What is Stock Appreciation Right (SAR)?
Stock Appreciation Right (SAR) refers to the right to be paid compensation equivalent to an increase in the company’s common stock price over a base or the appreciation of equity shares currently being traded on the public market.
An SAR is a form of deferred incentive compensation to employees when the company’s stock’s appreciated in market value above the option exercise price. It works the same way as a stock option since it gives its holder the right to receive an amount equal to the excess of the optioned shares’ market value during a defined period of time. However, an SAR differs from a stock option in that an employee receives the same proceeds without the cash outlay associated with an exercise price.
- Stock Appreciation Right (SAR) entitles an employee, who is a shareholder in a company, to a cash payment proportionate to the appreciation of stock traded on a public exchange market.
- SAR programs provide companies with the flexibility to structure the compensation scheme in a way that suits their beneficiaries.
- SAR is said to be tandem with stock options and grants an employee the right to receive an appreciation of the value of the underlying stock.
Understanding Stock Appreciation Rights
Essentially, SARs entitle holders the right to the appreciation in market value shares over a specific time interval. The SAR program arranges the vesting schedule for each employee, after which it can be exercised. The arrangement ties SARs to the performance objectives set by the company.
Employers can issue SARs to employees alongside stock options without requiring them to shoulder the exercise price. As such, the SARs are said to be in tandem with a stock option and entitle an employee to receive an amount proportionate to any increase in the stock price above the option’s exercise price.
If employees expect their own efforts to influence the future course of the stock’s market value, SARs will serve to motivate such efforts. As such, SARs serve as a form of incentive compensation. They are frequently authorized under the stock option plans because, as tandem SARs, they are an essential adjunct for employees to utilize stock options and pay off taxes due at the time of exercise.
How SARs Works
SARs can be transferred and are subject to a clawback policy. A clawback policy outlines triggering events under which a company may recover employees’ bonuses or any other incentive-based compensation under the plan, regardless of whether the provision is applied with a retrospective of future effect.
For example, the provision may allow a company to withdraw SARs if an employee switches to a competitor before the expiry of an employment contract. Furthermore, as with stock options, SARs’ settlement date may not be pre-planned. It means that employees enjoy the flexibility of exercise dates. Some SAR programs condition employees to meet certain company’s objectives, such as profits or sales targets.
Assume that ABC Limited granted stock appreciation rights on January 1, 2010, when the price of stocks was $10 per share, and the vesting date when an employee can exercise the right is on January 1, 2020.
John was awarded SARs for 100 shares of ABC Limited. Assuming that the share price of the company’s stock on the vesting date is $90, the in-money value of John’s SAR is $8,000 [($90 – $10) x 100]. John can choose to have the SARs settled in cash for $8,000 or in ABC’s shares of stock equivalent to 99 shares ($8,000/$90).
Tax Treatment of SARs
SARs generally are subject to the same tax treatment as non-qualified stock options (NSOs). Employers must shoulder the administrative burden of such withholding since they do not generate any employees’ cash. They are also obliged to account to the Internal Revenue Service (IRS) for the amounts required to be withheld.
Nevertheless, grantees of SAR bear several disadvantages, including the eventual payment of commission to stockbrokers upon sale and the risk of market decline. Furthermore, employees may face the unavailability of funds to pay for ordinary income tax on the spread at the time of exercise. The inadequacy of funds is attributed to employers’ tendency to withhold income to pay for the state and local taxes and supplement federal taxes.
Pros and Cons of SARs
SAR plans offer multiple advantages over other forms of stock compensations. One of the benefits is cash benefits without monetary payments. Another advantage is the flexibility that allows SARs to be arranged in a way that suits the beneficiaries. Companies with SAR plans must decide on a select number of employees to receive the benefits, the SARs’ liquidity, the value of the bonuses, and an ideal vesting rule.
An SAR arrangement is also used as an employee motivation strategy by providing additional incentives beyond the regular income, which reduces employee turnover rates. In addition, SARs attract beneficial accounting rules, which favor employers. SARs are also considered attractive compensation for employees, due to the elimination of the preferential taxation of the qualified stock options.
On the downside, SARs may exert a negative impact on the value of a company’s shares by diluting the per-share earnings due to stockholders.
SARs and phantom stocks share a few striking similarities. Phantom stock is an agreement that entitles an employee to a cash payment equivalent to the amount of the stock price increase at a designated time.
Employees granted phantom stock options realize income taxable as at the ordinary-income rate. The stock options are subject to similar tax treatment as ordinary income and is subject to taxation.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: