Stock Appreciation Rights (SARs) Why they’re gaining in popularity

As companies debate how to deal with an impending mandate to expense stock options, some “forgotten” long-term incentive (LTI) designs are receiving renewed interests. As part of this metamorphosis, stock appreciation rights (SARs) are garnering attention in large part due to developments affecting the accounting for equity-based compensation.

A SAR provides an individual with the right to receive the appreciation in value of a company’s stock during a specified period of time. Upon exercise of a SAR, the holder receives cash, stock, or a combination of cash and stock, equal in value to the underlying stock’s appreciation multiplied by the number of rights held.

For accounting purposes, SARs are subject to variable accounting under APB 25. Until recently virtually all publicly traded companies accounted for their stock-based compensation programs under APB 25; SARs were avoided since fixed accounting treatment was important for financial statements. By contrast, the typical stock option granted at fair market value (and without performance conditions on exercise) generated no accounting expense under APB 25. However, the recent movement to expense stock options either voluntarily now under Statement of Financial Accounting Standards 123 (FAS 123), or in the future under new rules being developed for stock-based compensation, has revived SARs as a viable LTI alternative.

While SARs that can be settled in cash still require variable accounting treatment under FAS 123, the same is not true for SARs settled in stock. SARs settled in stock generate the same accounting treatment as if a stock option had been granted under FAS 123, i.e., the value of the SAR at grant is expensed over the vesting period. The following tables provide examples of accounting assuming treatment under FAS 123. Under the assumptions shown in these examples, the accounting charge for SARs settled in cash is not only variable, but also 50% higher than for SARs paid in stock.

Event	Grant	Vesting	Exercise
Stock Price	$50	$70	$80
Black-Scholes (1)	$20
Accounting Charge (2)		$20,000
Company Tax Deduction			$30,000
Executive Gain (3)			$30,000
Payout in Shares (4)			375 shares

Assumed valuation = 40% of grant price
$20 x 1,000 shares = $20,000 accounted for ratably over the vesting schedule
Ordinary income taxation
(Exercise price – Grant price) x 1,000 shares) / price at exercise = ($80-$50) x 1,000) / $80 = 375 shares

Event	Grant	Vesting	Exercise
Stock Price	$50	$70	$80
Accounting Charge (1)		$30,000
Company Tax Deduction			$30,000
Executive Gain (2)			$30,000
Payout in Cash (3)			$30,000

$30 x 1,000 shares = $30,000 marked to market quarterly (i.e., variable accounting)
Ordinary income taxation
(Exercise price – Grant price) x 1,000 shares = ($80 - $50) x 1,000) = $30,000

Why SARs ?

Given that stock-settled SARs and stock options are subject to the same accounting treatment under FAS 123, several advantages inherent to SARs are causing many companies to examine them as possible alternatives to options. Some of these advantages include:

No cash is needed to exercise a SAR.
SARs settled in stock promote share retention since shares are received but none need be sold to finance an exercise.
Since recipients receive the stock appreciation value, as opposed to the appreciation value and the underlying share in the case of options, SARs are less dilutive.

Over the past several decades, stock options have swung from being a popular compensation vehicle to unpopular and back again. Given the flurry of activity around FAS 123, stock-settled SARs appear to be on the verge of an increase in prevalence. If nothing else, as companies review various LTI alternatives in anticipation of mandatory stock option expensing, such SARs merit consideration as part of an employer’s LTI mix.