What are Stock Appreciation Rights (SARs)?

As the global startup ecosystem grows, so do the options for employee equity compensation. ESOPs (Employee Stock Option Plans) have long been the preferred method, but as companies scale and ownership structures become more complicated, newer models like Stock Appreciation Rights (SAR) are gaining attention. These alternatives provide flexibility and allow employees to benefit from a company’s success—without the challenges of managing actual shares.

What are stock appreciation rights?

Stock Appreciation Rights (SARs) are a form of equity compensation that gives employees the right to receive the financial gain (or "appreciation") in the value of a company's stock over a specific period of time, without requiring them to actually purchase the stock.

Here’s how they work:

- Appreciation-based: Employees don’t own the stock itself, but they benefit from any increase in its value. The difference between the stock price at the time of the SAR grant and the price when it’s exercised is paid out as a reward.

Imagine you were granted stock appreciation rights (SARs) for ten shares of your company ABC's stock, initially valued at $10 per share.

As time passes, the share price rises from $10 to $12. This means you've gained $2 in value for each share. With ten shares, your total payout would be $20.

- Cash or stock payout: When employees exercise their SARs, they typically receive the payout in cash, company shares, or a combination of both.

‍- No upfront cost: Unlike stock options, employees don’t need to pay to exercise SARs.

‍- Can be issued to contractors: Unlike ESOPs, SARs can be issued to contractors as well.

Stock appreciation rights for private companies

In India, Stock Appreciation Rights (SARs) are regulated for listed companies under SEBI's Benefits Regulations. 

However, when it comes to unlisted companies, issuing SARs remains largely unregulated and is not formally recognized by SEBI or the Companies Act. This gap was highlighted in the March 2022 Company Law Committee (CLC) Report, which made key recommendations.

The CLC Report suggested that:

“The Committee was of the opinion that RSUs and SARs should be recognized under CA-13 through enabling provisions. If these schemes require the issue of further securities by the company, their issuance must be allowed only after shareholders’ approval through a special resolution. However, where the settlement of such rights does not involve the offer or conversion into securities, approval by shareholders need not be mandated.”

In contrast, SAR regulations in the US and Singapore apply to both private and public companies. However, in Singapore, listed companies must meet additional legal requirements outlined in the Listing Manual of the Singapore Exchange.

Difference between SARs and RSUs

Stock Appreciation Rights (SARs) and Restricted Stock Units (RSUs) are both equity compensation tools used by companies to reward employees, but they differ in structure, purpose, and payout.

1. Ownership

- SARs: Employees do not own any shares with SARs. Instead, they receive the value of the stock’s appreciation over time, either in cash or shares, without having to buy the stock.

- RSUs: RSUs represent an actual grant of company shares. Employees receive full ownership of these shares once the vesting conditions are met.

2. Payout

- SARs: Employees receive a payout based only on the increase in the stock’s value from the grant date to the exercise date. If the stock doesn’t appreciate, there’s no payout.

- RSUs: Employees receive the full value of the shares at vesting, regardless of how much the stock has increased in value.

3. Vesting

- SARs: Typically have vesting schedules, after which the employee can exercise the rights. 

- RSUs: Vesting occurs over time, or after specific milestones. Once vested, the employee is given actual shares.

4. Dilution

- SARs: May not dilute shareholder equity if settled in cash. If settled in shares, they can dilute equity, but to a lesser extent than RSUs.

- RSUs: Directly dilutive because new shares are issued to employees.

Taxation - SARs Vs RSUs

Tax in the United States

SARs

At exercise: When SARs are exercised, holders receive cash or shares equal to the stock’s appreciation since the grant date. This "spread" is treated as ordinary income, subject to income and payroll taxes.

At sale: If SARs are settled in stock, any further gain or loss from selling the stock is taxed as short-term or long-term capital gains, based on the holding period. 

If settled in cash, no additional tax applies upon stock sale, as the entire gain has already been taxed at exercise.

RSUs

At vesting: When RSUs vest, recipients receive shares or cash based on the stock’s market value. This value is treated as ordinary income and is subject to income and payroll taxes, which the company usually takes out of the employee's paycheck before they receive it.

At sale: Any gain or loss from selling the shares after vesting is taxed as short-term or long-term capital gains, depending on how long the shares are held. The holding period starts from the vesting date.

Tax in India

SARs

At exercise: The appreciation is taxable income. If settled in cash, it's taxed as perquisites (like salary). If settled in shares, the share value at exercise is considered as taxable income.

At sale: Capital gains tax applies on the difference between the sale price and the Fair Market Value (FMV) at exercise.

RSUs

At vesting: RSUs are taxed as perquisites, with the share value at vesting considered taxable income under the Income Tax Act.

At sale: Capital gains tax applies to the difference between the sale price and the Fair Market Value (FMV) at vesting. The gain is classified as short-term or long-term capital gains, depending on the holding period.

Difference between SARs and ESOPs 

1. Nature of the benefit

SARs: Employees receive a payout based on the increase in the company’s stock value over time (the “appreciation”). They don't own the shares but benefit from the stock’s growth.

ESOPs: Employees are given the option to purchase company shares at a predetermined price (the “exercise price”), usually below market value, giving them potential ownership of shares.

2. Ownership

SARs: No ownership of shares is involved. The employee only receives the value of the stock's appreciation, often paid in cash or shares.

ESOPs: Employees can acquire actual ownership in the company by purchasing shares when they exercise their options.

3. Cost to employee

SARs: There is no cost to the employee to exercise SARs. They simply receive the appreciation in value.

ESOPs: Employees must pay the exercise price to acquire the shares, meaning there is an upfront cost when exercising the options.

4. Payout

SARs: The payout is based on the difference between the grant price and the value of the stock at the time of exercise. It can be settled in cash or shares.

ESOPs: Employees receive shares upon exercise, and their gain is the difference between the exercise price and the current market value of the stock. 

5. Vesting

SARs: SARs typically have a vesting period, after which the employee can exercise their rights to the appreciation in the stock's value.

ESOPs: ESOPs also have vesting schedules, allowing employees to buy shares after meeting specific conditions.

6. Dilution

SARs: If SARs are settled in cash, there’s no dilution to existing shareholders. If settled in shares, there may be some dilution, though typically less than with ESOPs.

ESOPs: When employees exercise their stock options, new shares are often issued, which can dilute the ownership of existing shareholders.

Taxation - SARs Vs ESOPs

Tax in the United States

SARs

At exercise: When SARs are exercised, holders receive cash or shares equal to the stock’s appreciation since the grant date. This "spread" is treated as ordinary income, subject to income and payroll taxes.

At sale: If SARs are settled in stock, any further gain or loss from selling the stock is taxed as short-term or long-term capital gains, based on the holding period. If settled in cash, no additional tax applies on stock sale, as the entire gain has already been taxed at exercise.

ESOPs

In the U.S., Employee Stock Options (ESOPs) are taxed differently depending on whether they are Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs):

Incentive Stock Options (ISOs):

At exercise: No regular taxes, but may trigger Alternative Minimum Tax (AMT).

At sale:

Qualified sale: Long-term capital gains if held for 2 years from grant and 1 year from exercise.

Disqualified sale: If you sell the stock before meeting the required holding periods, it's considered a disqualified sale.

The spread at the time of exercise is taxed as ordinary income. Any additional gain from the exercise date to the sale date is taxed as capital gains.

Non-Qualified Stock Options (NSOs):

At exercise: Spread is taxed as ordinary income, plus payroll taxes.

At sale: Capital gains (short- or long-term) on any further stock appreciation.

Tax in India

SARs

At exercise: The appreciation is taxable income. If settled in cash, it's taxed as perquisites (like salary). If settled in shares, the share value at exercise is considered as taxable income.

At sale: Capital gains tax applies on the difference between the sale price and the Fair Market Value (FMV) at exercise.

ESOPs

i. At exercise: The difference between the exercise price and the Fair Market Value (FMV) on the exercise date is taxable as perquisites under the Income Tax Act.

ii. At sale: Capital gains tax applies to the difference between the sale price and the FMV at exercise when the shares are sold.

What is the process of owning SAR units?

Initially, the company allocates SAR units from its option pool, allowing eligible employees to benefit from any increase in the value of a set number of shares above the specified price in the SAR Grant. 

For example, if an employee is granted SARs for 100 shares with an exercise price of $10, and the share price rises to $15, the employee can receive the $5 increase in value per share, totaling $500 (100 shares x $5).

This is formalized under the company's SAR scheme.

It’s important to note that the ESOP pool typically encompasses only stock options, while RSUs and SARs should be managed through separate pools. This distinction helps to ensure clear management and tracking of each type of equity compensation.

The SAR Grant is subject to a vesting period set by the company, after which employees can choose to exercise or retire their SARs within the designated exercise period. Upon exercise, the company pays out the difference between the grant price and the stock's value at the time of exercise. This payout can be made in shares, cash, or a mix of both. Once the company settles the SARs, they are considered retired.

We hope you found this blog-post helpful, do reach out to us if you have any questions.