A company that is able to make distributions to founders might not want to also make these distributions to employees, which would be required if employees ultimately become stockholders via a stock option plan. This is where Stock Appreciation Rights (“SARs”) can be useful, as an alternative to stock options. SARs essentially give employees a lottery ticket – if the company is sold, the SARs employees have the right to participate in receiving some of the sales proceeds. A SAR, or “phantom stock”, is the right to receive money on the sale of a company, not a right to receive stock of the company.
How does this work?
When a SAR is granted, there is an initial SAR price as of the date of the grant. This initial price can be determined several different ways, but we recommend using a 409A valuation.
A 409A valuation is generally used when implementing a stock option plan and is a good, independent way to figure out the value of a SAR, as well. A 409A valuation is prepared by a third-party company (a valuation firm) based on several factors, including the current and historical financials of the company, an industry analysis, and a check on the company’s competitors. The valuation firm then determines the fair market value of the stock, which can be used by the company under the 409A safe harbor rule for 1 calendar year – or until there is a material change in the company that would affect the fair market value of the stock, at which point a new 409A valuation would need to be completed.
Once the initial value is set, the company can grant SARs to employees, independent contractors, or advisors to give them the right to receive a monetary payout of the increase in value per SAR at a given time or upon a pre-defined trigger event (generally a sale of the company).
Example: Let’s say Company A grants 10,000 SARs to Employee 1. On the date of grant, the SARs are worth $0.10 each based on the 409A valuation. Per the SAR Agreement, the company chose not to have any vesting in this SAR grant, so all 10,000 SARs are immediately available to Employee 1, but the SAR says that it can only be exercised upon the sale of the company – the defined trigger event. When the company is sold 3 years later, the SARs are now worth $1.10 each and Employee 1 has the right to receive the $1.00 increase per SAR, for a total of $10,000!
As you can see from the example above, the great benefit of granting SARs is that they are very flexible. The company can choose to have SARs subject to a vesting schedule, just like a stock option, so only the vested SARs at the trigger event date are counted. The company can define a time period or trigger event for when the payout to the employee will occur. And employees also don’t have to pay for anything when exercising the SAR, like they do when exercising their right to buy stock under a stock option plan.
The ultimate benefit of issuing a SAR is that the company can give employees a monetary incentive, without issuing any of the company’s stock.
With any major business decision, it’s important to consider the legal and tax implications. Contact your accountant to discuss the tax implications of SARs for your company and let us know if you need any help with the legal matters related to your equity incentive plan.