A Brief Guide to Stock Appreciation Rights (SARs)

The most important factor of production is Labour without any doubt. You can start with a small capital but to grow and expand from there, you need the right human resource to accompany you in the long journey. With the rise in the startup industry, almost every startup recognises the importance of setting up an employee benefit structure in place so that they can adequately incentivise their people for the growth the company has achieved. Widely used share-based remuneration systems in companies are ESOP and SARs. While both employers and employees acknowledge that employees should be adequately rewarded, there is a huge information gap at the hands of both parties, and they are not aware of which of these to use.

In this blog we will try to cover what SARs are and what are its pros and cons over ESOPs. To learn about how ESOPs work, you can have a look here.

What are SARs?

While ESOPs are an excellent employee benefits scheme that has worked for many companies, some companies are hesitant about the idea of diluting ownership rights and sharing equity with their employees. We have seen many founders be wary of getting employees on their cap table. Though they want to reward employees for their contribution to the startup's growth, they want it primarily in the form of monetary benefits.

This is one of the significant regards in which SARs comes out as a viable and feasible alternative for both employers and employees. SARs allow employers to share the benefits of value appreciation of the company with their employees either monetarily (cash settled SARs) or in equity (Equity settled SARs), without sharing control aspects like ownership stake or voting rights.  

When employees are granted stock appreciation rights (SARs), they get a right to receive the increased or appreciated value of company shares after fulfilling certain condition like vesting.  SARs seem broadly similar to ESOPs as they are granted at a set price and generally go through vesting and expiration periods. However, distinguishingly, in SARs, employees don't have to pay any price. The employee may exercise a vested SAR at any time before it expires, and the proceeds will be shared either in cash, stocks, or a combination of both.

SARs are convenient for both employers and employees as employers don’t have to put its employees on the cap table or share equity with them and for employees as they don’t have to pay any money as upfront cost of purchasing stock options.  

Implementation and Issuance Process

In any company, SARs are implemented through Compensation Committee (CC), which is established by the board of directors. The committee begins by deciding the number of SARs to be issued and the eligible beneficiaries. This is usually done on the basis of exceptional performance or time-based goals.  They then determine the grant date, vesting period, expiration date, and all terms and conditions adhering to which an employee will be granted a SAR. Compensation Committee also details how the company can finance its settlements efficiently, and it issues SARs to its employees' post vesting period. (This can also be explained through a simple flowchart infographic)

Post the vesting period, employees are evaluated on the set performance goals. If the committee finds the performance of the employees satisfactory, the SARs deem to have vested in the employee's favour. When employees exercise their SAR rights during the exercise period, they get either cash-settled SAR payment, share-settled SAR or a mix of both. However, they need to exercise their rights before the SAR expiry date. Generally, SAR expires 7-10 years from the date of grant.

The process of SAR issuance is different in listed and unlisted companies. According to SEBI (SBEB), 2014 regulations, in listed companies SARs can only be issued to permanent employees and directors of a company. The process of issuance and grant can be changed with the approval of company shareholders in an annual general body meeting. For changing the terms of the SARs scheme, a special resolution of the shareholders is required. The Compensation Committee set up by the company board oversees the entire issuance process, and SARs issued are non-transferable.  

In an unlisted company, the process is simpler and unregulated. They can also issue SARs to third-party actors and consultants and set varying prices for SARs for different employees. Unlisted companies are also not required to set a specified vesting period. For unlisted companies, it is also not mandatory to constitute a compensation committee (CC) for overseeing the SARs scheme; the board of directors can administer it too.

Taxation Guidelines for SARs

The process of taxation is also simpler with SARs. SARs are taxed like non-qualified stock option (NSOs). Employees don't incur any tax during grants or vesting periods. During exercise, cash-settled SARs are treated as part of the salary and taxed accordingly. For equity-settled SARs, taxation occurs twice, first as salary income and second as capital gains tax when the employee sells the share. An employee usually takes back a couple of shares to cover the tax price.  

Stages of Stock Appreciation Rights (SARs)

Advantages and Disadvantages

SAR can be beneficial or disadvantageous to both the employees and employers under different circumstances.

Advantages

• Since employees are either paid in cash bonuses or shares, there is flexibility with equity dilution. Also, it suits promoters who have reservations with the concept of employees as shareholders in the startup.  

• Regulations are flexible when dealing with SARs compared to ESOPs (Employee stock options). With ESOPs, you need to realign the equity shares and the corresponding voting rights.
• Employees need not pay an exercise price to acquire SARs. They are either offered cash payout or share ownership (without having to pay for the shares).
• Employees need not depend on liquidity events for cash-settled SARs unlike in stock options.  

Disadvantages

• The flexibility of SARs can be a challenge as the startup has to make numerous decisions on the liquidity of shares, share value, whom to grant, etc.

• The company needs to pay tax on the cash payout in cash-settled SARs as it is considered a profit and not an expense.  
• There is always an unpredictability associated with SARs. When company shares go down, employees will not receive the desired payout. Also, the company can put a clause in the SAR grant letter that employees will not get the payout if there are no fundraising rounds to finance SARs.
• The overall tax that employees need to pay may be higher than stock options as the whole payout is considered under the salary income.

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Qapita- Your Digitalised Solution

Qapita is an easy-to-use, equity management software that promotes efficiency and transparency between different stakeholders. With Qapita, you have the flexibility to customize your own SAR program directly on the platform and it can take care of all things from grants to sales.  

Issue Digital SARs to your employees, get them signed on the platform, and prevent any miscommunication in the entire process. Qapita helps you to reward your employees in an easier manner and increase your credibility among your employees.

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