool for 18 to 24 months of hiring.
- Use the same vesting terms for everyone.
- Give each employee a one-page explainer with an example.
- Get tax advice before employees exercise or the company changes status.
Options are one part of the offer; see compensation and benefits and offers and contracts.
Frequently asked questions
How do startup stock options work?
They give the right to buy shares later at today’s price, vesting over time, commonly four years with a one-year cliff.
What is a vesting cliff?
A period, usually 12 months, before any options vest. After it, a block vests and the rest vests regularly.
How big should a startup option pool be?
Often 10% to 15% at seed, sized to the hiring plan and topped up later.
How are stock options taxed in Canada?
For CCPC employees, the benefit is taxed when the shares are sold, with a 50% deduction if conditions are met.
What is the $200,000 stock option limit?
A Canadian annual vesting limit on the 50% deduction for options granted after June 30, 2021 by non-CCPCs with revenue over $500 million.
What is a 409A valuation?
An independent US valuation used to set the exercise price of options at fair market value.
Sources & further reading
Employment and tax rules change. These government sources let you check the current requirements directly.