A 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 value of appreciation of the equity shares currently being traded on the public market.
An SAR is a form of deferred incentive compensation to employees and is paid out 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 having to purchase the option.
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.
Tandem SARs are grants to an employee both stock options along with SARs which help the employee fund the option purchase.
Understanding Stock Appreciation Rights
Essentially, SARs entitle holders the right to the appreciation in market value of 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 benefit employees, alongside stock options which assists them in coming up the funds to pay the exercise price. As such, the SARs are said to be in tandem with a stock option.
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 tool to help employees to fund the payment of stock options and income taxes on any taxable gains.
How SARs Works
SARs are transferable 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 a 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-established which gives employees some flexibility to time the exercise of the right . Most SAR programs are tied to meeting 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 collecting withholding tax and submitting it to the Internal Revenue Service (IRS).
Nevertheless, grantees of only stock options bear several disadvantages, including coming up with funds to exercise the stock option, paying stock broker commissions on any trades, paying of tax on the employee benefit and gain, and risk of market price decline in the underlying stock. The potential shortfall in cash can be alleviated by the company if they grant SAR in tandem with the stock options. These rights will provide the necessary cash to cover the various outflows.
Pros and Cons of SARs
SAR plans offer multiple advantages over other forms of stock compensation. One of the benefits is cash benefits without having to pay upfront to exercise options. Another advantage is the flexibility to tailor SARs in a way that suits the beneficiaries. Companies with SAR plans can select the employees to receive the benefits, the SARs’ liquidity, the value of the bonuses, and an ideal vesting rule.
An SAR is an employee motivation tool which provides additional incentives beyond regular income, that are tied to a company’s performance which helps motivate employees and reduce turnover rates. In addition, SARs have less complex accounting rules, over other forms of stock compensation. SARs are also considered attractive compensation for employees, due to the elimination of the preferential taxation of the qualified stock options.
On the downside, tandem SARs may exert a negative impact on the value of a company’s shares much like straight stock options, as they will increase the shares outstanding thereby diluting the per-share earnings.
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 taxes at the ordinary-income rate. The stock options are also subject to similar tax treatment as ordinary income and is subject to taxation.
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