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Everything about Stock Appreciation Rights (SARS)

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Author
  • Harvey John Sanya Gupta
Updated: 09 February, 2024
Featured
  • ESOPs

SARs are a type of employee compensation that grants the holder the right to receive a cash payment based on the appreciation in the value of a company's stock over a specified period. Unlike stock options, SARs don't require employees to purchase shares upfront. Instead, they receive a pay-out based solely on the stock's price increase. SARs are profitable for employees when the company's stock price rises, which makes them similar to employee stock options (ESOs). However, employees do not have to pay the exercise price with SARs. Instead, they receive the sum of the increase in stock or cash.

Before we go deep into how SAR works, the process of granting SAR, and what are the tax implications of SAR. Let’s understand about the different types of Stock Appreciation Right (SAR)

Stand-alone SARs are granted separately from stock options, allowing the employees of the company to enjoy the benefit of increased stock price without purchasing the stocks. Key features of Stand-alone SARs include:

  • Cash payment to employees upon exercise, calculated based on the growth of the company's stock price
  • Vesting requirements comparable to those found in stock option plans
  • Taxation of the cash payout as ordinary income for the employee upon exercise
  • Accounting treatment by the company as a liability award on the balance sheet

Tandem SARs are issued alongside incentive or non-qualified stock options. Employees have the option to choose either the SAR or the stock option. Choosing the SAR, it enables the employees to benefit from the appreciation of a company's stock while being connected to stock options. Some key features of Tandem SAR include.

  • Tandem SARs are issued alongside stock options, allowing employees the flexibility to choose between exercising the stock option or the SAR.
  • When the associated stock option is exercised, the tandem SARs are automatically canceled in proportion to the number of shares exercised.
  • The company can offer employees either a cash payment or shares representing the stock's appreciation, depending on the structure of the compensation plan.

How Does a Stock Appreciation Right Work?

how sar works

  1. Grant: Companies grant SARs to employees, typically with a vesting schedule that specifies when they become exercisable.
  2. Vesting: Vesting periods often range from 3-5 years, encouraging employee retention.
  3. Exercise: Once vested, employees can choose to exercise their SARs, receiving a cash payment based on the difference between the current stock price and the grant price.
  4. Payout: This payout can be made in cash, shares of stock, or a combination of both, depending on plan rules.

Process of owning Stock Appreciation Rights (SARs)

Initially, the company allocates SAR units from the predetermined option pool to eligible employees. These SAR units enable employees to benefit from the appreciation in the value of a specific number of shares issued by the company, exceeding the designated price in the SARs Grant. This is part of the company's SAR scheme.

The SAR Grant must adhere to the vesting period established by the company. Upon completion of the vesting period, employees have the option to exercise or retire their accrued SARs within the specified exercise period outlined in the SARs scheme.

During the exercise, the company compensates the difference in share price from the issuance date to the exercise date. This compensation can be settled entirely in shares, cash, or a combination of both. However, they have to act on their rights before the SAR expiration date, which typically occurs 7-10 years from the grant date. Once the company fulfills the SARs, they are considered retired.

Process of granting Stock Appreciation Rights (SARs)

The process of granting of SARs follows different procedures in listed and unlisted companies.

  • In listed companies, as per SEBI (SBEB) regulations of 2014, SARs can only be granted to permanent employees and directors. Any changes in the issuance and grant process require approval from company shareholders in an annual general body meeting, and altering the SARs scheme terms necessitates a special resolution. The Compensation Committee, established by the company board, manages the entire issuance process, and the SARs issued are non-transferable.

  • In unlisted companies, the process is simpler and lacks regulation. Unlisted companies can issue SARs to third-parties and consultants, with the flexibility to set different prices for SARs among employees. Unlisted companies are not obligated to establish a specified vesting period, and it is not mandatory to form a Compensation Committee (CC) to oversee the SARs scheme; the board of directors can handle it instead.

What are the Tax Implications of Stock Appreciation Rights

Taxation is more straightforward with Stock Appreciation Rights. SARs follow a tax approach similar to non-qualified stock options (NSOs). Employees do not face any taxes during the granting or vesting phases. When cash-settled SARs are exercised, they are considered part of the salary and taxed accordingly. In the case of equity-settled SARs, taxation occurs twice: first as salary income and then as capital gains tax when the employee sells the shares. Typically, employees retain a few shares to cover the tax amount.

Cover the Tax Amount. Stock Appreciation Rights Stages
Taxation for Employees
Grant
Non-Taxable
Vesting
Non-Taxable
Mon
Taxable as regular income (income slab applied)
Sale (in case of equity-settled SAR)
Capital Gains Tax

How SAR is different from ESOPs?

ESOPs and SARs differ in how employees pay and get taxed.

  • Payment Structure: In ESOPs, employees pay for shares when they can use them, while SARs don't require any upfront payment. When employees use SARs, the company covers the extra share value.

  • Taxable Income: For taxes, ESOPs get taxed on what employees pay and when they sell, but SARs only get taxed as part of the salary when used. In ESOPs, employees truly own company shares, but with SARs, it's just about benefiting from the rising share price.

But the basic idea is the same: employees make money when the company's share price goes up, whether through ESOPs or SARs.

Example?

Let's delve into the concept of SARs using an example.

ABC Inc. has awarded stock appreciation rights to its employees under the following conditions:

  • Grant Date: January 1, 2023
  • Grant Price/Exercise Price: $120
  • Number of Shares: 100
  • Service Period: 3 years
  • Vesting Date: January 1, 2026
  • Expiry Date: December 31, 2027

Now, let's consider that an employee decides to exercise their right as of January 1, 2026, and on that date, the market price of the shares is $300.

Net Money Value of Shares = (Market Price of share – Exercise Price) * No of Shares

No. of Shares Received = Net Money Value of Shares/Market Price

This means that they would gain $18,000 from their 60 SARs

Particulars
Amount
Market Price
$300.00
Exercise Price
$120.00
No. of Shares
100
Net Money Value of Shares
$18,000.00
No. of Shares Received
60

Advantages of SARs

For Employees:

  • Potential for significant gains: Profit from stock price increases without upfront investment.
  • No risk of loss: No financial downside if the stock price falls.
  • Tax benefits: Typically taxed as ordinary income, potentially at lower rates than stock options.

For Companies:

  • Aligns employee interests with company performance: Encourages employees to contribute to company growth.
  • No dilution of equity: SARs don't require issuing new shares, preserving ownership structure.
  • Flexibility in pay-out: Can be settled in cash or shares, offering financial flexibility.

Disadvantages of SARs

For Employees:

  • Limited upside: Gains are capped at the stock's appreciation, unlike stock options with the potential for unlimited gains.
  • No voting rights: SARs don't confer ownership rights or voting power in company decisions.

For Companies:

  • Accounting complexities: Tracking and valuing SARs can involve administrative challenges.
  • Cash outflow: SAR payouts can represent significant cash expenses, especially during periods of high stock appreciation.
Frequently Asked Questions about Stock Appreciation Rights

Learn the complexities of Stock Appreciation Rights (SARs) and their advantages for employees and companies. Understand the key aspects of taxation, and vesting schedules.

Conclusion

SARs can be a valuable tool for companies seeking to attract, retain, and motivate employees by aligning their financial interests with the company's success. However, it's essential to carefully consider the advantages and disadvantages, along with the company's financial position and goals, before implementing a SAR plan.

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