Stock Appreciation Rights (SARs) enable a business owner to provide his or her employees with an opportunity to directly benefit from the growth and prosperity of the business.
SARs grant the recipient the right to be paid an amount equal to the difference between the value of the company’s stock price on the date of the grant and the value on the date of exercise. When the payout is made, the value of the award is taxed as ordinary income to the employee and is deductible by the employer.
SARs can be offered to employees instead of stock options or can be used in conjunction with a stock option program. SARs do not necessarily have a specific settlement date; like stock options, employees can have flexibility in when to exercise their SARs.
Three Types of Plans
1. Stock-settled SARs – the employee is paid in the form of shares of the company’s stock. The number of shares distributed to the employee is equivalent in value to the increase in the stock’s value over the life of the SAR.
2. Cash-settled SARs – the employee receives a lump-sum cash payment on the date of exercise equivalent to the amount of appreciation of the company’s stock.
3. Phantom stock plan – technically not an SAR, but very similar; the employee receives a dividend equivalent payment when exercised. These plans often refer to their phantom stock as “performance units” and, generally, condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets.
Please note that SARs and phantom stock plans can be given to anyone, but if they are given out broadly to employees and designed to pay out upon termination, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules.
For Stock-settled SARs, a liability is accrued for the estimated cost of the plan, which is the present value of the estimated award at the time it is granted. Adjustments to this liability must be made quarterly.
For Cash-settled SARs and Phantom stock plans, the compensation expense for awards is estimated each quarter.
For SARs and Phantom stock plans, the estimated payout is recorded as a liability on the company’s books until it is paid out or it expires.
Valuation and Appreciation
It is important to carefully consider how the company should be valued. For most small businesses, market share price is not available, so a fair market value analysis is often required. As an alternative, it is often best to rely on profit margins, sales numbers or something similar to establish a payout threshold.
Depending on the business owner’s personal goals and the anticipated future of his or her company, the Stock-settled SAR plan may not be a good fit. The effect of this type of incentive plan would be to dilute each investor’s ownership percentage. Further, it may be overly burdensome to account for changes in the present value of the company over time.
The Cash-settled SAR plan is often times not an ideal option for a small business because its accrued cost and ultimate payout is based upon an increase in the value of shares (or ownership equity) of the company. In the absence of shares listed on a stock exchange, this plan generally requires a fair market value analysis, updated quarterly, for the life of the SAR.
A Phantom stock plan, however, is frequently the best option for a small business. With this type of plan, you can establish a dividend equivalent payout that is based upon a benchmark that the owner deems appropriate. As noted above, the owner can condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. The characteristics of this type of plan are often closely aligned with the character of the small business; small, privately-held and flexible.