How to Reward Employees: ESOPs, SARs, or Employee Stock Options?

Posted by Jacob Niehof on Tue, Nov 02, 2021

Many employers, especially in a competitive labor landscape, are interested in finding ways to reward and retain great workers and leaders in their organizations.

Ownership equity is one great way to reward and retain employees while cultivating an ownership culture within your company.

But there are several ways to extend stock ownership to employees. Three of the most common paths to employee ownership of company stock are employee stock ownership plans (ESOPs), stock appreciation rights (SARs), and employee stock options (ESOs).

But these different types of equity compensation aren’t simply interchangeable. And, the different ways they work can have different effects — both on the company that offers them and on the employees who receive them.

So let’s take a closer look at ESOPs, SARs, and ESOs, to gain an understanding of the differences, and even explore how two of these compensation choices can work together to help reward and retain employees.

What Are ESOPs vs SARs? What About ESOs?

ESOPs, SARs, and ESOs are all ways of entitling employees to company stock value. But let’s start with a critical distinction: among the three, only an ESOP is a qualified retirement plan. A SARs plan, which is a non-qualified employee benefit, can be implemented to complement an ESOP and create flexibility for the seller of the business to reward senior employees.

Employee stock options (ESOs) are, as the name suggests, an option extended to certain (often targeted) employees, allowing them to use their own money to purchase company stock, typically at a discounted price.

Here’s a quick breakdown of each of the three:

Employee Stock Ownership Plan (ESOP)  An ESOP is an equity-based, tax-deferred compensation plan — a qualified retirement plan.  An ESOP is a defined contribution benefit plan that allows employees to become owners of stock in the company they work for. ESOPs are required by law to invest primarily in stock of the sponsoring employer. Unlike SARs and ESOs, ESOPs are subject to nondiscrimination testing, and are required to benefit a broad range of employees — not only highly compensated or management employees, for example. 

ESOPs do not require employees to use their own funds to make stock purchases, and generally, employees receive the vested value of their allocated stock ownership after their employment ends (through retirement, termination, disability, or death).

ESOP distributions are taxed as ordinary income, though they can often be rolled over into an individual retirement account to defer taxation.

Stock Appreciation Rights (SARs) — SARs are a form of incentive or deferred compensation that’s tied to the performance of the employing company's stock. SARs give employees the right to the monetary equivalent of the appreciation in value of a specified number of shares over a specified period of time

The appreciation in value is determined by the annual ESOP stock price valuation. If the stock price rises over the holding period, the employee is paid the amount of appreciation, and the SARs stocks return to the control of the employer.

While an ESOP is a long-term benefit, SARs can be considered a medium- to long-term benefit. Employers can choose which employees to offer SARs, and they can also determine the vesting schedule on an individual basis. This actually can make SARs a great tool for ESOP employers to further align employee financial objectives with the company’s goals. 

These individualized benefits make SARs a powerful way to incentivize and retain leaders at ESOP companies. SARs plans are based on allocation limits that are negotiated as part of the ESOP sale, and a trustworthy third-party administrator can incorporate a SARs sustainability study into an ESOP plan. This is important, since the company has to ensure it has the resources needed to pay for SARs at exercise.

Taxes on SARs are deferred until the rights are paid, at which time they are taxed as ordinary income. And unlike an ESOP’s stock purchase contributions, SARs payouts are a company expense, and are not tax-deductible.

Employee Stock Options (ESOs) — ESOs are a type of non-qualified equity compensation that companies most often grant to high-value employees and executives. ESOs are contracts between the employer and employee in which the employee earns the right (i.e. option, not obligation) to buy a specific number of shares at a predetermined strike price from the company within a certain period of time. 

ESOs are issued by the company and cannot be sold (like exchange-traded or standard listed options). If the stock rises above the call option exercise price, then the employee can buy stock at a discount. They can then choose to sell (at a quick profit) or hold the stock. ESOs have vesting schedules, so the ability to exercise them is earned over a period of employment.

ESOs are taxed at exercise, so when stockholders sell their shares, gains (known as the spread) are taxed as ordinary income. ESOs are often a benefit used by startups, where they have the potential to create a large payoff for early employees if or when there is an IPO in the future. They can also help incentivize employee retention, since they are canceled if the employee terminates before becoming fully vested. ESOs do not include dividends or voting rights.

A Side-by-Side Comparison of ESOPs, SARs, and ESOs

Because an ESOP is a qualified retirement plan, and also an owner exit strategy, a true apples-to-apples comparison isn’t really possible. But the table below explains some of the most important differences between these equity compensation types.

  SARs ESOs ESOPs
Subject to nondiscrimination testing     X
Employer can use to target and incentivize individual employees X X  
Employee participation is optional   X  
Employee purchases shares using their own money   X  
Can serve as employee retention incentive X X X
Subject to vesting Can be, and often are Yes Yes
Company needs to plan ahead for resources to cover obligation to pay employee (stock repurchase and/or value increase) X   X
Shares only valuable if company goes public   X  
Has an expiration date Yes Yes No
Employee holds/owns shares No Yes Sometimes*
Method of taxation Taxed as ordinary income on the spread at exercise Taxed as ordinary income on the spread at exercise Taxed on distributions received after termination of employment**

*If distributions are paid out in stock, then the employee may hold the stock until sold back to the company, subject to certain rules and time limits.

**When the company pays out the cash values of shares, the employee pays income tax at ordinary income tax rates. When an ESOP distributes shares of company stock, rather than paying out the value of the shares in cash, the employee pays income tax at ordinary tax rates on the value of company contributions to the plan, plus capital gains tax on appreciation in share value when they choose to sell their shares.

Which Stock Ownership Vehicle is Best for Your Company?

Every business is unique, and so are your reasons for wanting to incentivize and reward employees with company stock ownership. So, how do you know if an ESOP is the right option? The smart way to start is a no-cost, no-obligation feasibility analysis with an expert, but if you’re looking for more immediate feedback, you’ll want to take our free, interactive quiz, Is an ESOP Right for You? Just click the link below to get started.

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Topics: ESOP, employee stock ownership plan

Jacob Niehof
Written by Jacob Niehof

Jacob Niehof is a Senior ESOP Administrator with ESOP Partners. His focus is maintaining plan compliance with IRS and DOL regulations on a year-to-year basis. He has 7 years of experience in retirement administration and financial planning. Prior to working with ESOP Partners, Jake worked for The Retirement Advantage, a national third-party administrator specializing in 401(k) plans.

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