A stock appreciation right, or SAR, is a compensation tool that employers can use to attract and retain key employees. Like non-qualified stock options and incentive stock options, stock appreciation rights allow you to benefit from appreciating stock prices should the company’s stock price rise.
They’re also similar in that SARs are issued with a issued a grant date, a grant price, a vesting date, and an expiration date — but unlike their employee stock option cousins, SARs are generally settled in cash. When you exercise an employee stock option, you receive employer stock.
The fact that most stock appreciation rights plans leave you with cash instead of company stock may impact your financial plan in a different way than other kinds of equity compensation. Here’s what you need to know to make the most of your opportunity from owning SARs
How Does a Stock Appreciation Right Work?
Stock appreciation rights look and act very similar to non-qualified stock options. They are granted as part of a compensation package and upon receipt, they’re issued with key dates and figures of which you should be aware:
- Grant Date: The grant date is the date the stock appreciation right is given to you. This date also determines the grant price.
- Grant Price: The grant price is the price used to determine if your SARs are worth anything. If the stock price is above the grant price, your SAR is “in the money.” If the stock price is below the grant price, the right is worthless.
- Vesting Date: This is the first day you can exercise some or all of your stock appreciation right. Prior to this date, even in-the-money value cannot be captured. Once your SARs vest, you can exercise the right and capture the gain.
- Expiration Date: This is the last day you can exercise your stock appreciation right. For SARs with a share price below the grant price, shares will likely expire as worthless. For SARs with a share price that exceeds the grant price, exercising your stock appreciation rights it the way to go.
Your stock appreciation rights at grant may look like something like this:
- Grant Date: January 1, 2014
- Grant Price: $10
- Number of Shares: 1,000
- Vesting Date: January 1, 2017
- Expiration Date: December 31, 2023
To illustrate the potential value of stock appreciation rights, let’s assume that on January 1, 2017 (when your SARs vest), the share price of your company stock is $25. The in-the-money value of your SARs is equal to $15,000. The math is:
(Exercise Price – Grant Price) * Number of Shares Exercised
($25 – $10) * 1,000 = $15,000
Since your SARs are vested, you generally have two options to consider.
- You can exercise the stock appreciation right (some or all), pay the tax, and receive the proceeds of the sale. Or
- You can leave the SAR unexercised.
Unexercised stock appreciation rights will be subject to future market fluctuations. Should the stock price continue to go up, additional value can be created. Should the stock price decrease in value, you can lose the opportunity to cash in and build wealth.
Your decision on whether to exercise or wait is yours. However, the decision to exercise might be a no-brainer to as you approach the expiration date. If we changed the date in the example to December 31, 2023, it would make sense to exercise the SAR. Otherwise, your right expires and you forfeit your SAR. You would lose any value that you previously had.
How Are Stock Appreciation Rights Taxed?
The grant of a SAR is a non-taxable event. Like non-qualified stock options, you don’t have to report anything for tax purposes until you exercise.
When you do exercise your SARs, any in-the-money gain gets taxed as earned income and is subject to payroll tax. The tax due will likely be paid from the cash generated during the exercise via a tax withholding.
Following our example above, the amount of taxable income (which will appear on your W-2) is $15,000. If we assume a federal tax of 25% and a payroll tax of 7.65%, your tax liability would be $4,898.
Due to what you owe in taxes on the SARs, your net profit from exercising your rights would be $10,102.
Stock Appreciation Rights and Concentration Risk
Again, stock appreciation rights differ from non-qualified stock options in that SARs are paid in cash. There are some exceptions, and plans that issue stock do exist — but for the most part, exercising SARs will leave you with cash.
Exercising and receiving cash is important because it creates a different impact on your investment allocation and concentration risk than if you exercised non-qualified stock options and received stock. In fact, you could consider SARs as a kind of forced decision to diversify assets. To buy additional shares of stock would take an intentional effort on your part. You would need to take the cash you received and buy shares of stock.
It’s not uncommon to exercise and hold non-qualified stock options. If you exercise and hold non-qualified stock option shares many times, it may result in the accumulation of many shares — exposing you to over-concentration in your company’s stock. This requires you to develop a strategy to manage the risk and maintain diversity in your portfolio
There is no guarantee that SARs that settle is cash or stock options that settle in stock are the better answer, however, so you should still work with an expert to ensure you allocate your cash wisely after receiving it.
Planning for Stock Appreciation Rights
Stock appreciation rights look similar and operate very similarly to non-qualified stock options. For this reason, many of the planning considerations remain the same.
If you find yourself with SARs, you should begin by asking a few of the following questions:
- How much company stock do I own, and how do SARs fit into this strategy?
- When is the best time to exercise my stock appreciation rights?
- How will the exercise of stock appreciation rights impact my tax return?
- How does this fit into my overall financial and retirement plan?
Many of the answers to these questions will be the same as they are for employee stock options.
A good financial strategy around when to exercise your SARs and what to do with the cash once you exercise is something that should be developed along with your financial plan.
Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. n.