Using Stock Appreciation Rights to Keep Key Employees

Thursday, June 29, 2017

The successful growth of a business and its ability to prepare for a future sale is often dependent on keeping key employees. As a result, owners frequently resort to offering valued staff an equity interest, contingent on their remaining an employee, as an incentive to keep them from leaving. The chief advantage of course, especially for small businesses, startups and others on a tight budget, is that this can be done without straining already limited cash reserves. But, the stock incentive strategy can present disadvantages and risks as well, which often sneak under the radar undetected.

Becoming a shareholder, especially a minority shareholder, imparts additional rights and privileges to the holder that substantially alter the typical employer/employee relationship, and this can interfere with the company’s objectives, often in unanticipated ways. Fortunately, there is a simple mechanism by which owners can still achieve the objective of motivating valuable employees to stick around without granting them equity ownership.

A corporation can achieve this by issuing a Stock Appreciation Right (“SAR”), sometimes called Phantom Stock and in an LLC it’s known as a Profits Interest. An SAR is simply a contractual obligation in which the employee is guaranteed an economic benefit in the company’s profits in the same amount as a like percentage of stock, but without the voting powers and other rights associated with true equity ownership. Because an SAR is considered a non-qualified plan under the Internal Revenue Code, there are few if any restrictions as to what may be included in the plan, which gives the owner maximum flexibility in establishing vesting schedules and other conditions that the employee must satisfy to have “skin in the game.” SAR’s thus provide employees with a financial interest in the growth of the business without diluting the ownership rights of existing stakeholders, and without burdening the owner with the obligations that it can owe to minority shareholders.

Advantages of Stock Appreciation Rights

• Avoid issues related to minority shareholders
• Vesting schedules provide a performance-based retention tool
• Plans are very flexible because they have few if any restrictions
• Plans may be structured so that financial rewards in the form of bonuses are based on performance
• Plans can provide what the SAR holder receives if he resigns or is terminated
• Perhaps most important, the Plan may provide that key employees receive some of the net proceeds of a sale of the business thereby providing incentives that can result in the retention of the employees both before and after a sale.
• If the business entity is a Subchapter S corporation (or a limited liability corporation), there is no allocation of taxable income to minority shareholders and associated record keeping issues
• The corporation gets a tax deduction for any amounts paid to the employees under a SAR

Disadvantages of Stock Appreciation Rights

• If the employees receive cash upon a sale of the company, it is taxed at ordinary income tax rates (as opposed to the actual shareholder who will pay lower capital gains taxes on some or all of the sales proceeds that she receives).
• Accrued employee benefits may be subject to FICA and Medicare tax

Designing a Stock Appreciation Rights Plan

The design and implementation of an SAR plan is a generally a three step process as follows:

• An outline of the plan is created by the owners of the business with the assistance of an advisor who is familiar with the business and its employees and has experience with SAR plan designs
• An attorney reviews the Plan to ascertain that it doesn’t violate any laws and to draft the plan into a legal document
• The plan is presented to employees