Building the right team is critical to the success of your business, but finding and training the right personnel takes significant time and effort, and is a process repeated every time a member of your team moves on to future opportunities. In the current landscape, where competition for talented employees is high, business owners are constantly searching for ways to motivate and retain their key employees. Employee Stock Options are well-known employee incentives that give employees the right to purchase shares of stock in the company upon the occurrence of certain vesting events. However, issuing Employee Stock Options can be burdensome to both the company and the employee in ways that are avoidable by issuing Stock Appreciation Rights, or “SARs”, instead of Stock Options.
What’s the Difference between a Stock Option and a SAR?
A Stock Option grants the recipient the right to acquire shares of stock in the Company at a specified exercise price upon the occurrence of a vesting event, which can be time-based (e.g., years of service) or milestone-based (e.g., outside capital raise, IPO, sale of the company).
A SAR, on the other hand, grants the recipient a right to receive an award (usually cash) equal to the increase in the stock price over the time period between when the SAR vests and the award maturity event occurs. Like Stock Options, SARs can also use time-based and milestone-based vesting events, but SARs have certain distinct attributes that can make them more suitable than Stock Options for certain employers.
Why Might a SAR Be More Beneficial Than a Stock Option?
Taxes—Stock Options are generally taxable to the recipient (e.g., employee, independent contractor, advisor) at exercise to the extent that the fair market value of the purchased stock exceeds the exercise price to acquire the stock under the Stock Option. Therefore, the Stock Option recipient would either need to buy the stock at fair market value or pay income tax on the difference between the exercise price and the stock’s fair market value. Many Stock Option recipients may be put off by the expense of acquiring stock in a growing company that is reinvesting its profits and does not have an established market for the recipient to sell the securities, to say nothing of the downside risk of acquiring stock in a growing company.
Of course, the company could cover these costs for the recipients by increasing compensation, but the increased compensation would itself be taxable to the recipient, making this an available option, but tax inefficient. SARs, on the other hand, do not need an exercise price, and are not necessarily taxable until the SAR award matures, if structured appropriately.
With a SAR, the recipient would not incur an income tax liability as a result of the SAR grant until they had a right to receive an award (usually cash) upon the occurrence of an award maturity event, say for instance, a sale of the company. Recipients who have just received cash from an award maturity event are much better positioned to satisfy an income tax liability; compared to their Stock Option counterparts who are required to pay fair market value to acquire their stock, or pay income tax on the difference.
From an economic standpoint, SAR recipients should be in the same place that they would have been had they exercised under a Stock Option, but without the expense on the front-end of acquiring the stock at fair market value or paying income tax on the difference between the exercise price and the stock’s fair market value.
Shareholder Information Rights
A SAR may also be more beneficial to the issuing company because it does not confer the same shareholder inspection rights that an employee may acquire after exercising a Stock Option. For example, Sections 1600 and 1601 of the California General Corporation Law and Section 220 of the Delaware General Corporation Law, grant shareholders the right to make copies of the company’s stock ledger and its books and records, which can include the company’s accounting records and the minutes of shareholder and board meetings. Companies have a legitimate interest in keeping the identities of their investors private and maintaining their accounting and financial information on a need-to-know basis, which may be undermined by granting shares of stock pursuant to Stock Options.
Directors and officers also have fiduciary duties to maximize value to the Company’s investors. Turning key personnel into shareholders and taking on the same fiduciary duties owed to investors is often an unintended consequence of Stock Options.
SARs do not carry these risks because they avoid the issuance of shares entirely and instead grant to recipients a contractual right to payment upon the occurrence of an award maturity event.
To Summarize:
- SARs motivate their recipients to stay at the company and work hard on the promise that they will be rewarded when the award maturity event occurs.
- Linking company performance to compensation aligns the core team with the company’s interests and incentivizes staying with the company to achieve the award. Keeping the core team together increases productivity and saves on the cost of searching the labor market for suitable replacements and re-starting the training process.
- Unlike Stock Options, SARs can be structured so that the employee does not incur a tax liability until the award maturity event. This avoids burdening employees who may not have the liquidity to purchase stock at fair market value or pay income tax on the difference between the exercise price and the stock’s fair market value. Similarly, with SARs, companies are not forced to decide whether to compensate their employees for the financial burden of exercising the Stock Option.
- SARs do not confer statutory shareholder rights. Thus, companies can better protect their proprietary information by keeping their books and records confidential.
Closing Considerations When Using SARs
SARs are not as well-known as Stock Options. Thus, recipients may not be as enthusiastic about SARs because they are not “owners”. However, effectively communicating how SARs operate to compensate recipients in the same manner as Stock Options, but avoid the burdens and risks of Stock Options, can make SARs an effective method of compensation.
SARs, like Stock Options, can have unintended tax and legal consequences like those described above for Stock Options, or potentially violate the deferred compensation rules of Internal Revenue Code § 409A. Therefore, companies must carefully draft and thoughtfully consider the terms and conditions of the SAR documents.
SARs, however, are still an efficient way to motivate and retain top talent and avoid the added costs of continually hiring and training new candidates in a competitive labor market. Clearly communicating and illustrating to your employees how SARs can operate as economic equivalents to Stock Options, and appropriately structuring the SAR terms, are critical to their success. With careful planning and advice, SARs can be an effective and cost-efficient (to companies and recipients alike) alternative to Stock Options.
Note: This article is not meant to provide specific legal advice. For further advice, please contact any of the attorneys in our Corporate and Real Estate Practice Group who are ready to assist you.
Counsel in the firm’s Corporate and Real Estate Practice Group