As a business evolves from a startup to a growth-stage company, it becomes crucial to implement executive compensation programs that align with this new phase. Rather than just offering salaries and bonuses, you need incentives that motivate leaders to build long-term value. One approach is using stock appreciation rights.
Stock appreciation rights (SARs) provide executives the financial benefits of stock appreciation without actually owning company equity. Executives are granted a set number of SARs which vest over time. Upon vesting, the executive receives a cash payout equal to the difference between the SAR grant price and current fair market value (FMV) per share.
This provides the upside and incentives of increasing equity value without diluting ownership or granting voting rights. Executives are motivated to boost share price over time, aligning their interests with shareholders. The cash payouts could reward them for long-term focused growth.
In this article, we’ll explore SARs in-depth - how they work, key benefits, plan design considerations, and how they compare to real stock appreciation rights.
Table of Contents:
- What are Stock Appreciation Rights (SARs)?
- Potential Benefits of SARs
- Considerations in SARs Plan Design
- Stock Appreciation Rights (SARs) vs Stock Options
- Your Next Steps: Determining if Using SARs is Right for Your Business
What are Stock Appreciation Rights (SARs)?
Form of cash bonus tied to increase in company's share value over time
SARs provide executives a cash incentive award based on the growth in the company's share price from a predetermined grant price.
For example, an executive may be granted 10,000 SARs at a grant price of $5 per share, which vest over 5 years. If the share price increases to $10 after 3 years, the vested SARs can be exercised for a cash payout of $50,000 (($10 FMV - $5 grant price) x 5,000 vested SARs).
|
SARS Example |
Year 1 |
Year 3 |
Year 5 |
|
SARs Vested |
2,000 |
6,000 |
10,000 |
|
Stock Price |
$7 |
$10 |
$15 |
|
Potential Payout per Vested SAR |
$2 ($7 FMV - $5 grant price) |
$5 ($10 FMV - $5 grant price) |
$10 ($15 FMV - $5 grant price) |
|
Total Potential Payout |
$2,000 SARs x $2 = $4000 |
6,000 SARs x $5 = $30,000 |
10,000 SARs x $10 = $100,000 |
This is for illustrative purposes only. The information is being provided for general educational purposes only and is not intended to provide legal or tax advice.
This structure rewards executives for boosting shareholder value over time.
Executive granted set of SARs which vest over time
When SARs are granted, a certain number of rights are designated for an executive based on their position, salary, performance or other factors. These SARs do not represent actual shares or options.
They can vest incrementally based on the established schedule, say 20% per year over 5 years. Vesting is contingent on continued employment and may also depend on hitting performance milestones.
Another example of vesting is called “cliff vesting.” This is where the executive needs to stay with the company a certain period of time, e.g. 5 years, or they end up receiving nothing.
Upon vesting, cash payout equal to difference between grant price and current FMV per share
On the vesting date, the executive can redeem vested SARs for a cash payment. The payout is calculated as the positive difference between the current fair market value (FMV) per share and the original grant price, multiplied by the number of SARs vesting.
The FMV may be determined via 409A valuation, book value formula, or other methodology. The grant price is set at time of award.
Provides financial upside of equity appreciation without ownership
A key benefit of SARs is providing the financial rewards of stock price gains without actual ownership. Executives profit like shareholders when market value rises but do not receive equity, voting rights, dividends, etc.
This incentive alignment is achieved without diluting ownership control for founders and investors.
Potential Benefits of SARs
Incentivizes executives to boost share value
SARs incentivize executives to increase the company's equity value over the long-term.
Since the payout is tied directly to share price appreciation, leadership is motivated to implement growth strategies, make investments, and spearhead initiatives that will sustainably grow market value. This discourages short-term plays just to temporarily inflated share price.
Potential rewards for long-term growth, not short term gains
By linking payouts to long-term, sustained share price growth, SARs reward leadership for building fundamental value.
Executives must focus on multi-year strategic planning, not quick fixes to turn a fast profit. This mindset better serves shareholders' interests in the company.
Aligns interests with shareholders
Tying executive payouts to share price aligns their interests directly with shareholders, who also benefit from share appreciation.
It promotes viewing decisions from a shareholder perspective rather than only through the lens of compensation goals.
Flexible design to meet retention and incentive goals
SARs allow flexibility in plan design to balance incentives with retention power. The vesting schedule, grant size, grant price, and payout calculations can all be tailored to company goals for executive motivation and loyalty.
No dilution of ownership like stock options
A key benefit for private companies is SARs do not dilute ownership or require granting actual equity like stock options do. Founders maintain control while still incentivizing executives through share price-based bonuses.
Considerations in SARs Plan Design
Vesting schedule (time-based, performance-based or both)
The vesting structure impacts retention power and incentive effects. Time-based vesting over 3-5 years promotes retention but lacks performance linkage.
Performance-vesting ties payout eligibility to metrics like revenue goals. Hybrid approaches combine time-based and performance vesting for balanced incentives.
Fair market value determination method
Valuing shares requires setting a fair market value methodology.
Common approaches include 409A appraisals, discounted cash flow models, book value formulas based on assets - liabilities, or valuations based on recent funding rounds. The method should accurately reflect company value.
SARs grant size determination (percent of salary, etc)
Typically SARs are granted annually as a percent of base salary, such as 15% or 25%, then converted to units based on the grant price.
This provides a clear system for grant sizes linked to role and salary level. Alternatives include fixed unit awards not tied to salary or grants based on cash bonus amounts.
Plan funding/accounting considerations
SARs represent a future liability for the company until payout. Accounting rules require liability accruals over the vesting period.
Payouts are funded from company cash reserves. Careful cash flow planning helps ensure sufficient funds for payouts as SARs vest.
The design choices determine the retention power, incentive effects, expense impact, and dilution impact of the SAR plan.
Stock Appreciation Rights (SARs) vs Stock Options
When determining which executive compensation model to use, business owners may consider utilizing stock options instead of stock appreciation rights.
Here are some key similarities and differences between the two types of compensation.
Key Differences Between SARs and Stock Options
- Both give employees the right to profit from an increase in the company's stock price without needing to purchase shares.
- Neither SARs nor options require an upfront payment or investment from the employee.
- Both are forms of compensation that align employee incentives with shareholder value.
Key Differences Between SARs and Stock Options
- Stock options give employees the right to purchase company shares in the future at a set price. SARs do not give actual company shares, only the cash value of the appreciation.
- With options, employees only profit if the shares increase higher than the set purchase price. SARs provide cash value equal to any stock appreciation.
- Options must be exercised and shares sold to get cash value. SARs convert automatically to cash upon exercise/vesting.
- SARs do not dilute company ownership like issuing new option shares does.
SARs allow employees to potentially benefit from stock gains without needing to purchase or sell shares. They provide a similar incentive as stock options, in that they are tied to share price growth, but the potential benefit is paid in cash rather than company stock.
Your Next Steps: Determining if Using SARs is Right for Your Business
Stock appreciation rights can be an effective way to incentivize executives and align their interests with shareholders without diluting ownership.
Well-designed SAR plans provide leadership performance incentives while maintaining founder control and minimizing complexity for private companies. They strike an effective balance between compensation, motivation, and ownership considerations.
To determine if SARs could benefit your executive compensation program, consult experienced executive compensation professionals. Working with experts in equity incentives, valuation methods, plan design, legal and tax implications can help you build an impactful SAR program tailored to your business goals and context.