Stock Appreciation Rights (SARs)

What Are Stock Appreciation Rights?

Stock appreciation rights (SARs) are a type of employee compensation linked to the company's stock price during a predetermined period. SARs are profitable for employees when the company's stock price rises, which makes them similar to employee stock options (ESOs). However, employees do not have to pay the exercise price with SARs. Instead, they receive the sum of the increase in stock or cash.

The primary benefit of stock appreciation rights is that employees can receive proceeds from stock price increases without having to buy stock.

Understanding Stock Appreciation Rights

Stock appreciation rights offer the right to the cash equivalent of a stock's price gains over a predetermined time interval. Employers almost always pay this type of bonus in cash. However, the company may pay the employee bonus in shares. In most cases, employees can exercise SARs after they vest. When SARs vest, it simply means that they become available to exercise. Employers generally issue SARs along with stock options. These stock appreciation rights are called tandem SARs. They assist in funding the purchase of options and help pay off taxes due at the time the SARs are exercised.

Like several other forms of stock compensation, SARs are transferable and are often subject to clawback provisions. Clawback provisions specify conditions under which the company may take back some or all of the income received by employees under the plan. For example, they might allow the firm to withdraw SARs if an employee goes to work for a competitor before a specified date. SARs are also frequently awarded according to a vesting schedule that ties them to performance goals set by the company.

SARs are taxed the same way as non-qualified stock options (NSOs). There are no tax consequences of any kind on either the grant date or when they are vested. However, participants must recognize ordinary income on the spread at the time of exercise. Most employers will also withhold supplemental federal income tax. Furthermore, they will hold back funds to pay state and local taxes where applicable.

Many employers will also withhold taxes on SARs in the form of shares. For example, an employer may only give a certain number of shares and withhold the remainder to cover the tax. As with NSOs, the amount of income recognized upon exercise becomes the cost basis for taxes when holders sell the shares.

Special Considerations

SARs are similar in some ways to phantom stock. The major difference is that phantom stocks are typically reflective of stock splits and dividends. Phantom stock is a promise that an employee will receive either the value of the company's shares or the amount that the stock price increases during a specified period. The phantom stock bonus an employee receives is taxed as ordinary income at the time it is received. Phantom stock is not tax-qualified, so it does not have to follow the rules that employee stock ownership plans (ESOPs) and 401(k)s must follow.

Advantages and Disadvantages of SARs

The greatest advantage of SARs is flexibility. Companies can structure SARs in a variety of ways that work best for different individuals. However, this flexibility requires making numerous choices. Companies offering SARs must decide which employees receive them, the value of these bonuses, the liquidity of the SARs, and which vesting rules to adopt.

Employers like SARs because the accounting rules for them are more favorable than in the past. They receive fixed instead of variable accounting treatment, much like conventional stock option plans. However, SARs require the issuance of fewer shares and dilute the share price less than traditional stock plans. Like all other forms of equity compensation, SARs can also serve to motivate and retain employees.

Despite their many benefits, SARs are a high-risk form of employee compensation. If the company's stock does not appreciate, SARs often expire worthless.

Example of Stock Appreciation Rights

Consider an employee who earns 200 SARs as a performance bonus. Furthermore, suppose that the SARs mature after a period of two years. The stock of the company then proceeds to increase by $35 a share over those two years. The result is that the employee receives $7,000 (200 SARs x $35 = $7,000) in additional compensation. These SARs could also have a clawback provision where employees lose them if they leave the company before the two-year period ends.