Stock appreciation right

Stock appreciation rights (SAR) is a method for companies to give their management or employees a bonus if the company performs well financially. Such a method is called a 'plan'. SARs resemble employee stock options in that the holder/employee benefits from an increase in stock price. They differ from options in that the holder/employee does not have to purchase anything to receive the proceeds. They are not required to pay the (options') exercise price, but just receive the amount of the increase in cash or stock.

Description
Stock appreciation rights (SARs) and phantom stock are very similar plans. Both essentially are cash bonus plans, although some plans pay out the benefits in the form of shares. SARs typically provide the employee with a cash payment based on the increase in the value of a stated number of shares over a specific period of time. Phantom stock provides a cash or stock bonus based on the value of a stated number of shares, to be paid out at the end of a specified period of time. SARs may not have a specific settlement date; like options, the employees may have flexibility in when to choose to exercise the SAR. Phantom stock may pay dividends; SARs would not. When the payout is made, it is taxed as ordinary income to the employee and is deductible to the employer. Some phantom plans condition the receipt of the award on meeting certain objectives, such as sales, profits, or other targets. These plans often refer to their phantom stock as "performance units". Phantom stock and SARs can be given to anyone, but if they are given out broadly to employees, there is a possibility that they will be considered retirement plans and will be subject to federal retirement plan rules. Careful plan structuring can avoid this problem.

Taxes and accounting
Because SARs and phantom plans are essentially cash bonuses or are delivered in the form of stock that holders will want to cash in, companies need to figure out how to pay for them. Does the company just make a promise to pay, or does it really put aside the funds? If the award is paid in stock, is there a market for the stock? If it is only a promise, will employees believe the benefit is as phantom as the stock? If it is in real funds set aside for this purpose, the company will be putting after-tax dollars aside and not in the business. Many small, growth-oriented companies cannot afford to do this. The fund can also be subject to excess accumulated earnings tax. On the other hand, if employees are given shares, the shares can be paid for by capital markets if the company goes public or by acquirers if the company is sold.

If phantom stock or SARs are irrevocably promised to employees, it is possible the benefit will become taxable before employees actually receive the funds. A “rabbi trust,” a segregated account to fund deferred payments to employees, may help solve the accumulated earnings problem, but if the company is unable to pay creditors with existing funds, the money in these trusts goes to them. Telling employees their right to the benefit is not irrevocable or is dependent on some condition (working another five years, for instance) may prevent the money from being currently taxable, but it may also weaken employee belief that the benefit is real.

Finally, if phantom stock or SARs are intended to benefit most or all employees and defer some or all payment until termination or later, they may be considered de facto “ERISA plans.” ERISA (the Employee Retirement Income Security Act of 1974) is the federal law that governs retirement plans. It does not allow non-ERISA plans to operate like ERISA plans, so the plan could be ruled subject to all the constraints of ERISA. This does not necessarily have to be a problem, because ERISA is not a valid law in most countries. However, this might be a consideration for people living in the United States, where ERISA is applicable. Similarly, if there is an explicit or implied reduction in compensation to get the phantom stock, there could be securities issues involved, most likely anti-fraud disclosure requirements. Plans designed just for a limited number of employees, or as a bonus for a broader group of employees that pays out annually based on a measure of equity, would most likely avoid these problems. Moreover, the regulatory issues are gray areas; it could be that a company could use a broad-based plan that pays over longer periods or at departure and not ever be challenged.

Phantom stock and SAR accounting is straightforward. These plans are treated in the same way as deferred cash compensation. As the amount of the liability changes each year, an entry is made for the amount accrued. A decline in value would create a negative entry. These entries are not contingent on vesting. In closely held companies, share value is often stated as book value. However, this can dramatically underrate the true value of a company, especially one based primarily on intellectual capital. Having an outside appraisal performed, therefore, can make the plans much more accurate rewards for employee contributions. It is expected that hedge fund and private equity fund managers will begin to more frequently use SARs in order to circumvent IRS code 457A while maintaining proper alignment of long term incentives for employee and investors.