Stock Appreciation Rights

April 24, 2013

If you have a solely-owned business and are thinking of an end game for selling your company, you might want to consider utilizing stock appreciation rights agreements. Essentially, stock appreciation rights agreements help a solely-owned business or family-owned business transition ownership to key employees, thus enabling the key employees, in the future, to purchase the company from the family. It is an especially useful tool if there are no family members in line of succession that have the skills or the desire to continue the family business.

Essentially, stock appreciation rights agreements are agreements that give key employees an ownership in the appreciation of the business without any current ownership. This is typically how they work: A value is placed on the company as current fair market value. That would be fair market value, not book value or any other value, but rather the value of the business as it would be sold as a complete entity, including all key employees of the business. Once that benchmark is set, then the key employees who may have an interest in eventually buying the business are identified.

Once that occurs, a formula is created to value the company on a year-to-year basis giving a certain percentage of the increase in value to the key employees. This increase in value is an expectancy. In other words, it is not given to them in cash at that time but rather is an accounting device whereby value is transferred into accounts for the benefit of the employees going forward. For example, if a company is valued at $10,000,000 in year one, and the stock appreciation right agreement is granted, and in year two the company’s value goes up to $11,000,000, there would be a $1,000,000 increase in increment. If the company agrees that 30% of that increase would go to three key employees, then $300,000 of appreciation rights or $100,000 of value would go to each key employee. If and when the time comes, pursuant to the documents, that a sale transaction takes place, the key employees would use that $100,000 each as a down payment to the owners to purchase the company.

Essentially, what stock appreciation rights agreements allow is for companies to identify key employees and then give incentive to those key employees by giving them a piece of the appreciation of the business that allows them to leverage that into a purchase of the company down the road. Normally, stock appreciation rights are not allowed to be liquidated or sold unless they are for the purchase of the business or if an employee becomes disabled or passes away, in which case the value is liquidated for the benefit of the disabled or deceased employee.

Typically stock appreciation rights agreements are accompanied by employment agreements whereby the key employees agree not to compete and their obligations under the stock appreciation rights agreements are tied into their employment. Often times there are additional incentive plans for increase in net income to the company to encourage the key employees to put out the effort necessary to increase the value of the company to the degree that it makes sense for them to purchase it.

Stock appreciation rights can also be utilized to recognize key employees without allowing their appreciation rights to be used to buy in. The rights are just cashed in by the employee on retirement.

To put the concept into English, let’s go again to our company and assume that it has a value in 2012 of $10,000,000. The company agrees that 30% of the appreciation of the company will be available to two key employees who will purchase the company in a ten-year period. From year 2012 to 2022 the value of the company goes from $10,000,000 to $20,000,000. The key employees would then each have $1,000,000, or 10% each, of the appreciation of the company or $2,000,000 of down payment with which to finance their purchase of the company.

The benefit of this system is that it identifies the key employees, incentivizes them, and gives the owners a built-in purchaser for the company down the road. People they know, trust, recognize and are valuable to the operation of the business will be purchasing their company. It gives the key employees the incentive to work hard and keep the business profitable because they have an end game for the purchase of the business.

The foregoing examples are strictly for illustrative purposes only and do not indicate what an actual stock rights appreciation coupled with an employment agreement would look like. It is really an illustration to show the concept and how it could be useful to a solely-owned or family-run business.

In closing, there are multiple ways to skin every cat, and stock appreciation rights coupled with employment agreements may be a good tool for the solely-owned business owner to maximize value and to give key employees incentive.

Consult an attorney regarding your specific situation.

This article first appeared in the Ellenbecker Investment Group In Touch quarterly newsletter, the 4th Quarter 2012 issue. Past newsletters can be viewed at Ellenbecker.com.

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For more information about "Stock Appreciation Rights," contact Donald J. Murn at dmurn@axley.com or 262.409.2277.