Publication

A Unique Way to Retain Employees

Offering a share in the value of a business has long been a useful means of rewarding long-term employees and attracting and retaining top-quality management talent. One of the most effective ways to allow key employees to share in the growth of the company’s value is to adopt a Stock Appreciation Rights (SAR) Plan. A SAR Plan is a form of nonqualified deferred compensation plan, in which the value of the eventual payout to the employee is based upon the growth in value of a share of the company as measured over a period of time. One of the big advantages of using a SAR plan is that it allows incoming employees to share in the growth in value, which they help bring to the organization, but not in the level of value which already existed at the time of their employment and all without diluting the equity ownership in the company by its actual stockholders. Upon the granting of a SAR to an employee, the employee would become entitled, under contract, to receive certain payments from the company upon the happening of any one of a list of certain events (referred to as Triggering Events), typically the employee’s death, disability or retirement or the sale of the company. The amount of the payments would be equal to the growth in value of the company from the date of the granting of the SAR (the Grant Date) until the date of the Triggering Event, multiplied by a percentage stated in the SAR agreement between the company and the employee (the SAR Percentage) and further multiplied by the employee’s vesting percentage in the SAR at the time of the Triggering Event. For example, if the employee were granted a 2% SAR (that is, the SAR Percentage is set at 2%), then upon the happening of a Triggering Event, at a time when the employee was fully vested in the SAR, he would be entitled to a payout from the company equal to two percent of the growth in value of the company from the Grant Date until the date of the Triggering Event. In theory, this would approximate the gain that the employee would realize had he purchased 2% of the company’s stock on the Grant Date and sold it on the date of the Triggering Event. For most purposes of the SAR Plan, the value of the company at any point in time is generally established by formula. A typical formula might be five times the weighted average of the company’s earnings before interest and taxes, measured over the three most recently completed years, with the later years weighted more heavily than the earlier years. This is similar to a formula which might be used for actual stock purchases under a stockholders’ buy-sell agreement. The company’s value would be established at the time the SAR is granted to the employee, as a baseline. Then, upon the occurrence of a Triggering Event, the value would be computed again, and the growth, if any, would become the basis for the SAR payout. Once a Triggering Event has occurred, and the amount of the payout has been established, the actual payment is usually made in installments over a period of time, often five to 10 years. This enables the company to fund the payout from its operating income without having to borrow or liquidate assets. Installment payments can be grossed up to include an interest equivalent on the declining balance. However, it is important to remember that these payments are not principal and interest, but are deferred compensation to an employee or former employee. Payments are fully deductible by the company and fully taxable as income to the employee. In the case of a Triggering Event which is a sale of the business, the usual valuation formula for determining the payout amount is often replaced by the actual value of the company as determined by the purchase price being paid by the buyer. It is also typical, in this case, to replace the usual installment payout over five or 10 years with payment to the employee of the amount due him, when and as the purchase money becomes available for distribution to the selling stockholders, on a pro-rata basis. In this way, the employee is treated on an equal footing with the selling stockholders and should have an equal interest in a successful sale of the business. For the closely-held business which needs to attract high-quality professional management, a carefully crafted SAR Plan can be a valuable addition to an executive compensation package designed to align the interests of the hired executive with those of the stockholders. Jesse D. Delanoy, Esq. Mr. Delanoy concentrates his practice primarily in the areas of Corporations and Partnerships, Mergers and Acquisitions, Family and Non-Family Business Ownership Transitions, Commercial Contracts, Small Business Planning, Employee Agreements, and Real Estate. The foregoing information is for general information purposes only and is not intended to constitute legal advice and is not provided in the course of an attorney-client relationship.