Stock Appreciation Rights (SAR)

What is Stock Appreciation Right and how is it beneficial for employees?

The Stock Appreciation Rights refer to a technique for providing monetary incentives, that are based on the increase in stock price of a company. This is mostly used as a compensation tool by the employers, in order to reward their employees.

As part of a typical Stock Appreciation Rights scheme, if the stock price of the company moves up in a pre-defined time duration, then the employee will get a payout in proportion to the increase in price. This is usually paid in cash by the employer, but some companies might give equivalent Bonus Shares instead.

Whereas if the stock price decreases in the defined duration, then no incentive is paid out. So, the employees get the benefit of an increase in the stock price of their employer, without the need for actually buying the stock of the company. This makes the SAR plans an attractive way for the employers to provide ESOPs (Employee Stock Ownership Plans).

Stock Appreciation Rights example

Let us use a simple example to explain how Stock Appreciation Rights agreement will work in real life. Suppose that the current market price of a stock is INR 100, and the company issues 800 Stock Appreciation Rights at INR 100 to an employee.

Now, there could be some conditions associated with these Appreciation Rights. For example, the employee might be able to exercise these rights (receive the profits) at any time in the future, after a certain holding period is completed. Or there might be a default settlement date, when all the SARs are exercised, and all the employees are paid out.

Let us assume that 5 years later, the stock price touches INR 210, and the employee decides to sell/exercise the ESOP SARs. The share appreciation in this duration is INR 110. So, the employee will get a payout of:

\(INR 110 × 800 = INR 88,000\)

The INR 88,000 could be paid in cash, or in the form of shares of the company. On the other hand, if the stock price had dropped to INR 90 at the sale/exercise time, then the employee would not have received any cash compensation from the employer.

For listed companies, the market price on Stock Exchange is used as a reference. Whereas for startups and unlisted firms, the valuation at different funding rounds is used for calculations. (Refer: What are the different Startup funding rounds?)

Benefits of Stock Appreciation Rights

For the employees, getting an SAR can be a great way to be a part of the growth of their employer. In this scheme, the employee does not have to make any initial contribution, or make any payment at maturity/exercise time. If the settlement is happening in cash, then there is no need for the employee to open a Demat Account.

Besides the Basic Salary, these schemes can offer a great way to reward the employees for their performance, and for their loyalty to the company. That is why Startup Stock Appreciation Rights form an important part of the total compensation for the employees.

Benefits for employers

The main idea behind these financial instruments is to incentivize the employees, and to provide them a benefit that is directly linked to the performance of the company. If there is a Vesting Period, then it can also prevent employees from switching jobs. Moreover, the company could decide to selectively distribute the SAR ESOPs to their best performing employees.

A big benefit of Share Appreciation Rights for the employer is that they do not have to issue new shares of the company to the employees. So, there will be no Equity dilution for the existing shareholders of the company.

Stock Appreciation Rights vs Options

Both Employee Stock Appreciation Rights and Employee Stock Options are a technique for the employers to reward their workers. However, there is a difference in how the benefit of stock price appreciation is distributed in these 2 techniques.

In case of Employee Stock Options (ESOs), the employee gets a choice to buy the shares of the company, after a certain duration (also known as Vesting Period). The employer usually keeps a low Strike Price of the Options Contract, so that the employee gets the benefit of an increase in price. However, it is not mandatory for the employee to buy the stock.

Example: Suppose that an employee gets Stock Options at an Exercise Price of INR 200, and a vesting period of 5 years. After five years, if the stock price is greater than INR 200, then the employee can still purchase the shares at the lower price of INR 200. But if the price is less than INR 200, then it would not make sense to buy the shares at INR 200.

Difference between SAR and ESO

So, the employee can get ownership of the shares at the end of Vesting Period in ESO. But in case of SAR scheme, there is no Exercise Price, and the employees do not have to pay anything. So, there will be no distribution of stocks in case of SARs. The employee will only get a compensation, that will be in proportion to the increase in stock price.

Also, if new shares are issued to be distributed to the employees at the maturity of ESO, then it would lead to a dilution for the existing shareholders of the company. But in case of Equity Appreciation Rights, there is no dilution of ownership for existing shareholders, when the settlement is in cash.

Stock Appreciation Rights vs Phantom Stock

The Phantom Shares refer to a dummy stock, which allows the beneficiary to get a monetary compensation in the future, that will directly depend on the stock price. This is more like a mutual agreement, because no stocks/securities are issued. So, the beneficiary will only receive the benefit of price increase or decrease, and there will be no other shareholder benefits like Dividends, voting rights etc.

The main difference between Stock Appreciation Rights and Phantom Shares is that there is a possibility of downside in Phantom Shares. If the price of the Phantom Stock decreases from the Issue Price/Buy Price, then the employee will be faced with a potential loss.

While in case of a Stock Appreciation Rights plan, the employees only receive monetary compensation, if the price of the stock moves up. If the price remains same or moves down, then the employer usually does not pay anything to the employee. So, the only loss in that case will be the potential loss of the bonus/additional income.

Disclaimer

  • This page is for education purpose only
  • Some information could be outdated / inaccurate
  • Investors should always consult with certified advisors and experts before taking final decision
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