It's a dilemma that's plagued small companies for years: A business owner wants to grant key employees a stake in his company -- knowing this will boost their incentive to build the firm. But he wants to do so without diluting his own equity position.
Impossible you say? Not really. That's because a little known incentive plan, called stock appreciation rights, enables owners to share the wealth without sharing the pie.
SARs are common stock equivalents often structured as "units".
Typically, each unit corresponds to the value of the actual common stock according to a predetermined formula. Assume, for example, that Jane Smith is awarded 1,000 SAR units at the time that the stock of her employer, ABC Company, is valued at $100 a share.
"In a typical plan, if the value of ABC shares increases by 20 percent over five years, Smith's units would reflect the same increase in value," says Andrew Zuckerman, a senior manager with the accounting and consulting firm of Grant Thornton. "Vesting in the SARs can occur at any time the company's management specifies in the plan. Although management has great leeway in designing these plans, it should come up with terms that suit the business while simultaneously motivating employees."
SARs produce a win-win situation. Granted equity equivalents, employees are able to escape the limitations of straight salary, profiting from the growth of the business. And the owner is able to motivate his people without sharing actual equity and without giving his employees voting rights.
"Employees also benefit because they don't have to put up capital for SARs," Mr. Zuckerman says. "That's a marked difference from non-qualified stock options. With that type of incentive, the employer gives his people the right to purchase company stock at a set price. Should they choose to exercise the option, they will have to put up the funds to buy the shares. This is not necessary with stock appreciation rights."
SARs are also attractive from a tax standpoint. That's because SARs are not taxed when they are received, but only when they are exercised.
"In order to give employees added flexibility, SARs are often granted in conjunction with non-qualified stock options," Mr. Zuckerman says. "For example, an employee may get 1,000 stock options and 1,000 SAR units, with the right to choose among those offering the best gains. But in these situations, the employer will often stipulate that a total of 1,000 options and units can be exercised. So if the employee exercises 500 stock options, he is limited to 500 SARs. This is a way of controlling the employer's costs."
A recent IRS ruling has cleared up some concern about the use of SARs by S corporations. To be eligible for S treatment, a corporation is limited to one class of stock. With this in mind, some S corporations feared that the IRS would treat SARs as a second class of stock, thus disqualifying them for S status.
But in a letter ruling, the IRS held that it would not treat plan units, which were in the nature of SARs, as a disqualifying class of stock.
"Although a letter ruling applies only to the company that requested it, and cannot therefore be legally relied on by other companies, it does reflect the current IRS position," Mr. Zuckerman says. "This should give other S corporations some comfort about their plans."
One thorny problem concerning SARs relates to the valuation of the units. Unless the units adequately reflect the appreciation in the company's real shares, the employees will see the plan as an empty promise that hardly warrants extra effort on their part.
With this in mind you may want to value SAR units according to a formula based on a multiple of earnings per share or net book value. Accountants and benefits consultants can help to arrive at an appropriate formula for your business.
If you've shied away from stock and stock equivalent plans for fear that they'll cost you money, you may want to re-examine your approach. Motivating employees to build the business as if it were their own will earn back the cost of the plan many times over. Seek professional advice in structuring your plan.