Back

Stock Appreciation Rights

Lesson in Course: Finance at work (beginner, 5min)

My company is issuing Stock Appreciation Rights. How do they work and how can I maximize the value?

Eureka!

What it's about: Stock Appreciation Rights is a rare form of equity compensation that doesn't require the employee to buy shares in the company.

Why it's important: While not all startups issue Stock Appreciation Rights, receiving them can allow us to receive a payout before a liquidity event.

Key takeaway:  We should wait to exercise Cash-Settled SARs, and consider exercising Stock-Settled SARs when we can.

Under certain conditions, we can receive stock-based compensation that does not require us to own stock in the company. Some of us are probably scratching our heads right now. While rare, companies may elect to grant employees Stock Appreciation Rights along with their regular equity grants or in replacement.

What is Stock Appreciation Right?

A Stock Appreciation Right (SAR) is equity-based compensation that provides the employee the ability to profit from the appreciation in the value of a set number of shares of company stock over a set period of time.

Typically stock options allow us to buy shares in the company, and we make money if the shares of the company increase in value and there's an opportunity to sell our shares. SARs are quite different because they don't require us to buy the shares. Instead, SARs represent a promise from the company to compensate us for all future increases in the stock's value. When we are granted our SAR, the fair market value or FMV of the common stock is set as the benchmark. Our SAR profit directly when the stock price is above this benchmark. 

Let's step through a quick example.

The value of SARs

We've recently been granted 1,000 SARs by the company. The FMV of the shares of common stock at the time of our grant is $3 per share. Two years later, the FMV of the common stock is now $25 per share.

The value of our SARs is the difference between the FMVs or $22 per share. If we've vested and are allowed to exercise, the company would owe us $22 per share exercised. Our SARs are valued at a total of $22,000 ($22 per share x 1000 SARs).

 

Types of SARs

SARs are structured to pay in cash or in shares issued by the company. In the example above, we covered a cash-settled SAR

What is Cash-Settled SAR?

The right to receive cash in an amount equal to the difference between the Fair Market Value of a share of Common Stock on the date of exercise and the Fair Market Value of a share of Common Stock on the date of grant multiplied by the number of shares exercised.

Cash-Settled SARs can often be issued alongside ISO or NSOs. These SARs are often called tandem SARs and the SARs help pay for the exercise price required for the ISO or NSOs. Tandem SARs are very employee-friendly since they are designed to help the employee foot the exercise bill. 

Tandem SARs enable employees to celebrate alongside the company's success

The second type of SAR is a Stock-Settled SAR which pays in shares of the common stock at the time of exercise.

What is Stock-Settled SAR?

The right to receive common stock in an amount equal to the difference between the Fair Market Value of a share of Common Stock on the date of exercise and the Fair Market Value of a share of Common Stock on the date of grant multiplied by the number of SAR exercised divided by the Fair Market Value of a share of Common Stock on the date of exercise.

Let's break that down with a simple example.

Stock-Settled SARs

Let's revisit the same example as above except this time the SARs we've received are stock-settled. After two years, the value of our SARs is still $22,000. However, if we are able to exercise all of our SARs, the company would issue 880 shares of common stock at the FMV price of $25.

The total value of exercisable SARs: $22,000

Price of shares: FMV of $25 per share

Shares received: $22,000 / $25 = 880 shares of common

 

Vesting and exercising for SARs

SARs are structured with vesting periods similar to that of stock options in a company's ESOP plan. Often, SAR vesting periods match the vesting periods of ISOs or NSOs granted by the company. Let's take a look at an example of SARs with a 4 year vesting period and a 1-year cliff.

SAR Vesting

The one-year cliff means that we don't see a penny of the SAR until we've stayed beyond 12 months. After the first year, we start vesting into the full value on a monthly basis.

At the end of years 1, 2, 3, and 4 we would own 25%, 50%, 75%, and 100% of our SARs respectively.

Performance-based vesting

Depending on the SAR agreement, time-based vesting can be replaced by performance-based vesting. Instead of vesting linearly over a period of time, vesting is tied to a specific event. These events could include but are not limited to:

  1. Individual performance metrics
  2. Company milestones
  3. Liquidity events such as an M&A or IPO

Exercising

Once our SARs begin vesting, we are entitled to the value of the vested portion of the appreciation agreement. However, we won't receive any compensation until we decide to exercise our SARs. 

Exercising SARs allows us to cash in on the appreciation of the stock

By exercising, we will notify the company of the number of vested shares we would like to redeem to receive the appreciation bonus. Depending on the type of SAR, the company will prepare a cash payment or common stock in exchange for the SARs exercised. After receiving the compensation, the exercised SARs will go back to the company.

 

Actionable ideas

In the case we are offered SARs, it's important to remember that SARs do not represent ownership in the company and we do not need to file an 83(b) election. However, if we have received tandem SARs, we should still consider all of our exercise options for the NSO and ISOs, including potentially an 83(b) election. The next steps are to understand the tax consequences for SARs.

Glossary

What is Stock Appreciation Right?

A Stock Appreciation Right (SAR) is equity-based compensation that provides the employee the ability to profit from the appreciation in the value of a set number of shares of company stock over a set period of time.

What is Cash-Settled SAR?

The right to receive cash in an amount equal to the difference between the Fair Market Value of a share of Common Stock on the date of exercise and the Fair Market Value of a share of Common Stock on the date of grant multiplied by the number of shares exercised.

What is Stock-Settled SAR?

The right to receive common stock in an amount equal to the difference between the Fair Market Value of a share of Common Stock on the date of exercise and the Fair Market Value of a share of Common Stock on the date of grant multiplied by the number of SAR exercised divided by the Fair Market Value of a share of Common Stock on the date of exercise.