Updated October 12,2020:

What are Stock Appreciation Rights?

Stock appreciation rights are a type of incentive plan based on your stock's value. Employees receive a bonus in cash or equivalent number of shares based on how much the stock value increases over a set period of time - usually from the date of granting the right up until the right is exercised. People familiar with phantom stock will recognize the basic similarities between the two. It is important to note that unlike stock options, employees also do not have to pay the exercise price to receive the bonus in stock or cash.

Holding stock appreciation rights is not the same as holding shares of stock. Employees do not receive a share of equity when you award appreciation rights.

You are free to set the bonus at any level you feel is appropriate. The bonus is usually paid in cash, but you can elect to award shares of stock instead.

For example, imagine an employee is granted a Stock-Settled SARs (SSAR) for 1,000 shares when the company’s stock price is $10 per share. When the employee exercises the vested SSAR, the stock price is $20 per share. The employee gains $10,000 (($20 current price - $10 grant price) x (number of SSARs exercised) which is then divided by the current stock price ($10,000 / $20) resulting in 500 shares. The employee would now owe income and employment taxes on the $10,000 which would cause the shares to be withheld or sold from the 500 shares to cover taxes and fees. The left over shares would be given to the employee to hold or sell.

However, imagine if an employee is granted Cash-Settled SARS (CSARs), the employee would just immediately owe income and employment taxes on the $10,000 gain and would receive the remaining amount in cash. As you can see, employees only receive benefits when the stock prices rise or appreciate.

Phantom Stock vs. Stock Appreciation Rights

Phantom stocks are just a promise that an employee will receive a bonus equal to either the value of the company’s shares or the increase in stock price over time. They are typically reflective of stock splits and dividends. The bonus the employee receives is taxed as ordinary income based on the time it is received. However, since phantom stock is not tax-qualified, it does not follow the same rules as employee stock ownership plans (ESOPs) and 401(k) plans.

Stock appreciation rights offer the right to the cash equivalent of the increase in value of the stocks over time. This bonus is usually paid in cash or employee bonus in shares. Typically, SARs can be exercised after they vest. They are also issued with non-qualified stock options or incentive stock options to fund the purchase of options or pay off taxes due when the SARs are exercised, also known as tandem SARs.

Stock appreciation rights can be very flexible with differences in who gets how much, vesting, liquidity concerns, restrictions on selling shares, eligibility, rights to interim distribution of earnings, and rights to participate in corporate governance.

Why Are Stock Appreciation Rights Important?

Stock appreciation rights allow you to reward employees for helping your business grow without giving up equity. This is often an attractive option for young companies, such as start-ups. Employers have flexibility in payment options, depending on how their company is set up, and they can usually fund the rights (if paid in stock) through their own payroll system. The payments can be either cash, shares, or some combination thereof.

Employees also receive the benefit of not having to spend cash to buy a non-qualified stock option. Employees further benefit from the flexibility of stock appreciation rights in that they can choose when to exercise their rights at any point between the time it vests until the time it expires.

Reasons to Consider Using Stock Appreciation Rights

Growing companies commonly use stock appreciation rights for the following reasons.

It gives your employees incentives without giving up equity.

You are an S-Corp, LLC, partnership or other business entity that is limited in its ability to award stock.

It adds a different kind of incentive option to existing plans such as Employee Stock Option Plans (ESOP) or Employee Stock Purchase Plans (ESPP).

It saves employees from having to buy stock options.

Reasons to Consider Not Using Stock Appreciation Rights

These are reasons to consider avoiding stock appreciation rights.

A plan that covers all employees and continues to provide benefits after termination may need to follow ERISA (retirement plan) rules.

You want the additional cash infusion that comes when employees buy options.

In certain situations, special shareholder approval may be required before issuing stock appreciation rights. This most commonly occurs when a publicly traded company pays the bonus in stock rather than cash.

Key Features

Stock appreciation rights contain several key features.

Base Price: The bonus is based on how much the stock has increased over the base price. The base price is usually the fair market value on the date the appreciation rights were granted.

Vesting: The rights may be conditional based on how long an employee works for the company, an employee's performance or the overall company's performance.

Exercise Period: The time during which the employee may exercise their appreciation rights. This often runs from when the rights vest to the expiration date.

Expiration Date: Stock appreciation rights often have an expiration date. If the conditions for the bonus aren't met by this date, the employee loses the rights. Most rights last from 7-10 years before expiring.

Tax Implications - Upon exercising rights, employees must report any income on the fair market value of the amount of the right received at vesting - even if it is a share and is not sold. The employer usually must withhold taxes (usually by withholding cash or shares).

To learn more about the requirements for a stock appreciation rights incentive plan or to get help creating yours, search UpCounsel for a securities lawyer today. UpCounsel screens lawyers for you to match you with a highly qualified lawyer in your area.