Stock Appreciation Right – Types, Examples and How do they work?
Companies adopt several methods to incentivise or retain their employees. One of the most common methods for incentivising employees in the modern corporate world is offering them stock appreciation rights (SAR). Stock appreciation right is defined as an incentive or bonus given to employees equivalent to appreciation in the company’s stock price.
Read on to learn more about SARs, their types, and advantages.
What is a Stock Appreciation Right (SAR)?
Stock appreciation rights or SARs could be broadly defined as a type of employee incentive scheme that companies offer their employees if they perform exceptionally well in their job roles. This right entitles employees to receive a compensation amount in cash equal to the appreciated value of the company’s stock price.
It works in the same way as the Employee Stock Ownership Plan (ESOP), in which employees benefit if there’s an increase in stock prices. However, there is a significant difference between the two – employees having stock appreciation rights do not have to pay the exercise price, unlike employees who avail ESOPs.
It must be noted that this scheme does not provide a right to dividend or voting rights in the company. Companies can transfer these rights from one employee to another or can compel employees to give back some or the entire amount of compensation received under clawback provisions.
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What are the Types of Stock Appreciation Rights?
The two stock appreciation rights are as follows:
1. Stand-alone Stock Appreciation Rights
Under this stock appreciation rights scheme, employees will receive the compensation in an independent form. Therefore, they will not receive any stock option with these SARs.
2. Tandem Stock Appreciation Rights
Employees will receive these rights along with incentive stock options or non-qualified stock options. Under this plan, the holder has a choice to exercise these instruments either as a stock option or share appreciation right (SAR).
However, individuals can use this instrument only once. If they have used it for one alternative, they cannot use it to exercise their other choice.
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How Does Stock Appreciation Right (SAR) Work?
Under SAR, companies give an amount to their employees, which is equivalent to the appreciated value of their stocks. This value is the difference between the current trading price and the base price, i.e., price of that stock when it was offered to employees.
Entities can give this incentive to their employees in two ways – cash or bonus issue of shares. Generally, most companies go with the cash route, but some also offer bonus shares. However, some companies also give an option between the two, and employees can pick one according to their requirements.
There is a vesting or holding period, and only after the completion of this period can employees exercise their SAR. It is the minimum time period for which employees must keep their stocks with them.
Employees opting for tandem share appreciation rights can cover the cost of receiving stock options and tax-related matters while exercising their rights. All SARs are transferable in nature, i.e., employees can transfer these rights from one individual to another.
Companies also have certain clawback provisions which will allow companies to recover the amount paid to employees in certain situations.
Companies can trigger clawback provisions when an employee does not complete his/her contract period. Moreover, if they indulge in any unethical practices like colluding with another entity, companies can demand a return of stock appreciation.
Example of Stock Appreciation Rights
Let’s understand the concept of SAR with a simple example:
Suppose you are working in a company that provides several benefits to its employees apart from their basic salary. One of those benefits is employee stock appreciation right. The company offers you 200 shares at the base price of Rs.100 per share.
The company has mandated a vesting period of 3 years, meaning that you cannot exercise your SAR before three years. After completion of 3 years, you wish to exercise the right given to you.
The trading price of that stock after three years is Rs.250. This means that the company’s stock price has appreciated by Rs.50 in these three years. As per the right, you are eligible to receive an amount either in cash or through the issue of bonus shares.
In case you opt for cash, you will receive Rs.5000 ({250-200} X 100). However, if you are optimistic about the company’s growth in the coming years, you can also opt for bonus shares. In such a scenario, you will receive 20 more shares (5000/250) of the company.
We hope that this example has helped you clearly understand how SAR works.
Stock Appreciation Rights Taxation
According to the Income Tax Act, 1961, any gains arising from the sale of equity shares will come under capital gains and are subject to LTCG or STCG as per their holding period. The capital gains are the difference between the sale value and the cost of acquiring the stocks. Sale value is the stock’s market price on the day of sale.
- If the holding period of these stocks is less than 1 year, gains arising from these will be subject to STCG. The rate of STCG is 15%.
- On the other hand, if the holding period of these stocks is more than 1 year, gains shall be taxable under LTCG at the rate of 10%. However, gains of up to Rs. 1 lakh are exempt from LTCG. Moreover, employers must deduct requisite TDS at the time of settlement of SARs.
According to Section 17 of the IT Act, 1961, any transfer or allotment of any security like stocks by employers to their employees at normal or concessional rates will come under the tax net. The Income Tax Department will consider this as a perquisite which may be taxable as salary. Employees must pay this tax on the actual value of shares corresponding to SARs minus stock appreciation price.
For listed companies, the value of shares is an average of the opening and closing price on the date of settlement. In the case of unlisted companies, the value of their shares is the fair market price, which is determined by a Grade 1 SEBI-designated merchant banker.
What are the Advantages and Disadvantages of SAR?
First, let’s discuss the advantages associated with stock appreciation rights:
- Employees can execute their rights and receive compensation without making any upfront payment. They are not liable to pay the base price of stocks of companies.
- SAR is a flexible scheme that companies can tailor according to their needs. For example, companies can select a number of employees who will receive these rights; they can also decide on the vesting period as well as liquidity of SARs.
- It helps companies manage attrition rates. This serves as an additional income for employees apart from their regular salary. In addition, as these rights are tied to an employee’s performance, it motivates him/her to work and accomplish the objectives of the company.
- The accounting method of stock appreciation rights is simple and less time-consuming.
- Under stock appreciation rights, companies can issue fewer shares and go ahead with lower dilution of share prices.
Now that you are aware of the benefits that arise from SAR, let’s turn our focus to its downsides.
- As companies issue new shares to their employees, it increases the number of outstanding shares and thereby reduces earnings per share.
- Employees may not gain anything from holding stocks of the company if the stocks depreciate instead of appreciating.
Stock Appreciation Rights vs Stock Options
Some differences between SARs and Stock Options are as follows:
| Parameter | Stock options | SARs |
| Cost | Employees can exercise these options after paying the exercise price. | Employees do not have to pay any amount for exercising their rights. |
| Ownership | Employees can directly purchase shares and become part owners of companies after completion of vesting period. | Employees cannot directly own shares of the company. |
| Mode | Employees receive stocks at the time of execution. | Employees have the option to receive compensation either in cash or stock. |
| Dilution | Dilution is high in the case of stock options. | The level of dilution of stocks is lower than ESOPs. |
| Eligibility | Only non-qualified stock options can be given to anyone. Incentive stock option is reserved for employees only. | Anyone is eligible to receive SARs. |
What are Special Considerations in Stock Appreciation Rights (SAR)?
There are several similarities between phantom stock options as well as stock appreciation rights. Like SARs, employees can exercise phantom stock options and receive an amount equivalent to an increase in the price of stocks over a period of time.
All gains accrued to employees while executing their phantom stock options are subject to taxation as per normal slab rates.
Final Word
SAR is a type of employee incentive scheme popular in a modern corporate setting. This right entitles employees to receive an amount equal to the stock’s appreciated value. This is an additional source of income for employees apart from their regular salary.
FAQs
Ans. No, stock appreciation rights do not function like securities. Unlike securities, it is not mandatory for employees to hold the underlying asset of SARs. Companies offer stock appreciation rights, and employees receive an amount which is equal to an increase in stock price. They, however, do not receive the actual stock.
Ans. Yes, an unlisted company can issue appreciation rights to their employees. However, as per SEBI guidelines, the fair market value of these stocks will have to be computed by a category A merchant banker.
Ans. As SARs are transferable in nature, the company can transfer or allot an employee’s SAR to any designated beneficiary chosen by him/her. They can execute these rights as per the company’s rules and regulations after completion of the vesting period.
Ans. Generally, you are not eligible to receive a dividend income from the company on SARs. It is merely an incentive plan that provides additional monetary earnings to employees for achieving certain goals.
Ans. Even if an employee retires, he/she can typically hold his/her vested exercisable SARs till the expiration date. However, the rules differ from one company to another. Thus, it is advisable to refer to the employer’s rules for details.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
