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To keep up with the ever-changing business world, companies use a variety of incentives to get top employees to align their interests with the company’s. Among these, stock appreciation rights (SARs) have become very effective instruments.
Such rights, which often form a component of an employee’s salary, encourage loyalty and ownership by providing a chance to profit from the company’s stock performance.
This article delves into the intricacies of these rights in an attempt to clarify how they function and what their pros and cons are. It aims to shed light on SARs and their function in contemporary pay systems.
What are stock appreciation rights?
As the value of the company’s stock increases over a certain time period, employees with Stock Appreciation Rights (SARs) can earn in either cash or equity. When the stock price of the company goes up more than the price set on the grant date, these share appreciation rights are exercised or are otherwise lapsed.
Stock appreciation rights vs stock options
While they are forms of employee compensation, the SARs and Employee Stock Option Plans operate differently. Unlike SARs, which enable employees to profit from a rise in the share price without actually purchasing the shares, ESOPs enable employees to purchase company shares at a set price.
This means that, unlike stock options, employees can profit from the appreciation of their shares with SARs without having to incur any upfront costs or risks.
How stock appreciation rights work
Unlike other forms of employee compensation, Stock Appreciation Rights (SARs) are directly linked to the stock price of the company. The idea behind them is to pay employees a sum equal to the gap between the stock’s base price and its current market value. The base price is determined on the grant date and serves as a representation of the original stock price.
There is a minimum holding period before employees can exercise SARs; this is after the shares have vested. Employees can use SARs to cover option purchase expenses and associated taxes, which are commonly offered alongside stock options (known as tandem SARs).
Usually, SARs have transferable rights, which allow employees to assign them to other people. Clawback clauses, on the other hand, might be a part of these rights and set requirements for using SARs. For example, if an employee quits to work for a direct competitor, the company may be able to reclaim the SAR.
Employees who exercise their stock appreciation rights (SARs) are compensated based on the stock appreciation rights valuation, which entails estimating the rise in the value of the company’s stock over a given time frame.
Employees can profit from the company’s success without having to make any initial financial commitment thanks to this mechanism. For both the business and the employees, it’s a win-win situation.
Stock appreciation rights example:
Imagine that Zomato Ltd. grants an employee named Rajesh 100 SARs with a base price of ₹100 per share. After a year, the market price of the company’s shares rises to ₹150 per share.
Base Price: ₹100 per share
Market Price: ₹150 per share
Increase in Stock Value: ₹150 – ₹100 = ₹50 per share
Since Rajesh holds 100 SARs, his total appreciation would be:
100 SARs ₹50 (increase in stock value per share) = ₹5,000
Therefore, Rajesh would receive ₹5,000 in cash as compensation for exercising his SARs, reflecting the increase in the company’s stock value during the specified period.
However, if it were ESOPs instead of SARs, Rajesh would need to buy the shares at the exercise price of ₹100 per share. After buying, he could sell them at the market price of ₹150 per share. His profit would be the selling price minus the purchase price, which would also be ₹5,000. However, unlike SARs, this requires an upfront investment.
Benefits and drawbacks of SARs
Stock appreciation rights advantage
- No upfront cost
- Flexibility
- Incentive plan that does not dilute equity
- Talent retention
- Financial gains
Stock appreciation rights disadvantages
- Dependent on share price appreciation
- No tax benefits
- Potential liquidity issues
- Higher tax rates
- Requires cash for payouts
- Complexity and market risk
Taxation of SARs
When Stock Appreciation Rights (SARs) are exercised, the income that is generated from their distribution becomes taxable. When it comes to tax laws in India, the money you make from SARs is considered long-term capital gains.
When employees exercise their stock options, their employers often distribute a set number of shares and withhold the rest to cover tax obligations. Profits made by investors through the sale of their shares are subject to taxation.
By aligning the calculation of taxes with the income generated from the sale of the acquired shares, this approach efficiently meets the tax liabilities associated with SARs.
Bottomline
By linking employee interests with company growth, Stock Appreciation Rights (SARs) provide a unique and flexible approach to employee compensation. Attracting and retaining talent in the competitive corporate world will require understanding and leveraging instruments like SARs, as companies innovate their compensation strategies.
FAQs
Restricted Stock Units (RSUs) and Stock Appreciation Rights (SARs) are both forms of employee compensation, but they function differently. RSUs are company shares given to an employee through a vesting plan and distribution schedule. They fluctuate with the market value of the company’s shares. On the other hand, SARs are rights that entitle an employee to a bonus equal to the appreciation of the company’s stock over a certain period. This bonus can be paid in cash or equivalent shares.
Yes, private companies can issue Stock Appreciation Rights (SARs). SARs are a form of employee incentive that allows employees to benefit from the increase in the company’s stock price. Private companies that issue SARs must follow general equity compensation valuation rules and use a reasonable valuation method, such as an express written formula, or have a third-party appraisal performed to determine the Fair Market Value (FMV) per share. This flexibility allows companies to structure SARs to suit the needs of different employees.
No, Stock Appreciation Rights (SARs) do not dilute shares. Unlike stock options, SARs are often paid in cash and do not require the employee to own any asset or contract. This is beneficial to employers as they do not have to dilute the share price by issuing additional shares. Instead, SARs are a contract that derives its value based on the amount of stock appreciation. This allows companies to incentivise and motivate their employees without diluting the equity pool.
Yes, Stock Appreciation Rights (SARs) do expire. The expiration period varies from plan to plan. Once the rights expire, they become worthless. There are often special rules for terminated, retired, and deceased employees, as these life events may accelerate the expiration. It’s important to check the specific plan rules for details about expiration dates. Typically, SARs can be exercised at any time prior to their expiration, once they have vested.
Stock dilution can be unfavourable for existing shareholders for several reasons:
Decreased Ownership: When a company issues more shares, the proportional ownership of existing shareholders decreases.
Reduced Earnings Per Share: Dilution can lower the Earnings Per Share (EPS), potentially reducing the stock’s value.
Diminished Voting Power: As ownership decreases, so does the voting power of existing shareholders.
Potential Stock Price Decline: An increased supply of shares can put downward pressure on the stock price.
Investor Confidence: Dilution can negatively impact investor confidence, especially if it leads to a decrease in the stock’s value.