What are Restricted Stock Units? What are Stock Appreciation Rights? When you have the choice of receiving both, which better fits your financial plan?
There are a handful of employers in the United States that have an employee equity plan that involves presenting employees with compensation in the form of Stock Appreciation Rights and Restricted Stock Units. The plan offers a certain amount of compensation to employees, delivered in a certain percentage of each option, as chosen by each individual employee.
This blog post will discuss both forms of equity compensation, and for those who must choose what combination of each they want as compensation, we’ll also go over the pros and cons of choosing one type of the other. We will start with an explainer of each offer type.
Stock Appreciation Rights are a form of equity-based compensation, which provides employees with the right to receive the appreciation in value of a set of number of shares over a predetermined period. You do not receive anything upfront in the form of cash, instead you receive a quantity of shares in which the future value of your package will be determined. What an employee will receive in value is the difference in share price upon grant and the value on exercise (if the stock value has increased). Unlike stock options, employees don't have to purchase the underlying shares, they just initiate an exercise and receive the value of growth in cash.
The number of SARs an employee will receive is based on an internal formula devised by each company’s plan. Variables that dictate SAR numbers include the health of the company, prediction of future stock growth and external market conditions.
While you can control when you want to exercise the SARs, there is not a lot of flexibility in the tax efficiency of the exercise. The delta between the price at receipt and the exercise price is 100% ordinary income.
Example: You receive a grant of 1000 SARs, while the underlying stock is valued at $20 a share. You exercise the stock at a future date when the underlying stock has a value of $40 a share. The $20 delta between prices will net you $20,000 in compensation.
Restricted Stock Units, on the other hand, are a bit different and more straight forward. When you receive RSUs, you are receiving equity (the shares) as your compensation. You will receive a certain number of shares (as decided by the plan) and the total value is your compensation under the plan. Taxation of RSUs upon receipt (vest) is also considered ordinary income, however, if you chose to hold on to the shares going forward, all future gains follow capital gains rules.
Example: Your company offers you 1000 RSUs. Upon receipt the shares have a value of $20 per share, which makes your package worth $20,000 (of ordinary income).
What is a better option within a company plan; SARs or RSUs?
If you are part of a plan that requires you to take a certain percentage of your equity in one form or another, you must figure out which best fits your financial plan. To begin, it’s worth nothing that they are both good options, providing an opportunity to increase your income.
However, only RSUs are a guaranteed income source. Granted, the stock price may go down, but if the stock value is above zero the grants will be worth something when they vest. They are the ‘bird in the hand’ option. As long as you meet the vesting requirements, and the stock has value upon vest, you will have the ability to sell the shares and collect the additional income. If you don’t want your compensation to be too risky (albeit not risk free) RSUs will be more appealing.
With SARs, the strategy is to hold on to the SARs after they vest, with the goal of receiving the value of the stock gains over a period of time. The larger the difference between the price grant and the price at exercise, the more money you will have.
Additionally, the formula a company uses to dictate how many SARs an employee will receive creates a multiplier effect which makes either option close to equal upon grant. As a simple example, if you were to choose to receive your package as 50/50 compensation RSUs to SARs, that might create a package of 1,000 RSUs and 3,000 SARs (in order to even the potential income and make SARs more appealing). The company is creating a carrot and stick of saying if you were to take a chance on the company, we want to give you this multiplier of stock participation. This creates the opportunity to earn more money than an RSU package if you hold the shares and experience significant growth. SARs are the ‘two birds in the bush’.
With this information, the concept of the planning strategy becomes fairly straight forward. If you want a greater chance of guaranteed income, RSU's are a better option. If you prefer the opportunity for greater future gains, and you have faith in your company’s growth, you will choose a higher percentage of SARs.
Everybody's opinion of how to best use this type of plan will be different, and you really must figure out what is important to you and how your decision may affect your financial goals. Again, both options are a good opportunity, and if your company only offers one, accept the benefit of potential income. If you must decide between the two, you must choose what fits you best, potentially receiving money now, or potentially receiving more money later.
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