Options, SARs and SPLPs are valuable instruments for companies expecting significant future share price growth. However recent updates to ESS provisions reclassify them as “contribution plans” imposing strict limits and significant regulatory and disclosure requirements. Any company currently operating or considering an option plan should look at switching to SARs.
GRG Remuneration Insight 147
by Denis Godfrey, James Bourchier & Peter Godfrey
19 May 2023
In this Insight we explore the significant advantages offered by share appreciation rights (SARs); a modern alternative to traditional options or share purchase loan plans (SPLPs), which should now be considered the superior leveraged variable remuneration plan instrument following the changes to the Corporations Act that came into effect from 1 October 2022. Options and other leveraged option-like structures, which can be argued to include SARs and SPLPs, remain a valuable instrument for companies expecting significant future share price growth. The low grant value and exponential intrinsic value that flows from such leveraged products can be very attractive. However, from 1 October 2022, new ESS provisions reclassified options and SPLP structures as “contribution plans” that are now subject to significant regulatory and disclosure requirements, as well as strict limits. Therefore, any company currently operating or considering an option plan should consider switching to SARs; the financial benefits to the participant and the cost to the company remain identical, with the added benefit of SARs being typically 50% to 80% less dilutive, with significantly reduced expense and administrative burdens. The only remaining case for options to be issued into the future is where special tax exemptions apply i.e. either options with such a high exercise price that they have a nil taxable value, or in unlisted companies that qualify for the start-up tax concessions.
What is an Option?
An Option is a security which represents an entitlement to a share upon the option holder exercising the option and paying the “exercise price”. There are multiple variations of options defined by how the exercise price is set. They are generally related to the expected share price growth rate. Variants include market exercise priced options (MEPOs) which are the dominant form of option, Premium exercise priced options (PEPOs), which can enjoy special tax treatment, and discounted exercise priced options (DEPOs) which are exceptionally rare.
Partner with GRG to align your executive pay to performance
An option may be subject to vesting conditions that must be satisfied before vesting, such as service and/or performance conditions. It is common for options to have no vesting conditions attached as they are often considered to have an intrinsic share price hurdle, set by the exercise price; if the share price does not materially exceed the exercise price, then the intrinsic value is close to or equal to nil and therefore, there is no reason to exercise them. Zero exercise priced options (ZEPOs) are more commonly referred to as Rights and are not considered options for the purposes of this discussion and regulations being addressed, because they do not usually involve a “contribution” by the participant, since the exercise price is nil.
What is a Share Appreciation Right (SAR)?
A SAR is a derivative and is simply a “cashless exercise” option. It is also common for a SAR to be able to be settled in cash rather than shares if so desired by the Board. SARs can be constructed to have identical terms and benefits to their traditional option counterparts. However, on settlement of a SAR, the exercise price is deducted from the share price, and the aggregated net value of exercised SARs is settled in shares (or cash if so desired). The participant generally receives a number of shares calculated as follows:
Shares Received = (Share Price – Exercise Price) x Number of Exercised SARs ÷ Share Price
SARs are, therefore, classifiable as “indeterminate” for tax purposes because there is no 1:1 relationship between the number of SARs and the number of shares that will be received (see advantages, below).
When are Leveraged Structures like SARs, SPLPs or Options Used?
Because of the presence of an exercise price, whether or not it has to be paid or is simply deducted from the net benefit to be settled, leveraged structures like SARs, options or indeed SPLP’s are generally only deployed in one of the following scenarios:
- High share price growth is expected: because these structures have a marginal value at all times (excess of the share price over the exercise price), they have a low intrinsic value to start with and are usually granted in much higher numbers than un-leveraged structures. As the share price grows, the value accruing to the holder becomes exponential. For example, a typical MEPO held for 3 years, the share price growth rate generally needs to exceed 17.5% per annum compounding, in order to produce more benefit than non-leveraged structures like a Right. For options (only) if the exercise price is set sufficiently above the share price, they can be designed to be taxable up-front, at a taxable value of nil and thereafter any gain would be taxable as a capital gain and possibly qualify for the 50% capital gains tax (CGT) concession.
- There are significant shareholder participants that cannot access Employee Share Scheme (ESS) tax deferral and/or wish to access CGT treatment from day 1: in the case of businesses with participants who are founders or significant shareholders (own, control or can direct the voting of 10% or more of the company’s shares), equity plans can present a challenge, because they cannot access tax deferral. Instead, ESS interests will be taxable at grant, the payment of which cannot be funded from the equity received. SARs on the other hand cannot be assessed for tax purposes until they have been exercised, providing effective tax deferral (though eventually the tax liability may be backdated if settled in shares). SARs can also be structured such that they are subject to CGT treatment from day 1, if so desired. SPLPs also offer no taxable value at grant for such participants, and provide leveraged returns equivalent to options, as well as CGT treatment from day 1.
- The company is unlisted and qualifies for start-up concessions: there is a special tax provision for “start-ups” (unlisted companies that have existed for less than 10 years and have not reported more than $50m in turnover in the prior year). This provision is extremely attractive because it offers a “safe harbour” valuation method that is often a deep discount to the true share price, and tax will not have to be paid until the underlying shares are sold, at which point CGT will apply to the excess of sale price over the exercise price.
In all other scenarios, an Option, SPLP or SAR will produce an inferior outcome compared to alternatives such as Rights, which are also subject to significantly lesser regulation, disclosure conditions and limits.
Advantages of SARs over Options and SPLPs
SARs produce an identical net benefit for the participant compared to options with identical terms, however there are a number of advantages that SARs offer over options that make them the superior choice, except in the cases of PEPOs and scenario 3 (“start-up” plans) outlined above. The advantages include the following:
- SARs are typically 50% to 80% less dilutive than options with the same terms, while providing an identical net benefit,
- Participants do not face the challenges or costs associated with paying the exercise price,
- Smaller volume sales into the market result from SARs (market signalling risks),
- Advantageous tax treatment for significant shareholder participants can be obtained from SARs,
- Unlike options or an SPLP, SARs are not considered “contribution plans” under the newly amended Corporations Act. This relieves companies from disclosure requirements and removes limits on the number that can be issued, in relation to the Corporations Act ESS framework.
Much Less Dilutive Compared to Options
When Rights, SARs or options are exercised, companies may provide shares to participants via on-market purchases, or through the issue of new shares. While some shareholder groups may prefer on-market purchases, the issue of new shares is generally the most cost-effective approach from a company perspective because there is no net cash outflow. This ultimately benefits shareholders also. However, this approach results in the dilution of share value for existing shareholders which can be undesirable, especially when the number of shares involved is high, such as typically applies to options which are often issued in comparatively large numbers due to their marginal, low relative value. In the case of options, a 1:1 relationship with shares applies on exercise, whereas SARs do not have a 1:1 relationship with shares on exercise, even though the same number of SARs and options are initially granted. This is because of the cashless exercise feature; only the net benefit needs to be settled in shares, which is generally a fraction of the number of options or SARs issued. In general, SARs are 50% to 80% less dilutive than options, depending on the share price growth rate and the period prior to exercise.
The following tables model the net benefit and dilution impact of both SARs and options, assuming a typical MEPO structure has been used: