What are Share Appreciation Rights?
A Share (aka Stock in the USA) Appreciation Right (SAR) is an award which provides the holder with the ability to profit from the appreciation in value of a set number of shares of company stock over a set period of time.
The valuation of a stock appreciation right operates exactly like a stock option in that the employee benefits from any increases in stock price above the price set in the award.
However, unlike an option, the employee is not required to pay an exercise price to exercise them, but simply receives the net amount of the increase in the stock price in either cash or shares of company stock, depending on plan rules.
How do they work in practice?
Stock Appreciation Rights are similar to Stock Options in that they are granted at a set price, and they generally have a vesting period and an expiration date. Once a SAR vests, an employee can exercise it at any time prior to its expiration. The proceeds will be paid either in cash, shares, or a combination of cash and shares depending on the rules of an employee’s plan. If proceeds are received in shares, they can be treated as any other shares of stock in a brokerage account.
Types of SAR's
There are two different types of Stock Appreciation Rights:
Stand-alone SARs are granted as independent instruments and are not issued in conjunction with any stock options, or;
Tandem SARs are granted in conjunction with a Non-Qualified Stock Option or an Incentive Stock Option, which entitles the holder to exercise it as an option or as a SAR. The election of one type of exercise prevents it from being exercised as another.
Advantages of Share Appreciation Rights
An employee automatically receives the proceeds from an exercise without having to pay for the cost of the shares.
Motivates management to grow the value of the enterprise by linking personal wealth with growth in the value of the Company’s equity.
Management and shareholders see the business in the same light as they both own a stake in the company. Hence, their interests are aligned as well as their objectives to grow value over the long run. The challenge of management’s incentives not being aligned to shareholders is called the ‘Agency Problem’.
Successful companies understand that rewarding loyalty of long-serving employees is in their own best interest. This reduces staff turnover costs as well as enhancing commitment to the company.
Providing access to purchase shares in a company creates an opportunity for staff to accrue long-term wealth through share ownership.
Disadvantages of Share Appreciation Rights
Risks / disadvantages include:
Participants are exposed to stock market fluctuations and share price movements which have no direct linkage to the company’s underlying profit performance. Hence, they can be penalised by adverse general stock market conditions, despite good profit growth.
Existing shareholders are diluted once the shares vest. Issued share options form part of the denominator in the Diluted EPS calculation.
Requires significant cash to fund the purchase of the share on vesting date (if exercised) as well as cash to fund the high taxes due on all gains made whilst the instrument was restricted.
These instruments require significant expertise to implement, manage and account for. Tax, valuation and disclosure also significant management, audit and Board oversight.
As the options need to be valued and accounted for upfront, there is a lot of guesswork required. The value of the award could be negligible once received as a result of the tax leakage and other factors outside of the control of the participant.
Up to 45% of all gains are ‘lost’ due to employees’ tax. The company must withhold this from the employee’s remuneration.
The shares can only count towards BEE targets once they vest.
What to be aware of
Many share incentive strategies were both tax and cash flow efficient for both the employee and company. Careful consideration of these benefits should be reviewed if your existing share incentive scheme was implemented prior to 2016.
If you wish to explore this topic in more detail, please contact us.