Your-Guide-to-the-Pros-and-Cons-of-Stock-Appreciation-Rights
ESOP

Stock Appreciation Rights: Pros and Cons

SARs may be a word we have learned to dread since the past two years; nevertheless, in the corporate language, SARs or stock appreciation rights hold the opposite connotations—it is a mutually beneficial,  positive employee compensation mechanism for companies.

Via stock appreciation rights, employees can profit from the rise in the stock prices of their employer during a predetermined period. Since the benefit of SARs is market-linked, they are similar to employee stock options (ESOPs).

The significant difference between SARs and ESOPs is that employees do not have to pay the price of the stocks in the case of the former. Instead, they only receive funds in the form of stocks or cash. When using SARs, the employee doesn’t need to hold assets. Instead, they are compensated per the contract.

The Advantages of Stock Appreciation Rights 

Let’s see the major advantages of using stock appreciation rights as a form of employee compensation:

Provides incentives without equity dilution

It is in the benefits and interests of start-ups to dilute less equity. However, start-up founders often choose between growth and preserving the equity pool. A great way to accomplish both is through using stock appreciation rights. Stock appreciation rights allow companies to incentivize and motivate their employees without diluting the equity pool.

This is because SARs do not provide shares to employees. Instead, they are a contract that derives its value based on the amount of stock appreciation.

Hence, when an employee exercises their SAR, they receive compensation in cash or shares (as preferred by the employer) depending on the amount of stock appreciation.

SARs provide a great way to retain talent as well. In addition, since part of the employee’s compensation is SAR, an employee feels compelled to do a better job and stick with the company for the long-term (similar to other stock-based compensation schemes).

Provides greater flexibility 

The primary benefit of using SARs is that they are highly flexible. As the employer, you can decide all the terms and conditions related to the SAR. However, since SAR is a contract, it is up to you to determine how the agreement is written.

Some of the flexibility lies in the fact that the employer can decide which employees receive the SAR, how much liquidity is put in it, the quantum of the SAR’s bonus, and how the SARs will be vested.

Employees do not have to purchase stocks

SARs are contracts linked to the performance of the company’s stock. However, this does not mean that the employee owns any company stock. In fact, employees do not have to pay any amount to exercise their rights under a SAR contract. 

This means that employees do not have to worry about funding their right to exercise a SAR. In addition, unlike other stock-based compensation plans, SARs work without any funding required from the employee.

Since there is no capital requirement from the employee, an employee may prefer to be bestowed SARs rather than other types of compensation schemes that do require upfront capital.

SARs can be transferred 

SARs can be made transferable. This decision is up to the organization that is issuing SARs. Since SARs are purely contractual instruments, it is up to the employer to decide whether the SAR should be made transferable or non-transferable. 

Usually, start-ups provide transferable SARs since it provides greater incentive to employees and has no potential downside for the company.

The transferable nature of SARs means that the employee can transfer his rights under the contract to another person. This person can be a spouse, adult children, relatives, or anyone. The transferability of SAR provides more flexibility to the employee who can use it as they wish.

Favorable accounting rules 

The accounting rules associated with SARs have changed over time. Earlier, SARs were dealt with using variable accounting treatment. However, nowadays, SARs are treated with fixed accounting. This accounting treatment is similar to that of other employee stock options.

The Disadvantages of Stock Appreciation Rights  

SARs have several advantages; however, there are a few disadvantages that you should be aware of:

SARs only work if stock prices appreciates 

SARs, by their very definition, are linked to the performance of the issuer’s stock price. Therefore, if the stock price goes up during a predetermined period, the holder can profitably exercise the SAR. However, in case the price of the stock goes down during the predetermined period, then a SAR is worthless in the hands of the holder.

Hence, employees need to be careful when accepting SARs as compensation. In addition, the stock markets are unpredictable. Even if the company is doing well, the stock market’s overall performance can cause a stock to perform poorly.

SARs work best when used as a long-term compensation instrument with a higher chance of being highly profitable.

No additional cash infusion 

As mentioned earlier, the employee does not have to purchase any stocks under a SAR. A SAR is a contract that provides compensation based on the performance of stocks. However, it does not require the employee to hold any stocks in the process.

Hence, since an employee does not hold any stocks, there is no additional infusion of cash when the employee exercises the SAR. This can be contrasted with ESOPs that provide the company funding when an employee decides to purchase shares.

May result in liquidity issues 

Rather than providing additional funds, a SAR can result in liquidity issues for the company. For example, this may happen if several company employees decide to exercise their SARs together at an opportune moment.

When employees exercise their SARs, the company has to pay them their due. For example, suppose the company’s stock price rose tremendously during the predetermined period; this may create significant liability for the company that has issued the SARs.

Wrapping Up 

Stock appreciation rights are fantastic to have in a company’s arsenal. If you’re an early-stage start-up owner and are confident in the future, then using stock appreciation rights as compensation to employees can be a great option. The start-up does not have to dilute its equity pool or forego crucial liquidity while compensating employees fairly.

You can compare SARs to ESOPs by checking our earlier blog post here.

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