Stock appreciation rights are a way for private companies to reward their employees or management with a bonus if the company is doing well financially. This process is called a ‘plan.’ Stock appreciation rights is a lot like employee stock options wherein the employee benefits from an increase in stock price. Though it’s a lot like options, it is different in the way the employees do not have to pay the exercise price. They receive the amount of the increase in cash or stock.
Hence, stock appreciation rights or share appreciation rights offer the cash amount of a stock’s price gains over a definite time. Employers often offer stock appreciation rights along with stock options. These stock appreciation rights are called tandem stock appreciation rights.
Stock appreciation rights are transferable and subject to clawback provisions. Clawback provisions refer to situations under which the company may take back some or all of the income received by employees under the plan. For instance, the company might take back the bonus offered to an employee if he is about to join a rival firm. Stock appreciation rights are often awarded to employees, in proportion to a vesting schedule that links them to performance goals of the company.
Benefits and Drawbacks of SARs
A significant benefit that stock appreciation rights bring about is its minimal usage of money to exercise them for cash. An employee receives the proceeds without having to pay for the cost of the shares. The next big advantage is certainly flexibility. Companies have the right to structure stock appreciation rights to suit the needs of different employees. This flexibility requires individual choices. Companies offering stock appreciation rights decide which employees would receive them, the bonus amount, the SARs liquidity, and the vesting rules to adopt.
Employees prefer stock appreciation rights due to its traditional accounting rule. They receive fixed instead of variable accounting treatment, which is more convenient for them. Share appreciation rights dilute the share price less and require the issuance of fewer shares. Share appreciation rights also help to motivate and retain employees.
However, despite its many benefits, Share appreciation rights happen to be a high-risk form of employee compensation. If the company’s stock is not doing too well, SARs expire and go to waste.
Taxation of SARs
Stock appreciation rights are taxed like non-qualified stock options (NSOs). In this case, there are no tax consequences of any kind on either the grant date or when they are vested. However, participants need to keep in mind ordinary income on the spread at the time of exercise. An employer usually gives a certain number of shares and takes back the remaining to cover the tax. When holders sell the shares, the amount of income recognized upon exercise becomes the cost basis.
Similarity with phantom stock
SARs are very similar to phantom stock. The difference is that phantom stocks were reflective of stock splits and dividends. Phantom stock refers to the reward to an employee of either the value of the company’s shares or the amount of the stock price increase in a specific time. The phantom stock bonus is taxed as ordinary income when the employee receives it. Phantom stocks may pay dividends while SARs would not.
If you retire, you could hold your vested outstanding share appreciation rights. You should still check this with your employer for greater clarity. In the event of leaving the company, there are special rules too. It’s advisable to check with your employer in this case also. Finally, in case of your death, your vested SARs would be transferred to your designated beneficiary.
With a modelling tool called Stock Appreciation Rights Summary Screen, you could check different exercise scenarios for your share appreciation rights. This tool could also help you to estimate the potential taxes you may owe from an exercise.