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.
|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.