Key Points:
- SARs Overview: SARs allow executives to gain from stock value appreciation without buying shares.
- Key Terms: Important terms for SARs include Grant Date, Grant Price, Expiration and Exercise Dates, Vesting Schedule, and Fair Market Value.
- Tax Treatment: SARs are typically taxed as ordinary income, lacking ISOs’ potential capital gains tax benefits.
- Advantages vs. Disadvantages: SARs offer simplicity and reduced risk but lack the tax efficiency of other equity compensations.
- Strategic Importance: With their longer exercise periods, professionals should strategize long-term tax planning with SARs to maximize benefits.
Introduction
After the long and exhausting section on stock options, this section on stock appreciation rights (SARs) will be welcomingly brief. SARs can be thought of as the little sibling of stock options.
SARs allow corporate professionals to benefit from a company’s stock value appreciation over a specific period. But unlike stock options, SARs do not require the executive to purchase shares. Instead, they grant the right to receive a cash payment equal to the company’s stock price appreciation during a predetermined period. Essentially, SARs provide executives with a form of “phantom equity,” linking their compensation to the company’s financial performance.
Unit Appreciation Rights (UAR) is another term you may hear. These are economically similar to SARs and are awarded to the recipient as a right to receive a cash payment equal to the appreciation of a specified number of partnership units.
First, let’s review the terms and examples before getting into the advantages and disadvantages of SARs compared to other compensation tools.
Terms & Example
The terms involved with SARs are almost the same as the options below:
Grant Date
The date the stock options are awarded or granted. This date is the starting point for determining vesting schedules and other conditions.
Grant Price
This is the SAR equivalent of the Strike Price in options. It serves as a reference point to determine the company’s stock price appreciation that an executive will receive upon exercising their SARs. If the stock price exceeds the grant price at the end of the vesting period, you can exercise the SARs and receive a cash payment equal to the difference between the current stock price and the grant price.
Expiration Date
The last date the employee can exercise the SAR. After this date, it becomes invalid, cannot be exercised, and is now worthless. The expiration period for Stock Appreciation Rights (SARs) can vary depending on the specific terms of the SAR plan established by the company. There is no fixed or standard duration for SAR expiration dates; the company’s discretion determines it so they can tailor it to their specific compensation and business objectives. However, the most common duration is between three and ten years.
Exercise Date
The date the employee chooses to exercise the SAR and lock in their compensation. The exercise date is also the date of the taxable event.
Vesting schedule
The timeline or conditions determine when the SARs become eligible for exercise. As we have previously discussed, vesting schedules can be based on factors like tenure with the company, achievement of performance milestones, or the passage of a specific period of time.
Fair Market Value (FMV)
The current market price of the company’s stock at a given time. The FMV determines the compensation as the difference between the FMV and strike is the taxable income when exercising the SAR.
Let’s walk through an example: Let’s assume you work for Manatee Corp, and as part of your compensation package, you are granted appreciation rights on January 5, 2023 (this is now the Grant Date). The SAR specifies that you have the appreciation rights on 1,000 shares of Manatee Corp stock at a grant price of $50 per share. The option has an expiration date of one year from the grant date. We will ignore vesting for now.
On January 4, 2024 (a day before the option will expire), the stock price of Manatee Corp rose to $70 per share. Since the stock price is now higher than the strike price of $50, you decide to exercise your SAR. January 4, 2021, is now the Exercise Date. By exercising the SAR, you have generated $20,000 of income ([$70 market price – $50 strike price] x 1,000 shares). The income is considered ordinary income for tax purposes and will be processed through your employer, withholding all applicable taxes and reporting the amount on your W2 at year-end.
Here is the example in tabular format:
SARMarket Value of Stock at Exercise$70Grant Price$50Gain Per Share$20Number of Shares1000Pre-Tax Gain$20,000Ordinary Inc Tax Rate32%Tax$6,400After-Tax Gain$13,600
If you recall the options section, this after-tax gain is the same as the Non-Qualified Stock (NSO) options. The only difference is that you do not own the company shares after the transaction. It’s interesting to think about the psychology of these two transactions, though. With NSOs, many professionals without a formal financial plan to reduce concentration risk will let the shares acquired through the exercise of NSOs accumulate, creating a concentration risk. However, corporate professionals rarely exercise SARs and then actively purchase more company stock – which they could do with the proceeds of the SAR and end up in the same situation as with the NSOs. Because of this, concentration risk is greatly reduced with SARs compared to traditional options.
Vesting
I have thoroughly covered the subject of vesting and example vesting schedules in earlier sections. To avoid repetition, I will not repeat those details here. If you need a more detailed explanation of vesting, please refer back to those sections.
Regarding Stock Appreciation Rights (SARs), it is common for them to include a vesting period. This means that executives must remain employed by the company during this period to become eligible for the potential appreciation in value.
All I will say here is that SARs are almost universally subject to some form of a vesting schedule. The specific vesting terms and conditions may vary depending on the company and the SARs grant. Executives should refer to the details in their SAR agreement or plan document to obtain accurate information about the vesting period, requirements, and any additional provisions associated with their SAR grants.
Advantages & Disadvantages
Advantages
Stock Appreciation Rights (SARs) offer several advantages over stock options and RSUs. One significant benefit is the simplified process and reduced complexity. Unlike stock options, SARs eliminate the need for professionals to purchase shares or navigate intricate tax considerations associated with options. When you exercise SARs, you receive a cash payout, typically treated as ordinary income and subject to taxes at your marginal income tax rate. This straightforward mechanism allows executives to focus on enhancing company performance instead of dealing with complex financial transactions. Additionally, SARs mitigate the risk of accumulating substantial equity in the company, which could lead to concentration rate issues.
Although the duration of a SAR can be any length, the normal period of 10 years before expiration provides a good window for tax planning. The long tax planning window is a significant advantage over RSUs. Using that window to “fill up” tax brackets can reduce the impact of exercising all of their rights in one year. See the separate topic on tax planning to learn more about some strategies.
Disadvantages
It’s important for you to be aware of the downsides of Stock Appreciation Rights (SARs), particularly in terms of tax implications. A key drawback is that SARs lack the tax advantages you might find in other equity-based compensation plans, such as Incentive Stock Options (ISOs). When SARs are exercised and settled in cash, this income is typically treated as ordinary income and taxed at the current rates. This tax treatment is in contrast to ISOs, which can convert the income into capital gains, potentially offering more favorable tax treatment. This lack of tax efficiency is a significant limitation of SARs.
From the company’s perspective, SARs still offer advantages similar to other forms of equity compensation as they align the interests of corporate professionals with those of the shareholders. When the company’s stock value increases, SARs holders directly benefit from the value they have helped create. This alignment fosters a stronger sense of ownership and accountability, incentivizing executives to drive long-term value creation.
Summary
Stock Appreciation Rights (SARs) offer numerous advantages for executives but come with considerations and potential risks. Thoroughly evaluating the terms and conditions of the SARs plan, including vesting periods, exercise windows, and potential clawback provisions, is crucial, as is understanding that the future FMV of the company shares determines the value of the future compensation.
While SARs do not offer the same tax benefits as ISOs, their long tax planning window is a significant advantage over other compensation types, such as RSUs and cash bonuses. As with almost every compensation component, preparing a long-term tax strategy is important to ensure you minimize the total tax paid and maximize the net compensation you receive.
Frequently Asked Questions (FAQ)
Q: What are Stock Appreciation Rights (SARs)?
A: SARs are a type of employee compensation that allows executives to benefit from the increase in a company’s stock price without needing to purchase actual shares.
Q: How do SARs differ from stock options?
A: Unlike stock options, SARs do not require executives to buy shares. Instead, they provide a right to receive a cash payment equivalent to the stock’s appreciation.
Q: What are some key terms associated with SARs?
A: Important terms include Grant Date, Grant Price, Expiration Date, Exercise Date, Vesting Schedule, and Fair Market Value.
Q: Are there tax advantages to SARs?
A: SARs generally do not offer the same tax advantages as ISOs. The income from SARs is treated as ordinary income, subject to regular income tax rates without options for capital gains conversion.
Q: What should executives consider when dealing with SARs?
A: Executives should understand the specific terms of their SARs, consider their tax implications, and develop a long-term tax strategy to maximize net compensation and minimize total tax paid.
If you have any questions about corporate compensation, SARs in particular, or want to explore how a Flat-Rate Fee-Only structure can help you realize your financial goals and purpose, set up a time to talk.
Your financial well-being is too important to leave to chance. Choose wisely.
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