As the global startup ecosystem has been expanding leaps and bounds, employee equity compensation has also been evolving. Equity Stock Option Plan (ESOP) has been the most popular compensation method for the longest time, but newer equity-based compensation models have gained significant traction as the ecosystems matures and cap tables get complex. One such model is Stock Appreciation Rights (SAR).
In the last blog of our series, Employee Lens, we explored various aspects of owning equity in a startup as an employee, and considerations to be kept in mind while accepting ESOPs. We now delve into another popular compensation scheme.
What is SAR?
In simple words, SAR allows an employee/contractor to receive the increase in value of a company’s stock over a set time. In other words, employees do not directly own shares of their company’s stock. The company compensates by paying the difference in the value of its share price over the vesting period. Employees or independent contractors can be issued SARs.
Is SAR legalized for Private Companies?
In India, the SEBI Benefits Regulations for SARs apply to listed entities.
Issuing SARs by an unlisted company remains unregulated and unrecognised under the SEBI Benefits Regulations or the Companies Act. The Ministry of Corporate Affairs has recognised this gap under the report of the Company Law Committee published in March 2022 (CLC Report).
The CLC Report recommended that:
“The Committee was of the opinion that RSUs and SARs should be recognised 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 do not involve offer or conversion into securities, approval by shareholders need not be mandated.”
As for the US and Singapore, SAR regulations are applicable to both private and public companies. But in Singapore, listed companies have to fulfil further legal obligations under the Listing Manual of the Singapore Exchange Securities Trading Limited.
How is SAR different from ESOP?
There are a few differences between ESOPs and SARs. One of the biggest differentiators is the payment structure.
- In ESOPs, an employee pays the share price when it has vested to be able to exercise its grant. In the case of SAR, employees need not pay anything to get the grant. At the time of exercise, the company pays the share price increase from when SAR was granted to when it is exercised.
- Further, while ESOPs are taxed on exercise price and liquidity both, SARs are only taxed as “salary income” when exercised.
- More importantly, with ESOPs, an employee actually gets to own the shares in the company, while with SARs, there is no ownership, just the benefit in rise of share price.
However, on a fundamental level, in both cases, ESOPs and SARs, employee earns when the company’s share price increases.
What is the process of owning SAR units?
To start with, out of the option pool set by the company early on, the company grants SAR units, which provide the eligible employees with the ability to profit from the increase in the value of a set number of shares of the issuing company, over and above the price specified in the SARs Grant. This is established under the SAR scheme set up by the company.
This SAR Grant has to follow the vesting period set by the company. Once the vesting period is complete, the employees can exercise or retire their earned SARs within the exercise period stipulated under the SARs scheme.
At the time of exercise, the company pays the difference in share price from the issue to the exercise date. This compensation can be settled wholly in shares, cash, or a combination. Once the issuing company settles the SARs, they are considered retired.
Let’s say you were granted stock appreciation rights on ten shares of your company ABC’s stock, valued at $10 per share.
Over time, the share price increases from $10 to $12.
Then you will receive $2 per share since that was the increased value. So at $2 per share, you will receive $20 total ($2 x 10 = $20).
Risks Associated With SARs
While SARs are usually seen as flexible compensation method, it is not foolproof and has its own sets of risks.
Most importantly, since the benefit for an employee is based on company’s share price, it may not always turn fruitful. There is no guarantee that a company’s share price will increase over the vesting period, and this can be because of host of reasons.
For example, economic downturns as seen in 2008 and 2020, startup funding winters as seen in 2022, company not faring well compared to competitive landscape or major companies entering the sector thus causing disruption, or anything else. At the end of the day, an employee has no direct control over the company’s performance.
SARs have vesting schedules, which means an employee must fulfill certain conditions like staying in the company for a certain period or perform as per pre-decided metrics, etc. Hence, in the case of termination or resignation before the vesting period, an employee may lose their SARs. However, there are some companies which factor in these scenarios in ther SAR policy and look to compensate the employees fairly. Hence, it is important to read policy documents clearly and ask for company’s stance in such circumstances early on.
Furthermore, SARs have an expiration date, i.e. once the grant has vested, the employee has to exercise its grant in a specified period or the grant expires.
Therefore, it is very important to understand the pros and cons of the stock being granted by your company. Read the policy documents clearly and seek advice, when needed. For any questions, please write to us at email@example.com
Thanks for reading till the end; this is an excellent start to building your equity compensation knowledge. Stay tuned!