By Maurie Cashman
A Stock Appreciation Rights Plan can help you to retain key employees for the long term, adding to and protecting the value of your business.
Letâ€™s say you have recently hired your replacement or other key employee and you want him or her to stay long term and to help grow your business. What do you do to motivate him or her to stay and to perform?
First, you could offer stock. Doing so, however, is probably premature and may be expensive. After all, he or she might not be the right fit, long term or even short term. In addition, he or she may not even want ownership.
Second, you could offer cash, but remember that cash alone has no strings to bind him or her financially to the business.
As a third option, you could create a deferred compensation plan with the future benefit subject to vesting and that future benefit being determined by the future profitability, cash flow, or value of your business. This option is worthy of further consideration, especially if the amount of that future benefit is tied to the increase in business value measured from a date after the employee commences employment.
One tool, and perhaps an appropriate one for the job, is a Stock Appreciation Rights Plan, or SAR Plan.
A Stock Appreciation Rights Plan may meet both the needs of the key employee and of the owner, because it gives employees something that looks like stock, grows in value like stock, and can be turned in for cash just like stock, but is not stock.
As employees strive to make the company more valuable, they make their interest in the SAR Plan more valuable. Participation corresponding to shares of stockâ€”but not representing actual ownershipâ€”are allocated to the participating employeesâ€™ accounts. As the value of true stock increases, so does the value of the employeesâ€™ rights in the participation units.
When the employee terminates his employment, the company usually pays him the per share equivalent value of each of the participation units vested in his account. The amount received is taxed as compensation to the employee and consequently is deductible to the company.
The success of a Stock Appreciation Rights Plan depends on careful design of valuation, vesting, forfeiture, payment schedules and funding devices. The benefit formula used in Phantom Stock Plan is the value of the companyâ€™s stock.
If all this sounds strangely like the terms of a Phantom Stock Plan, you are correct. The difference, however, between a Phantom Stock Plan and a SAR plan is the definition of the benefit offered. In a Phantom Stock Plan the benefit is the value equal to a portion of the entire value of the businessâ€”Phantom Stock units equal to, for example, five percent of the value of the company are worth just thatâ€”five percent of the company. SAR units based on five percent of the value of the company, however, are valued on the future appreciation or growth in value of five percent of the company from the date of the SAR grant. The original value is not part of the benefit.
Letâ€™s assume that a key employee is granted an SAR benefit equal to five percent of the future growth of a business which has an enterprise value of $1 million. Further, assume a ten year vesting schedule (ten percent vesting per year). After five years, letâ€™s assume that the enterprise value has increased to $1.5 million. The key employeeâ€™s vested benefit is calculated as follows:
- Growth in value ($1.5 million less $1 million) = $500,000
- Key Employeeâ€™s SAR five percent benefit = $25,000
- Key Employee is 50 percent vested in $25,000 = $12,500
SAR plans work well as incentive plans when the company can expect significant future growth and to motivate newer employees whose past efforts have not contributed to existing value.
It is not uncommon for one company to implement both an SAR Plan and a Phantom Stock Plan. Each plan may apply to a different key employee. SAR Plans are often ideal when owners want to reward key employees based on the future growth in value of the company. Isnâ€™t that precisely the goal we want our employees to achieve?