When a company is contemplating a transaction involving an employee stock ownership plan (“ESOP”), there are a lot of considerations regarding structure, including how to retain, incentivize and reward key individuals. One set of considerations is stock appreciation rights (“SARs”) and warrants, both of which may be utilized as part of the structuring of an ESOP transaction to provide benefits to the key individuals of a business.
Download the Employee Stock Ownership Plan: How to Leverage Stock Appreciation Rights and Warrants PDF
What Are Stock Appreciation Rights (SARs)?
SARs are compensatory, incentive awards granted to employees. SARs entitle their holders to the appreciation in value of a specified number of shares of stock of the company during a specified time period. SARs function very much like an option to purchase stock, except that no stock is actually purchased, and the employee acquires no rights to receive dividends or to vote shares. Instead, the employee receives a right to cash payments, the amount of which is determined by reference to the company’s stock price. Upon exercise of a SAR, the company pays the holder an amount equal to the excess, if any, of the fair market value of the company’s shares on the date of exercise over the designated “exercise price.” The exercise price is typically the fair market value of the company shares on the grant date of the SAR. Accordingly, the payment generally represents the appreciation in value of the underlying shares from the grant date until the date of exercise.
How Do SARs work?
Similar to stock options, SARs provide holders with the ability to profit from an increase in the company’s stock price. Unlike stock options, the holder is not required to pay the exercise price in order to exercise SARs, and the holder never becomes a shareholder. Instead, upon exercise, the holder receives a payment equal to any increase in stock price over the exercise price, subject to the company’s plan rules.
SARs are typically subject to vesting requirements. Generally, SARs are forfeited if the employee quits without good reason or is dismissed for cause before vesting, and in general, SARs cannot be exercised until they vest. As part of an ESOP transaction, some portion of the SARs granted to an employee will vest upon completion of a time-based service requirement (e.g., the employee has to wait three to five years to be vested in the SARs), and the remainder will vest if the company achieves certain performance goals (often meeting a certain EBITDA target, meaning that the some of the SARs will vest only if the company achieves the performance goal). Customarily, SARs will not vest unless the holder remains an employee on the vesting date.
Generally, vested SARS may be exercised, in whole or in part, at any time on or after the date of vesting up to the SARs’ expiration date (which is often five to ten years from the date of grant). Holders may have flexibility in determining when to exercise the SARs after they vest in the SARs; holders may exercise the SARs immediately upon vesting, or they may wait some period of time to see if the company’s value increases. Unvested SARs usually are not exercisable following termination of a holder’s employment – however, holders are often given a limited period of time (e.g., 60 days) post-termination to exercise any vested SARs.
What Documentation is Required for SARs?
Most SARs are granted under a stock appreciation rights plan or other equity incentive plan that sets forth the terms and conditions applicable to all SARs grants. The material terms of each employee’s SARs grant are set out in a separate SAR agreement between the company and the holder.
Material terms include the:
- Grant date;
- Number of SARs;
- Exercise price (sometimes called the grant price or base price);
- Vesting provisions; and
- Expiration date.
In addition, the company issuing the SARs will determine the fair market value of its shares on the date that it grants any SAR. In an ESOP transaction, the value can be determined based on the price that the ESOP Trustee agrees to pay for the company shares.
How Many SARs May be Issued?
There is no tax or regulatory limit on the number of SARs that can be issued. In consultation with its financial advisors and the ESOP Trustee, the company will set an overall maximum number of SARs.
The number ensures that the obligations of the company under SARs are appropriately restricted, and so that the potential for a sudden drain on company cash flow is manageable.
There are several ways, in addition to limiting the number of SARs outstanding, to reduce the risk to the company that several employees may opt to exercise their SARs simultaneously, and in turn, drain company cash. These can be used separately or in combination:
First, although SARs are normally exercisable at the option of the holder within a specified window of time, the company may provide for the SARs to be exercisable only upon a liquidity event (sale of the Company). In an ESOP transaction, a later sale is less likely, and so this provision is less important in this context.
Second, the company can opt to make the payment in installments, over a certain number of years.
Third, the company may provide deferral of the payment if the company would be left without sufficient funds to pay its other obligations. The tax regulations specifically allow this deferral.
What is a Warrant?
A Warrant entitles the holder to the right to purchase stock in the company. This right is limited to (i) a predetermined exercise period, and (ii) a set number and type of shares in the company (the “Warrant Stock”). As part of an ESOP transaction, the selling shareholders are the parties who will receive Warrant Stock. The exercise price for the purchase of Warrant Stock is usually set at the fair market value of the company’s stock at the time the Warrant is issued. Often, Warrants are issued in connection with a transaction as an incentive for the holder (for example, tied to an interest rate enhancement in an investor/lender context). The intention is for the fair market value of the equity in the company to increase so that when the holder is entitled to exercise the Warrant, the holder receives the benefit of purchasing the Warrant Shares at a lower price.
How Do Warrants Work?
Similar to stock options and SARs, Warrants provide the holder with the ability to profit from an increase in the company’s stock price. The holder is required to pay the exercise price in order to exercise the Warrant – by cash, net exercise or a combination – and the holder then becomes a stockholder of the company. If the company has a shareholder or similar rights agreements in place, the exercise of the Warrant is usually conditioned upon the holder becoming a party to such agreements.
In contrast to stock options and SARs, the holder does not need to be an employee or consultant of the company.
Warrants are not usually subject to vesting requirements, but they do have exercise timing limitations. In addition to a set exercise termination date, examples of the exercise periods include upon the satisfaction in full of certain company indebtedness or sale of the company. Often times, a partial exercise of the Warrant is not permitted and any partial exercise results in the forfeiture of the Warrant Shares not exercised.
In certain instances, a Warrant may be structured to be callable by the company or put by the holder.
In the event of a call or a put, as applicable, the holder would surrender the Warrant and the company would pay the holder the cash value equal to the current fair market value of the Warrant Shares less the exercise price. The Warrant may provide that the company can pay the holder in cash, by promissory note or a combination.
Customarily, a Warrant will include adjustment mechanisms to account for any restructuring or recapitalization of the company while the Warrant is outstanding and to provide the holder with anti-dilution protection.
What Documentation is Required for Warrants?
The Board of Directors of the company authorizes the grant of Warrants, and the grant is documented by the issuance of a “Warrant” or “Common Stock Warrant” which outlines the specific terms of the grant, including the number of Warrant Shares, exercise price, and exercise terms. The Warrant will also include, to the extent applicable, any call or put rights and adjustment provisions.
How Many Warrants May Be Issued?
There is no tax or regulatory limit on the number of Warrants that can be issued, but the company will need to ensure there are enough authorized but unissued shares of company stock available for issuance upon the exercise of all outstanding Warrants. Warrants are reflected on the company’s cap table and would be accounted for in fully diluted ownership determinations.
How Can I Learn More?
There are numerous factors and considerations when a company is contemplating and ultimately negotiating the structure of an ESOP transaction. It is important to consult tax, financial and legal advisors to discuss and assess these critical structuring options. Hinckley Allen’s cross-disciplinary team of corporate, tax, ERISA, financing and employment attorneys work together to ensure that ESOP transactions are structured to address our clients’ goals and objectives.
Contact Us
For additional information related to this article, please contact Jennifer V. Doran or Libbie Howley O’Keeffe to learn more.