Alternatives to Stock Options - Share Appreciation Rights (SARs)
- greenwoodphilip
- Oct 4, 2024
- 4 min read
Stock options have been a popular compensation strategy used by young companies for several decades. While there are many advantages to their use, there a reasons for a company to consider looking at evaluating other strategies for employee compensation.
Reasons for Avoiding Stock Options
Exercising stock options could reduce shareholder ownership, potentially increasing long-term expenses. Stock options, especially ISOs, involve intricate tax implications such as the Alternative Minimum Tax (AMT), which may diminish the perceived value of employee benefits. Stock options could encourage risky short-term choices, possibly contradicting the company's future objectives. Assessing the value of stock options, particularly in private firms, presents difficulties and introduces ambiguity to compensation assessments. Stock options might lose their motivational impact during stock price declines, linking compensation to external factors beyond employees' influence.
A Brief Story
In the early 2000s, a Midwest startup faced challenges with its equity structure, needing $15 million for growth. VCs hesitated due to dilution concerns. To address this, the company used Share Appreciation Rights (SARs) instead of more options, aligning interests and retaining talent. This innovative solution showcased adaptability and forward-thinking in equity financing.
In essence, the introduction of SARs as an incentive mechanism underscored the company's dedication to sustainable growth and balanced corporate governance. This shift in strategy not only addressed the immediate worries of VCs but also laid the groundwork for a more harmonious and efficient distribution of ownership and control within the organization. As the company progresses and grows, the strategic use of SARs establishes a solid foundation for future expansion and success.
Key Characteristics of SARs
Stock Appreciation Rights (SARs) are tied to stock price changes, increasing in value as the stock price rises. Unlike stock options, SARs don't need an initial purchase, making them attractive for employees without the means to invest upfront. Employees can choose to receive their payout in cash, company stock, or a mix of both. SARs follow a vesting schedule and require specific conditions to be met before employees can exercise them. There is a set exercise period for employees to decide whether to exercise their rights, missing the deadline could result in losing out on potential gains from stock price increase.
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Here's a hypothetical example of Share Appreciation Rights (SARs). Let's say TechInnovate Inc., a growing technology company, decides to grant SARs to its senior software engineer, Sarah.
Grant Details:
- Number of SARs granted: 1,000, Grant date: January 1, 2022
- Grant price: $50 per share (current market price)
- Vesting schedule: 25% per year over 4 years
- Expiration: 10 years from grant date
- Settlement: Cash settlement
Initial Grant (January 1, 2022): Sarah receives 1,000 SARs at $50 per share. No immediate financial impact or tax consequences.
First Vesting (January 1, 2023): 250 SARs vest (25% of the grant). TechInnovate's stock price is now $60. Sarah doesn't take any action yet.
Second Vesting (January 1, 2024): Another 250 SARs vest. Stock price is now $75. Sarah decides to exercise 300 of her vested SARs.
Calculation:
Appreciation per share: $75 - $50 = $25
Value of exercised SARs: 300 x $25 = $7,500
Sarah receives $7,500 in cash (subject to income tax and payroll taxes).
Third Vesting (January 1, 2025): Another 250 SARs vest. Stock price drops to $65.
Sarah holds off on exercising any more SARs.
Fourth Vesting (January 1, 2026): Final 250 SARs vest. All 1,000 SARs are now fully vested. Stock price rebounds to $90.
Final Exercise (June 1, 2026): Sarah exercises her remaining 700 SARs.
Calculation:
Appreciation per share: $90 - $50 = $40
Value of exercised SARs: 700 x $40 = $28,000
Sarah receives $28,000 in cash (subject to income tax and payroll taxes).
Total Benefit: Over the course of the grant, Sarah received a total of $35,500 ($7,500 + $28,000) in additional compensation through the SARs program, without having to invest any of her own money upfront.
Tax Implications: The $7,500 received in 2024 and $28,000 received in 2026 are both treated as ordinary income in their respective years. TechInnovate will withhold applicable income and payroll taxes from these payments.
Taxes, Accounting and Reporting:
Companies are required to account for a liability related to outstanding SARs, which is adjusted regularly based on fluctuations in stock prices. This may lead to increased volatility in the income statement compared to stock options. A stock appreciation right (SAR) grants an employee the right to receive cash, stock, or a combination thereof, equivalent to the increase in a company's stock value from the grant date to the exercise date. SARs are similar to stock options as they can be exercised at the employee's discretion within a specified period, without granting ownership of the underlying stock. Unlike options, SARs typically do not involve the payment of an exercise price. Furthermore, the method of settlement (cash or stock) also determines whether a SAR is classified as a liability or as part of shareholders' equity.
Income tax accounting comparison of cash-settled SARs and stock-settled SARs
Cash-settled SAR | Stock-settled SAR | |
Grant date | Measure at fair value | Measure at fair value |
As the award vests | Remeasure the fair value of the award at each reporting period and adjust cumulative compensation expense (and the corresponding compensation liability) based on the portion of the vested award; adjust the corresponding deferred tax asset based on the temporary difference arising from the book liability. | Recognize the book compensation cost over the service period based on the grant-date fair value; recognize a deferred tax asset for book compensation expense recognized in advance of the tax deduction. |
After the award has vested but before it is settled | Remeasure the book compensation liability at fair value and adjust it each reporting period accordingly and adjust the corresponding deferred tax asset. | No accounting required. |
At the time of settlement | The deferred tax asset at the time of settlement should equal the current tax benefit, resulting in no excess tax benefit or deficiency. | Reverse the existing deferred tax asset through income tax expense and recognize any excess tax benefit (or deficiency) in the income statement. |
Considerations of Stock Appreciation Rights (SARs)
SARs have limitations for employees, including no dividends or voting rights, complex accounting treatment, and risks tied to stock price fluctuations. Additionally, payouts may be taxed at higher rates than capital gains.
In summary, Share Appreciation Rights offer a flexible tool for companies to align employee interests with shareholder value, providing upside potential without the complexities of actual stock ownership. Their design can be tailored to meet specific company goals and compensation strategies.
ALWAYS GET GOOD ADVICE FOR TAX AND ACCOUNTING IMPLICATIONS FROM YOUR TAX AND ACCOUNTING ADVISORS!
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