Stock appreciation rights (SARs) are a powerful form of employee compensation directly linked to the company’s stock performance over a fixed period. Unlike traditional stock options where employees purchase stock at a set price, SARs provide employees with the benefit from stock appreciation—without needing to purchase any shares upfront. Essentially, SARs deliver the value of any increase in the company’s stock price, either in cash or additional shares.
Key Takeaways
- Financial Incentive Linked to Performance: SARs closely tie employee compensation to the company’s stock performance, essentially making employees stakeholders in the company’s success.
- Cash or Share Payment: Unlike typical stock options, employees receive the appreciation proceeds in cash or stock without needing to pay an exercise fee.
- Reduction in Dilution: Employers benefit from SARs since they do not require issuing new shares, which can dilute existing shareholders’ value.
Understanding Stock Appreciation Rights
Stock appreciation rights grant employees a value equivalent to any appreciation in stock over a given timeframe. This type of compensation often comes as a cash bonus, though it may sometimes be fulfilled using shares. SARs typically vest over a specified period, becoming exercisable as they vest.
Employers might issue SARs in tandem with stock options to enhance employee compensation packages. These joint options—known as tandem SARs—may be used to fund the purchase of additional shares or for tax payments triggered upon exercising the SARs.
Similar to other equity compensation forms, SARs may include clawback provisions, enabling the employer to retract SARs under specific circumstances, such as an employee leaving the company for a competitor before a predetermined time. Vesting schedules linked to company performance goals are also common.
In terms of taxation, SARs are subject to the same tax rules as non-qualified stock options (NSOs). This means no tax penalties occur at grant or vesting. However, upon exercise, the income difference must be declared as ordinary income, with employers often withholding federal, state, and local taxes.
Special Considerations
While similar to phantom stock, SARs fundamentally differ in handling stock splits and dividends. Phantom stocks promise an employee a bonus reflecting the company’s stock value or incremental value over time, typically taxable as ordinary income upon receipt.
Advantages and Disadvantages of SARs
Pros:
- Unmatched flexibility: Organizations can tailor SARs to meet varied individual needs
- Shares or cash delivery: Employees don’t need upfront capital to buy stock
- Favorable accounting treatment: Fixed accounting treatment makes them advantageous on company balance sheets
- Enhances employee motivation and retention: Similar to other forms of equity compensation
Cons:
- Potential Risk: If the company’s stock doesn’t appreciate, SARs lose value
- Complex Choices: Employers must carefully decide eligibility, bonus values, liquidity, and vesting rules.
Example of Stock Appreciation Rights
Imagine an employee earning 200 SARs as a performance reward maturing after two years. Suppose the company’s stock appreciates by $35 per share over these two years. The employee would gain $7,000 (200 SARs x $35 = $7,000) other those two years. Moreover, should the SARs come with a clawback provision, the employee could lose these gains if they depart from the company before the two-year mark.
By understanding and incorporating SARs into compensation plans, companies can foster a stronger performance-driven culture while providing employees with lucrative incentives aligned with company growth and success.
Related Terms: Employee Stock Options (ESOs), Non-qualified Stock Options (NSOs), Performance Bonus, Equity Compensation, Clawback Provisions.
References
- Fidelity. “About Stock Appreciation Rights (SARS)”.
- Internal Revenue Service. “Publication 17, Your Federal Income Tax”, Pages 15-16.
- Internal Revenue Service. “Publication 15, Employer’ s Tax Guide”, Page 39.
- Internal Revenue Service. “Publication 525, Taxable and Nontaxable Income”, Page 5.
- Internal Revenue Service. “Publication 17, Your Federal Income Tax”, Page 51.
- National Center for Employee Ownership. “Phantom Stock and Stock Appreciation Rights (SARs)”.
- Internal Revenue Service. “Nonqualified Deferred Compensation Audit Techniques Guide”.
