EP37 - SAR - a long, long way to run

Welcome to this podcast. This is the ESOP guy, and we are on a journey to an ESOP. Thank you so much for joining the podcast today. If you are joining for the very first time, I wanted to say thank you for taking the time to, to listen to this podcast. I know you have a lot to do, everybody does. So we're honored that you would check us out. Um, the podcast really is a resource for companies that are thinking that they want or are considering going towards an employee stock ownership plan. And it's really been designed to provide, I think, important information along this, what I would call this journey to an ESOP or and the steps it takes to become an ESOP company and Really providing that resource. It's been interesting because we've been able to do a lot of interviews with ESOP professionals, whether that be ESOP attorneys, ESOP trustees, um, valuation firms, and those have been helpful because there's not just a topic and, you know, what, what I think it's, it's a lot of different perspectives from people across the country. Now, today is going to be a day where we do a topic and just talk through that. I think that's also very important. So if, if you're new to the podcast and you haven't been to our website, go to our website at journey to an ESOP.com. There's all of our episodes are there for you to look at and they're listen to, I, I would say, and they're there to really provide you a resource um to help you understand what it looks like to be an ESOP company. If you've continued on this journey to an ESOP, I want to say thank you and for continuing to listen and to tune into new episodes. Today's title of this episode is SA, A Long Long Way to Run. And the first thing I want to say about that is, oh no, you didn't. Yes, I did. And this topic is going to be today, using that title about stock appreciation rights programs. First off, what are they? How do you use them in an ESOP transaction? And really, what are the issues related to SARS that you should be concerned about, that you should be prepared to ask your advisors about so that you don't walk into a meeting and say, oh, I didn't know what a SAR was. So tune in, listen to this episode because you will at the end, you will know and understand what a stock appreciation rights program is about. And how they're used and it'll be helpful for you on your journey to an ESOP. If you like what you hear, please subscribe to the podcast and share it with a friend if you think they might be help, they might be helped by this podcast and rate and review the podcast. It's very helpful for us to get that type of feedback so that we can continue and make changes as we need to. So as I go back to the titlear A Long Long Way to Run, the first thing I wanted to say, yes, it is, if you, if you guessed it, it is based on the song in The Sound of Music, and whether or not you like the Sound of Music or not, um. It, it's for me, it's a movie that, first off, my family loves, my wife loves, and therefore, I love watching it with them. And of course, I am just gonna tell you right now, I'm not gonna sing this song, but the title comes from the song where it says, you know, it's a far, you know, it goes through all the notes of, of then it goes to far, a long, long way to run. So I just put, hey, SAR, a long, long way to run. And really the connection here is that If I need to make a connection, is that this idea of SARS is, is a long, long way to run, is that a SAR is a stock appreciation rights program that takes time for it to gain value. So there you go, that's the connection point, and I wanted to make sure it was relevant to the topic. So let's start off, what is a SAR? It means a stock appreciation rights program. It is a way for a business to create a benefit to their key employees. And the benefit is created by, well, the benefit it really anticipates that the employee will be there to receive the benefits, so that what they're going to get at the end of the SAR is as long as they're still employees and they've been retained with the company, they're going to be able to cash in the SAR. In addition to that, SARS are also created and designed to incentivize an employee for their performance in what they do for the business. And so SAR is a form of bonus compensation given to employees that is really equal to the amount of appreciation in the company's stock over a period of time. So what happens is that the, the whole word appreciation with stock appreciation is the key. What happens is as the stock price rises or the value of the business rises, the stock price rises and it creates value within the SARS for and assigned to key individuals. So it's, it's really a contract that the company makes. With its key individuals to, and it's a promise for that contract to, to basically pay them X amount, depending on the value of what the of what the SAR is going to be worth at a period, over a period of time. So participants generally have the right with SAR to exercise at the end of the maturity of the SAR. And it's gonna be usually at an event that occurs. Now, typically, when you're designing a SAR for an ESOP, this event's gonna be a specified date in the future. However, you could design a SAR to also mature during other, other events like termination of unemployment. It could be a change in control, it could be that the company went public. So there's multiple ways to, to determine what that event is, but I just wanted to say the common way is to, is to look at it, that it's a specified date in the future. SARS are different from stock options to the fact that they, when the option is exercised, an employee does not have to pay or acquire the underlying security or or buy the stock. What happens is is basically it's it's a straight cash expense for the company to the employee. Now, SARS are also considered synthetic equity. And are issued on a fully diluted basis, which means they dilute the existing shares of stock. We, we'll get into that a little more when we get into the issues at the end of the episode, but just to make sure that you understand they're considered synthetic equity. And because of that, they, they're also one of the aspects of our negotiations with our trustees when we do an ESOP transaction. So, so let's jump into why would a company want to go through the trouble of setting one of these SARS up. So I wanted to kind of connect on this a little bit with other episodes. One of the episodes I did was episode 25, and it was in an interview with an attorney named Greg Doherty. And Greg's an ESOP attorney and he specializes in compensation. And one of the topics that we had in our conversation that day was discussing how you can use different compensation approaches for your key people. And so this, this idea of a SAR was was discussed in that. In that interview, this topic or this episode will go into much deeper content related to that, but that might be helpful for you to listen if you have an interest in other um areas relative to ESOP compensation. So why, why would a company want to go through the trouble of setting this up and I want to use some ideas that I got just from the NCEO article that was published. Um, and CEO stands for National Center of Employee Ownership. And so some of these are just thinking about your company and where you might fit in one of these categories. But so you have a company that that clearly is wanting to share the, the, the ownership wants to share the economic value of the equity with its key individuals. And But they don't necessarily want to share the equity itself, and there's all kinds of reasons not to want to share equity and you probably could think of, of a lot of different reasons on your own. But really, there's, there's a reason why they don't want to, and because of that, the SAR is a good option. Now, in the case of an ESOP, you know, clearly what happens is the employees are getting the equity value of the business through these shares. So, um, there might be, so there might be listeners that have an existing company that are not ready to go that route yet and they're thinking maybe Sar might be a good option to retain and incentivize some key people. Another reason might be that the company cannot offer conventional kinds of ownership because of the restricted nature of the company. Maybe it's um an S corp or a limited liability company or, or just because of the, the nature of the structure of the entity, there's, there's limits on who can have equity. The company already has a conventional ownership plan, so maybe they're already an existing ESOP. And so they want to continue to reward and have an additional reward for the key people. That's going to be a very common theme when we talk about. Using SARS for ESOP companies. The company's leadership maybe has um considered other plans, but found their rules too restrictive or implementation costs too high. The stock appreciation rights program isn't that expensive to create, and it's, it's as simple as you want to make it because it's a contract that you're making with your key employees. Um, primarily, it's gonna be created by the attorney that you're working with. Um, the design and the planning of, of a SAR would be part of your, the advisor's work though, and we'll get into an example as I go through that and how the advisor would help plan out the SAR appropriately. So it could be just another couple of examples just, just to throw it out if, if this might touch on a few things is that uh you may, the company might be large enough to have multiple divisions and we wanna incorporate ownership thinking in the division so equity value might help people to think on that level. And so we might reward people around the the division's performance and create a sar around that. The company may not even be a um a real company, it might be a nonprofit or a governmental entity, and they can still use This type of, of, of reward system in that environment as well, um, because that would mimic the equity growth and so there's creative ways that you can use, um, this concept around other, other way, other types of organizations. But for the most part, I just wanted to give the spectrum there because I think this, it's interesting, it does touch on a lot of different um areas. So essentially, the point I want to stress with this topic is. That and, and I've touched on this in other episodes, but most, one of the most important aspects of any successful business is retaining its key people. And we've had episodes about, you know, building your talent and culture and, and, you know, every business knows that once they get the right people in the right seats, it's like, I don't want that person to walk into my office and give me their resignation letter. And it's got to be one of the worst feelings. It's like losing a really good client or a really good customer. Um, losing a really good key individual in your business, it really hurts bad. And We all want to make sure that we are keeping our best people. But when I started thinking about a potential ESOP company, I immediately start thinking of what I would say is sustainability, the sustainability of the company going into the future. So, so that's where I think it really has a lot of strength in terms of when we, when we tie this back to using a stock appreciation rights program. So as we plan for the future, really it's, it's thinking about intentionally about how do I keep these this talent pool in place. Now this is going to benefit everybody in the whole in the whole of the ESOP. It's going to benefit the key owners who are selling and they're taking maybe a piece of seller financing back, and they don't want to jeopardize that. That note coming back to them. It's gonna benefit the trustee who wants to make sure that this company is sustainable and is there to create value and reward the employees. It's gonna, it's gonna really benefit everybody in the end of the day. So this is one of the parts of, of planning that is kind of fun because it is, it's, it's very mutual for almost everybody involved. And even though you move, you do move into negotiation with SARS, which we're gonna talk about. Um, it's, it's still pretty positive because it, it is, there's a benefit for everybody in at the end of the day. Now, an ESOP obviously rewards all the employees and there's a fairness to the accumulation of shares based upon wages. So there's already a benefit, but as we go into this a little bit deeper, the key employees that are working around the clock, and these are the people that are, are really helping the business to grow in ways that are significant. beyond their just normal 9 to 5 hour job. They're taking on new projects, they're creating the vision of the future. They're the ones that are maybe spearheading, you know, key initiatives. So, so I don't want to dilute and say, you know, anything negative about the rank and file because they're everybody's important in the business and that's why they're all being rewarded with an ESOP. But we all know that some people put above and beyond energy into a company and typically they're already, you know, You know, rewarded by higher compensation, bonuses and everything. So, so everybody kind of knows that there's, there's key individuals and key employees in the company. And so this really does provide an additional reward to help those key individuals to stay in the, in what in their positions and continue to function and perform at the highest levels. One of the, one of the aspects of this that has to be thought about is what is What are some of the planning ideas around ASAR? And so we, we, we'll talk a little bit about What's important within ASA and then we'll move into some an example so that we can kind of really illustrate. How this is used. So, some of the things we're going to be concerned about is what is the vesting schedule of the SAR? Is it gonna be vested over in, in our example, we'll talk about what the vesting schedule is, but is it going to be a vested a long enough period to where we do keep and retain the key people or is it too long to where it makes it not really an effective SAR plan? So that could be 5 years, it could be 6 years, it could be longer, it could be shorter. Is the vesting schedule gonna be based on time of employment or company performance? Now, in SAR negotiations with trustees, they're normally going to ask for some type of not only retention ar, but also a, a performanceA, which basically means that the individuals are going to have metrics or goals to accomplish or hit in order to Be able to vest in the tsar or able to satisfy the requirements of the tsar and earn that sar over a period of time. So other things are gonna be, um, how is, how is the SAR gonna be treated with a change of control or liquidity event? How will the share value on the SAR, on the SARS be based, um, how will they be determined? Will you use the day 2 price, which is the lower value to base the uh the beginning baseline part of the SAR when you're measuring the appreciation, or what would be your baseline measurement? Um, are the SARS settled in cash, stock, or both? Typically, we're talking about cash settlements. How many SARS are outstanding and how is this number expected to change over time. So what we're concerned about here is, is because they fully dilute the shares of stock, what that could do is if there's too many SARS, it could dilute all of the stock for the employees. The trustee is not going to like that. So we're gonna want to make sure that we are able to look at that part of it in the planning stage and also look at The potential impact on the future evaluation of what those SARs are going to be worth. So what is the company going to have to pay out in that, you know, maturity period of when the SAR matures? And so we need to be planning for that and that could be a very big number in cases where you, the company gave more SARS away than they should have. Um, what are the the age of the employees that hold SARS and when will the payments associated with the SARS likely occur? So is it, is your employee population that you're, you're giving SARS to, or is it too many years? Are they going to retire before this, this is even working out? So these are all planning thoughts that need to be, you know, looked at and asked, and the questions need to be asked at the front end. And I'll just say that. In our, in our planning part, the, the processes that we do going through an ESOP, we're gonna normally discuss this at the end of the feasibility model, and we're gonna normally as an advisor model out the SARS for the client so that they can understand the impact of the SAR on a potential future evaluation. So that, and I'm saying that to you as you should ask your advisor as you go through this, if they, if they bring up SARS, how do they explain that and how do they actually quantify the impact for SAR in your business? So let's move into our example. Um, so we want to want to visualize this a little bit. We have a business that makes clothing for kids, particularly the kind of clothes that are good for playing outside. Now, this company has a special competitive advantage because they use curtains. As low cost material that nobody wants anyways. So they're able to take some discarded curtains and create these cool clothes that kids love to play in. Now, the business was started by none other than a nun who got married and now didn't, doesn't want the business anymore, even though it was very successful. And what if she really wants to do is really sell her business and run off into the mountains with her husband. But she decides really the right thing to do is to sell her business to an ISA because she's really, she knows that her employees really helped her build this business and she also has three key individuals that really helped run the business and she knows that she can leave the company because they're doing everything and, and really, she's just been kind of designing clothes at this point. And so she's ready to, to, you know, pull the trigger. Um, they, she knows that these key people that are really important, and they, they do need an an extra incentive to stay focused. And so her advisor suggests to her that they use a SAR and so she responds as do re mi fa so la ti do and and the the advisors like, I don't know what that means, but here's what how the SAR works. So that's, so the advisor then explains that the SAR will work um as we, as we look at this modeling that she's going to need to set up. What he believes is a 6-year SAR, which is that it, that these key individuals, these 3 key individuals will have 6 years to earn out their entire SAR. And the Advisor is also determined that they want to basically set the SAR targets before they even get to negotiate with the, with the trustee because the advisor knows that the trustee is going to want to make this a part of the uh an incentive or every performance SA. So the advisor suggests a 7% SAR, which would be 7% of the total the total stock that's available. And he's created a schedule of um EBITDA targets that match pretty much what the forecast is with an average EBBEA target of each year of $2 million. So, what we're, what he is suggesting to her. Is that the 3 individuals would, would earn each SA at 1/6 of the SAR, so it's a 6-year SAR. So each year they would earn 1/6 of it if the company hit the $2 million EBA target. And they would also earn the SAR if they were still in the company after 6 years. So that's kind of how the, the modeling works. And they believe a 7% SAR would not be Um, too restrictive and too dilutive of the stock. And when they do their calculation, the advisor determined that at the end of 6 years, The valuation would be if they met these EIA targets would be $6 million or it would have an $8 share price. Now what happened when we, when they planned the sar with they're planning for a dollar share price as their baseline value based on what they estimate the day two price to be, which just means. When the ESOP transacts and the plan would be your day one price is what she sells it for, the day two price is what it's worth after it's sold, and that's the number that they're going to use to plan the potential appreciation of the SAR. So very simply, their day 1 $1 per share is going to appreciate to now $8 a share over 6 years, and the $8 a share is what we're gonna use for our appreciation calculation. And so the math works like this at 7% of $6 million the SAR appreciation is $420,000 minus the, the actual share price at the time the SAR was created at, and that's $27,096. That will give us a total appreciation of, of the SAR at $392,904 at the $8 per share value. And so these key individuals are each going to get 17,500 shares of the total. And that's going to be worth at the end of the SAR $130,968. So, Pardon me for not rounding, but it was just uh doing the math, um, on this template. But what basically you get the idea that the plan with the 7% SA and the, and you're able to then talk to the key individuals or the key management about the potential for them to earn this reward down the road. So, so now you have a vehicle and a model to explain what they could possibly could earn if they stay in place, do their job, and the company gets to that $2 million in a year. Now, what happens if the company doesn't hit the $2 million of Ibida? They don't qualify for that SAR that year. So it could be that they missed the mark and they mess up the company and that's gonna obviously not only affect the value of their SAR, of trying to be what they would say is in the money on the SAR, but it's also going to affect the evaluation. So if our valuation model is correct, and they have a down year, then that would possibly, you know, erode the value, but it could also come back up and be more than that too. So, So the, the value of the SAR for them is, is that if they do better than the $2 million and they earn the SAR, then the and the valuation goes up higher than $8 per share, then they would actually be able to earn more and their payout would be more than the 130, roughly $131,000. Um, in value at the end of the SAR period. So I hope that from a modeling standpoint, that makes sense. Um, and when you start thinking about the math, it's just putting things in the right category, but building out the model is is a very important step. Because we want to prepare not only for the negotiations with the trustee, and we want to know what that is gonna look like before we get there, but we also want to prepare to explain this to our corporate management. Now, in negotiations, um, this very much could happen and, and so it could be as we lead off in the negotiations with the client, we're gonna say we're gonna have a totally diluted or a fully diluted SAR at 7%. And this is gonna be for our tier one management and for 3 employees, and it's gonna be also based on an EIA target um vesting of, of what we just explained for $2 million a year. And so that's our lead off in what we would lead off in negotiations. Now the trustee could come back and say, well, they're OK with the SAR program at that percentage, but what they might want is an employment agreement signed for each of those key individuals. In exchange for the SAR. So the way that would work is that each of those individuals would sign an employment agreement that would have a non-compete and a non-solicitation provision, so that that protects the company from them getting, you know, leaving the company and having an issue. So it, it, it, it binds them closer to the company. In this case, of course, what we're talking about this negotiation, we're assuming they didn't have an employment agreement before, so just keep that in mind. And so in the negotiations, everybody agrees to that, and then the surrogates kind of set up for the um potential. So, it could be that the negotiations could be that the trustee was not comfortable with the 7% and then recommended lower. But if you're going into it, you may want to recommend and you want a higher SAR, you might want to go in obviously with a higher um uh percentage of the SAR going in to make sure that if you did negotiate it. Down, it would get to where you want it to be. So that's kind of like a quick um understanding of how the process works cause you model it out and then you move into negotiations. And then the SAS set and it becomes part of your, of your documentation that the attorney creates for the closing of the ESOP. So, let me round this out a little bit at the end and just talk a little bit about the issues that, that SAR can create. And I'm just gonna primarily talk a little bit about um the fact that it is synthetic equity. And because it's, it's considered as part of the equity that is being tested in an ESOP, we're gonna have to go back to the 409P discussion which we just did an episode on, and we use this SAR as synthetic equity and, and, and Use that in our calculation for the disqualified person's test. And so that really is to make sure that we don't violate 409P and at any point in the plan year where we'd have somebody owning more than 10% of the total ESOP shares. And so if they do, then they become a disqualified person. And that if they do violate foreign IP, what can happen is the plan could um be, it could violate its, it's as selection. There could be then excise taxes of 50% that are levied and they would also then um be disqualified as a pla as an ESOP plan, so they would lose the tax benefit of the Scorporation ESOP. And so, That we, well, the big thing I wanna make, I wanna point out at the end here is that because it's synthetic synthetic equity, it is going to have to be part of your test on 409P and that needs to be contemplated. At the beginning of the planning stages and estimating the amount of the SARS and as part of also as part of the negotiations because we all, we know that the trustee is going to be thinking about that as well. And so we don't want to create a plan that might have a a problem when you look at it. You know, other, other issues related to synthetic equity are really related to SARS. Or just the communication and how the key management understand how the SAR works and whether or not they're OK if they don't have the employment agreement, because that's typically going to be required. Um, understanding the benefit that they're getting and And so it's, it's more about a communication, the right communication with your key people to make sure that they understand that this is not a guarantee for them. And this is something that they have the benefit of if the company does well and they're doing what they're, they're supposed to be doing. And so it's, it's not as much of an uh like I'd say a major issue, but I think partly it is, it does need to be communicated and that's why um having your advisor really model that out it's gonna be important. Um, but you don't want to oversell the SAR either because it, you don't wanna say that there's, there's a major benefit. You just need to make sure that they really understand how it works and why we're giving them this as a benefit. But I think overall, what it does is it creates a great opportunity to use something to strengthen the company in a way that um helps the company not only become sustainable, but it helps you as the selling shareholder to be in a position where you feel like your team has what they really need, um, and, and it's going to be rewarded appropriately as, as the, as the business moves forward. So with all of that, as I, as I round out all of this, this episode is, I just want to say, the hills are alive with the sound of ESOPs. OK. Sorry, don't shoot me, but I had to say it, um, I had to tie it back to the Sound of Music, so. Anyway, so going through all this, I just want to say thank you for listening to this episode and I wanted, you know, just to kind of remind you if you like what you hear, please subscribe to the podcast, share it with a friend, rate and review us. It's very helpful. And um, you know, as you, as you listen to this podcast, um, you know, just prepare for the next part of our, our journey to an ESOP and with that, have a great day. Thank you so much.