Stock Appreciation Rights (SARs)
Stock Appreciation Rights (SARs) are a form of employee compensation that lets recipients capture the economic gain from an increase in a company’s stock price without purchasing shares. They provide a payout equal to the appreciation in the stock price over a specified period and can be settled in cash, shares, or a combination.
How SARs work
- SARs grant the right to receive the increase (the “spread”) in a company’s stock price between the grant or base price and the exercise date.
- They typically do not require an exercise price or an upfront purchase by the employee.
- Payouts are usually in cash but can also be delivered as shares. When shares are issued, employers often withhold a portion to cover taxes.
- SARs commonly vest according to a time schedule or performance conditions. Only vested SARs may be exercised.
- Employers often issue SARs alongside stock options (tandem SARs) to help employees fund option purchases or cover taxes.
Tax treatment
- SARs are generally taxed like non‑qualified stock options: no tax on grant or vesting, and ordinary income is recognized on the spread at exercise.
- Employers typically withhold federal (and applicable state/local) income taxes and employment taxes at exercise.
- If settled in shares, the income recognized at exercise becomes the cost basis for later capital gains calculations when those shares are sold.
Comparison with phantom stock
- Phantom stock is a related cash‑settled plan that more directly mirrors total shareholder returns (including adjustments for splits and dividends).
- Both deliver value without immediate share issuance, but phantom stock often ties payments to dividend and split adjustments and is taxed as ordinary income when paid.
Pros
- Allows employees to benefit from stock appreciation without buying shares.
- Can motivate and retain employees without immediate dilution of shares.
- Flexible plan design—companies can tailor vesting, performance goals, settlement method, and eligibility.
- Typically requires issuing fewer shares than some equity plans, reducing dilution.
Cons
- High risk for employees: if the stock doesn’t appreciate, SARs can expire worthless.
- Plan design complexity—companies must make multiple structural choices (who receives SARs, vesting, liquidity, settlement mechanics).
- Ordinary income treatment at exercise means immediate tax liability on the spread.
Practical example
An employee receives 200 SARs that vest in two years. If the stock rises by $35 per share over that period, the employee receives 200 × $35 = $7,000. A clawback provision could nullify the payout if the employee leaves before vesting or breaches other conditions.
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Key considerations
- Vesting schedule and performance targets determine when SARs become exercisable.
- Clawback provisions can allow the company to reclaim SARs or proceeds under specified circumstances (e.g., departing to a competitor).
- Settlement method (cash vs. shares) affects cash flow for the company and tax/cost‑basis treatment for the employee.
- Understand the plan’s treatment of tax withholding and any impact on dilution.
Conclusion
SARs offer a way to align employee incentives with company performance while avoiding immediate share purchases and reducing dilution. They are flexible tools for compensation design but carry risk for recipients and require careful plan structuring and clear communication about vesting, taxes, and clawbacks.