Business Valuation and Appraisal

This article is about the role of Stock Appreciation Rights in retaining key employees, which goes a long way in increasing the value of your company. One of the least understood, but most valuable, strategic assets of any privately held company is the quality of management, including its breadth and depth.

Put yourself in the position of the buyer, for example.  Would you pay a lot for a company the executive corps of which consists of the founder/CEO and a cast of minor characters?  Of course you wouldn’t, and for one very sound reason.  If something were to happen to that individual (illness, injury, death or, simply, loss of motivation) your return on investment would be in serious jeopardy.  So, you would reduce your risk by reducing the price.

Therefore, it is critically important that ownership find effective ways to retain key employees.

Fewer Practical Options (Pun Intended)

Financial incentives have always played a key role.  However, because IPOs are much harder to come by in today’s market, one of the traditional favorites (stock options) has lost much of its appeal.  Not to worry.  Riding to the rescue is a great alternative: Stock Appreciation Rights or SARs.  This vehicle conveys no equity ownership.  Instead, the employee shares in the financial success of the company through what amounts to cumulative deferred income, with a vesting schedule that can take seven years or longer to play out.

Advantages and Disadvantages

There are several distinct advantages of SARs over traditional stock options, including:

1. The value of the SAR shares is directly related to critical measures of company success, such as Pretax or After-Tax Profit, or Net Worth.
2. The value of the SAR shares can reflect the success of an individual's efforts in his or her area in addition to, or instead of, #1 above.
3. The bases for the (hopefully increasing) value of the SAR shares are strictly a matter of management discretion.
4. There are none of the nettlesome issues associated with employee equity ownership, such as membership on the Board of Directors.
5. All SAR shareholders have a common goal, which encourages cooperation among sometimes competitive individuals and/or departments.
6. The vesting schedule provides a powerful incentive to stay with the company – the whole point.
7. When the company repurchases vested shares, these payments are fully deductible.

The principal disadvantage is common to stock options; namely, inadequate short-term incentives.  This problem can be very effectively addressed with cash bonuses.

The next article will discuss the logistics of setting up and managing an effective SAR program, as well as how to structure a cash bonus program so that it actually benefits the company, and not just the employees.