If you’re a small or mid-size business owner, odds are you may still spend a significant portion of your time involved in the day-to-day operations of that business. But as the company continues to grow and managerial responsibility becomes more decentralized, more often than not, there are non-owner employees that prove critical to the success of the company. What’s more, as you look towards succession planning, it may become clear that retaining and motivating those employees will be vital to your ability to preserve value when transitioning ownership in the business.
This dynamic—where the seller or sellers may have a smaller role to play in future leadership and non-owner management will be responsible for driving the success of the business—is especially common for business owners selling to an employee stock ownership plan (ESOP) where there’s no third-party buyer assuming oversight of the company after the sale closes.
If you’re a business owner considering an ESOP as an exit strategy, one way to reward and incentivize your leadership team over and above their participation in the ESOP is to implement a stock appreciation rights plan (SARs).
What Are SARs?
SARs are a form of deferred compensation that is tied to the company’s stock price. SARs give employees the right to be paid an amount equal to the increase in per-share value from the time the SARs are granted to the time they are exercised. SARs differ from other equity-based incentives, such as stock options, in that the employee does not have to pay the grant price for the SAR in order to exercise and the employee can never exercise the SAR in exchange for the underlying common stock. Rather, if the stock price rises, the employee is simply paid a cash bonus equal to the amount of the appreciation per share. The payout is taxable income to the employee when received, just like a normal bonus, and the company takes a deduction in the year the SARs are exercised.
For ESOP companies, the terms of the SAR plan are typically negotiated in conjunction with the initial ESOP transaction, though such terms are often only agreed to in summary with the formal implementation of the SAR plan taking place at the direction of the board shortly following closing. The SAR plan document sets forth the detailed provisions of the plan, including the number of SARs available to be granted to employees, any performance criteria upon which grants must be conditioned, the timing of payouts and expiration, and any vesting or forfeiture criteria.
Who Do SARs Go To?
Employees eligible to receive SARs are typically those employees, as determined by the board of directors, who hold positions of responsibility and whose performance can have a significant impact on the value of the business. Participation in a SAR program is at the discretion of the board, and as non-qualified plans, they are not subject to the same limitations as other types of qualified deferred compensation plans.
How Many SARs Can Be Granted?
The quantity of SARs available to be granted is typically established as a percentage of the company’s fully diluted number of shares outstanding. For instance, if there are 1,000,000 common shares outstanding, and if SARs totaling 10% of the outstanding share count on a fully diluted basis may be granted to employees (a common size for SAR pools), then 111,111 SARs may be granted under this plan, calculated as:
1,000,000 / (1 – 10%) = 1,111,111 x 10% = 111,111
While there is no legal or regulatory limit to the number of SARs that can be granted in a non-ESOP-owned company, there are practical and economic limitations on what would be deemed a fair number in an ESOP transaction. In either case, an analysis is generally undertaken to assess the likely value of a given SAR in the future, which will help inform how large the total pool of SARs should be and how many to grant to each participant in order to achieve a reasonable benefit when the SARs are ultimately exercised.
When Can SARs Be Granted?
The question of when a SAR can be granted ultimately depends on the type of SAR being granted. Generally, there are two types of SARs: (i) “Retention” SARs, which can be granted at any time, subject to potential limitations for how many in a given year, and (ii) “Performance” SARs, which may only be granted, or in some cases vested, upon the achievement of certain thresholds for company performance.
These performance targets, which are generally annual, are usually tied to the EBITDA projections prepared by management and provided to the ESOP trustee in connection with the initial ESOP transaction. In any given year when the company’s EBITDA exceeds the projected level, the board would be entitled to grant a specified number of SARs. In other instances, the SAR plan may allow for all of the performance SARs to be granted in a single tranche immediately following the ESOP transaction, but they may only vest if the company exceeds the projected level.
Some plans contain provisions that allow for a cumulative measurement of performance, such that if the company falls short of projections in a given year, granting or vesting can still occur in future years if the underperformance in one year is less than outperformance in another year, thereby allowing management to recover from short term or temporary underperformance.
At What Price Are SARs Granted?
The grant price of each SAR is typically set at the fair market value per share of the company as of the date the SAR is granted. For ESOP companies, this almost always equates to the most recent annual ESOP valuation performed by the trustee’s independent valuation advisor. If SARs are granted immediately after the initial transaction closes, the trustee’s valuation advisor will often prepare a “post-transaction” valuation to establish the grant price on the day immediately following closing (to reflect the new transaction debt, remove any distributed cash, etc.). If the ESOP purchases 100% of the company’s stock in a leveraged transaction, this initial grant price will likely be significantly lower than the price per share paid to acquire the stock, as it will reflect the new transaction debt.
The dynamic is similar to purchasing a new home with little or no down payment where the house may cost $1 million, but if you borrowed $950,000 on your mortgage, you have $50,000 in equity on the day after you close. The grant price for SARs correlates to the $50,000 of equity not the $1 million total home price. Thus, granting SARs shortly after the transaction closing date provides key employees with the maximum amount of upside, as the per-share value of the company will typically experience strong growth over the next few years as the debt is repaid.
When Can the SARs Be Exercised?
SARs will typically be exercisable at the holders’ election any time after a minimum period has elapsed, typically several years or more. There will also generally be an expiration date, such that the SARs are exercised and the obligation satisfied at a date in the future that is not indefinite, with most plans calling for expiration no later than 10 years from the grant date.
When any vested SARs are exercised, the company will pay the difference between the grant price and the current per-share value of the company, multiplied by the number of vested SARs. If an employee separates from the company prior to his or her SARs becoming fully vested, the unvested SARs will usually be forfeited and are immediately available for re-issuance to other participants.
How Do SARs Impact the Value of the Company?
Generally, all SARs that have been granted are considered in the annual ESOP valuation as SARs represent future cash obligations for the company to satisfy. Thus, the future obligation is treated as a reduction to the equity value of the company, not unlike the payment of a debt or any other liability. On the other hand, performance SARs that have been granted, but have yet to satisfy the performance-based vesting criteria, are typically not deducted from equity until and unless the performance targets are met and the SARs become vested. Similarly, any SARs that have not yet been granted would not be considered as an obligation in the valuation until those SARs are granted.
The value of SARs is generally estimated by using either (i) the intrinsic value method, or (ii) an option pricing model. The intrinsic value method is simply the current per-share value minus the grant price, multiplied by the number of SARs outstanding. In other words, this method views the obligation as though all granted and vested SARs were to be exercised immediately. However, assuming the SARs were all to be exercised today, this does not capture the value of the potential for future appreciation. In order to capture this “time value”, an option pricing model is used to quantify this premium over the intrinsic value.
Time value refers to the premium that investors would pay for an option with a longer time horizon before expiration because the value of that option has more time to move in a favorable direction. As an option (or in this case a SAR) approaches its exercise date over time, this time value approaches zero because there is less time for the underlying stock to move in a favorable direction, thereby increasing the SAR’s value.
Now more than ever, retaining employees is critical to the continued success of a business. When implementing an ESOP, a business owner may find that SARs can be a flexible and effective tool for rewarding, retaining, and motivating key employees over and above the benefits that they will enjoy through the ESOP. At the same time, SARs can serve to align the interests of key employees with the entire workforce as they are only paid out as the value to all employees increases. Thoughtfully structuring and implementing a SAR plan is vital to ensuring that this tool ultimately serves its desired purpose and maximizes the beneficial outcomes for all stakeholders.
For more information on SARs or ESOP’s, please visit our website at www.acuityadvisors.com and click on our resources page or reach out to us directly by phone or email at (714) 380-3300 or [email protected]