What Are Stock Appreciation Rights?

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  • 10 Nov 2023
What Are Stock Appreciation Rights?

Key Highlights

  • Employees holding shares of a company and having stock appreciation rights (SARs) are entitled to cash payments equal to the increase in prices of those shares.
  • SAR programs provide businesses the freedom to design the compensation plan whichever best serves the beneficiaries.
  • Tandem SARs are given to employees in the form of stock options and SARs to assist them in paying for the option purchase.
  • When you use SARs, they are regarded as taxable compensation. If you get compensation in the form of stock shares and later sell them for a profit, you can also be liable for capital gains tax.

A stock appreciation right (SAR) is the right to receive payment equal to a rise in the price of the company's stock over a certain level or the value of equity shares currently traded on the open market. A SAR is a form of deferred incentive compensation awarded to employees when the company's stock value exceeds the option exercise price.

Given that SARs grant the holder the right to collect a sum equal to the excess of the optioned shares' market value over a certain period of time, it functions similarly to a stock option. A SAR, however, differs from a stock option in that an employee receives the same money without having to spend money on buying the option.

An Example of SARs For instance, suppose you received stock appreciation rights on 20 shares of your firm XYZ, each of which is worth Rs. 20. The share price rises from Rs.100 to Rs. 120 over time. This indicates that since Rs. 120 was the higher value, you would receive Rs. 20 for each share. If each share were worth Rs. 20, you would get Rs.20 overall (Rs.20 x 100 = Rs.200). This is only an example; additional things must be taken into account before you can be paid.

In essence, SARs give investors the opportunity to benefit from share price growth over a certain period of time. Each employee's vesting timetable is set up by the SAR program, after which it can be exercised. SARs and the company's predetermined performance targets are connected by the agreement.

Employees may receive SARs from their employers in addition to stock options, which help them raise the money needed to pay the exercise price. As a result, it is argued that the SARs work in conjunction with a stock option.

SARs can motivate employees if they believe their efforts can influence the future market value of the stock. SARs are, therefore, a type of incentive payment. Tandem SARs serve as a vital tool for assisting employees in funding the payment of stock options and covering income taxes on taxable profits. This is why they are often integrated into stock option programs. Hence, they are commonly authorised under stock option programs.

SARs function by giving employees the right to benefit from an increase in the estimated value of the company's shares over a certain period of time. The appreciation is calculated using the difference between the stock price at the time of grant and the stock price at the time of exercise.

Employees who exercise their share appreciation rights are rewarded with cash equal to the increase in the company's stock value. SARs may be paid in cash or shares. Cash-settled SARs are more common since they reward employees with cash when the value of the company's stock rises. Some businesses may provide employees genuine shares of the company's equity in the form of share-settled SARs rather than cash payments.

SARs offer flexibility and reduce share dilution. This is the key benefit SARs offer employers. However, it's important to note that this does not address the primary objectives of employee equity compensation, which include motivating, retaining, and attracting talent.

Flexibility: SARs may be planned in a variety of ways to suit various people, such as through vesting requirements and the choice of whether to pay out SARs in cash or shares.

Less stock dilution: Because SARs call for the issuing of fewer company shares, companies can pay employees equity-linked remuneration without having to diluted their stock. You can decide on an individual basis what the vesting schedule will be in order to encourage, reward, keep, and attract talent.

Favourable accounting rules: Stock-settled SARs are handled much like traditional stock option plans and are given fixed accounting treatment rather than variable treatment.

The primary advantage of SARs for employees is that they are not required to purchase company shares. When the value of the company's stock increases, employees will gain from the SARs since they will get an increase in either cash or stocks (which is typically the case). The anticipated prize won't come to pass, though, if the stock price doesn't increase.

In other words, using SARs, employees don't really run any risk. However, they are vulnerable to changes in the stock market.

The income from a SAR spread is taxable at the time of exercise. In India, the earnings from SARs are taxed as long-term capital gains. In order to pay the tax, an employer often grants a set number of shares and retains the rest. The taxes are calculated on the amount of revenue earned when holders sell the shares.

There are two ways to gain equity: stock appreciation rights and employee stock options. Employees who have stock options have the opportunity to purchase shares of the company's stock for a certain price and duration. The following are the differences between SARs and employee stock options based on various parameters.

Ownership

With stock appreciation rights, you don't need to buy company shares to benefit from their increased value. Contrarily, employee stock options require you to exercise your right to buy company shares in order to profit from any appreciation.

Appreciation Payout

The corporation may provide cash or shares of stock valued at the same amount when you exercise a stock appreciation right. On the other hand, you purchase company stock when you exercise a stock option. After exercising the option, you would need to sell those shares if you wanted to convert them to cash.

Taxation

When you exercise your stock appreciation rights, the proceeds are regarded as taxable income. If you choose to sell the stock you received, you shall have to pay capital gains. The amount of tax is based on the increase in the value of the stock. On the other hand, stock options are taxed depending on whether they are non-qualified or incentive stock options.

Here's a table capturing the differences between stock appreciation rights vs. employee stock options.

Parameter Stock Appreciation Rights (SARs) Employee Stock Options (ESOs)
OwnershipNo need to purchase company shares to benefit from increased valueMust exercise the option to purchase company shares to profit from appreciation
Appreciation PayoutMay receive cash or shares of stock valued at the same amountPurchase company shares
TaxationProceeds from exercising SARs are taxed as ordinary incomeTaxed differently depending on whether they are non-qualified or incentive stock options
Timing of TaxationTaxed upon exerciseTaxed upon exercise (non-qualified options) or upon sale of shares (incentive stock options)
Capital Gains TaxOnly if you sell the stock received instead of cashOnly if you sell the shares acquired through exercising the options
RiskNo upfront investment required; limited potential gainUpfront investment required; potential for higher gains
SuitabilityEmployees who are unsure about long-term ownership of company stockEmployees who believe in the company's future growth and want ownership

FAQs on Stock Appreciation Rights

No, stock appreciation comes in two forms. The first one is equity, while the second one is cash.

No, stock appreciation rights are different from equities. This is because they don’t need employees to hold a contract or asset.

Employees frequently get SARs as a bonus or a performance incentive as part of their base pay. However, SAR terms and conditions vary from business to business and can be changed to suit the needs of the organisation.

Phantom stocks are an assurance to grant an employee a bonus in one of two ways. The equivalent of the share price of the firm or the rise in share price over a specified period is paid to employees. However, stock appreciation rights are not promised to the employees. They are incentives given to employees when the company's stock value exceeds the option exercise price.

This depends on the business and structure of the arrangement. For instance, a business can alter the SAR plan's structure or offer an alternative route to equity ownership following a merger or acquisition.

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