What is Stock Appreciation Right (SAR)?
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.
How Does Stock Appreciation Rights Work?
Stock Appreciation Rights (SARs) allow employees to benefit from the increase in a company’s share value over time. Employees are granted SARs with a base price set at the time of the grant and can later exercise these rights to receive a reward based on the appreciation in stock value.
The value is calculated as the difference between the stock price at the time of grant and the price at the time of exercise. SARs can be settled either in cash or shares, though cash settlements are more common. Employees can only exercise SARs after a vesting period, which is the time they must wait before the rights become available. SARs are often offered alongside stock options in a tandem arrangement, allowing employees to use SARs to cover costs and taxes related to their options.
Additionally, SARs are typically transferable but may include clawback clauses that enable the company to reclaim the rights if certain conditions are met, such as the employee joining a competitor. This structure aligns employees’ interests with the company’s performance by rewarding them for increases in stock value.
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.
Stock Appreciation Rights vs. Employee Stock Options
| Aspect | Stock Appreciation Rights (SARs) | Employee Stock Options (ESOs) |
| Ownership | Benefit from the increased value of company shares without needing to purchase them. | Must exercise the option to buy company shares at a predetermined price to benefit from any increase in value. |
| Appreciation Payout | Employees receive cash or shares equivalent to the stock’s increase in vlue. | Employees purchase company shares at a set price and can then sell them to realise any appreciation. |
| Taxation | Proceeds from SARs are taxed as ordinary income at the time they are exercised. | Taxation varies: non-qualified options are taxed as ordinary income upon exercise, while incentive stock options are taxed upon the sale of shares. |
| Timing of Taxation | Taxed when the SARs are exercised. | Non-qualified options are taxed when exercised; incentive stock options are taxed when the shares are sold. |
| Capital Gains Tax | Only applicable if the stock received as part of the SAR is sold. | This applies only if the shares acquired through exercising the options are sold. |
| Risk | No upfront investment is required, which limits the potential gain but also reduces financial risk. | Requires an upfront investment to purchase shares, leading to higher potential gains but also greater financial risk. |
| Suitability | Suitable for employees who are uncertain about owning company stock long-term but still want to benefit from its potential increase in value. | Suitable for employees who are confident in the company’s future growth and are interested in long-term ownership of its stock. |
Conclusion
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.
FAQs
What Is Stock Appreciation Rights in Accounting Example?
Stock Appreciation Rights (SARs) are a form of employee compensation that grants the recipient the right to receive the difference between a stock’s market price at a future date and a predetermined price. From an accounting perspective, SARs are initially recorded as a liability on the company’s balance sheet, with the associated expense recognised gradually over the vesting period. For example, if a company awards SARs with a fair value of ₹1,00,000 and a vesting period of 3 years, it would record a liability of ₹1,00,000 and expense ₹33,333 annually.
What Is the Difference Between Stock Options and Stock Appreciation Rights?
Unlike SARs, stock options grant the holder the right to purchase company shares at a fixed price. This means employees must invest their own funds to benefit from any stock price increase. SARs, on the other hand, entitle the holder to the monetary appreciation of the stock without requiring a purchase.
What Are the Disadvantages of Stock Appreciation Rights?
While SARs can incentivise employees, they also carry potential disadvantages. These include tax implications for both the company and the employee, potential cash flow pressures if settled in cash, and accounting complexities. Additionally, as SARs do not provide an ownership stake, they may not align employee interests with long-term shareholder value as effectively as stock options.
