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Building a Phantom Stock Plan: Key Decisions & Considerations

April 13, 2022 • By Ken Gibson

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A guide for business leaders who want to share value with employees without diluting equity

Embarking on a journey to launch a phantom stock plan is a strategic move that can align the interests of your employees with the long-term goals and success of your company. But you need to know where to start.

To help you, this article provides an overview of the essential aspects of creating and implementing a phantom stock plan. In it, we cover:

  • The strategic decisions you will make as you are initially building your plan
  • Supporting considerations that will shape how your plan is implemented.

If you’re new to the idea of phantom stock, consider reading our article on how a phantom stock plan works before diving in. 

The Big Picture: Strategic Decisions You Need to Make When Building a Phantom Stock Plan

A phantom stock plan is more than a mechanism for employee compensation; it can also be an important part of a larger strategy for business growth. To ensure your phantom stock plan reaches its potential in this regard, you will need to make the following strategic decisions as you set out to design your plan:

We go into detail about each of these decisions below. 

What Is the Objective and Purpose of Your Phantom Stock Plan? 

If you are moving forward with a phantom stock plan, begin by defining your objectives and intentions

  • Is the purpose of the plan to share company value with the employees who help create it? 
  • Are you looking to provide a long-term wealth accumulation or retirement opportunity for key team members?
  • Is it intended to help employees focus on maximizing company value in preparation for a substantial event like the sale of the company? 
  • Do you want to use it to attract premier talent and help retain current employees? 
  • Have you made commitments to key employees that need to be fulfilled? 
  • Are your goals a combination of the above? 

Establishing your desired outcomes should help you determine how much value your company may create before the phantom stock plan pays out. Combined with the determinations you make about eligibility and participation, this can help you analyze the relative value that could become available for the average employee under the plan.

Do You Want to Use Phantom Stock to Support the Eventual Sale of Your Business?

If you decide one of the objectives of your plan is to maximize company value in preparation for a sale, you’re in luck. A phantom stock plan can be a highly effective tool for encouraging employees to grow your company and increase its profitability. If you think your company is on track to sell within the next 10 years, and you are comfortable disclosing that to plan participants, then this could be a good option for you. 

If this is your objective, your plan agreement should stipulate payoff in the event of a change in control, and you should consider working with an experienced consultant to structure and communicate the plan in such a way that it optimizes employee performance leading up to the sale.

What Type of Phantom Stock Plan Should You Create?

The type of phantom stock plan that your company chooses should be based on your company’s objectives and purpose for the plan. Your plan needs to align with your company goals and be tailored to the preferences and needs of both your company and your employees. In short, you want to choose the plan that best fits your company’s unique circumstances and objectives.

More information on different types of phantom stock plans can be found here

Who Will Participate in Your Phantom Stock Plan?

To determine who should participate in your company’s phantom stock plan, you should consider which members of your company are accountable for economic value creation. To do this, you’ll want to examine the levels of leadership at your company and identify the employees who are essential to the fulfillment of your long-term business plan. 

Keep in mind that participation in phantom stock plans is typically limited to a relatively small group of employees. Occasionally, a company may even adopt a plan for a single employee. More often, one or two levels of leadership are included. As a broad rule-of-thumb, you will probably consider between 1%-10% of your employee population for the plan.

Some companies generously include a broad group (or even all) employees in the plan. However, you should only consider this approach if you can offer every participant a meaningful amount of value. This approach also requires an assessment of whether your participation levels must be considered under the “top hat” rules of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA governs nonqualified deferred compensation (NQDC) programs, which most phantom stock plans are considered. 

The “top hat” rules state that a NQDC program can only be provided for a “select group of management or highly compensated employees.” Unfortunately, you shouldn’t expect to find clear direction from the Department of Labor if you are looking for the definition of a “highly compensated group.” Instead, you should consult with a qualified advisor before including a broad group of employees in your plan.

It may be possible to draft the plan and avoid the ERISA rules altogether. Court cases and other rulings have suggested that plans with payout dates shorter than five years may not need to limit participation to the “top hat” group.

How Will You Set and Manage the Phantom Stock Plan Within an Approved Budget?

A phantom stock plan is a serious long-term commitment. It could become the largest variable compensation commitment you ever make. So, you need to set and manage it to a budget. 

Begin by forecasting the future growth of your company. For example, if you expect your company value to increase by $40 million dollars over a period of years, you can determine the percentage of that increase (e.g., 10% or $4 million dollars) as the overall budget for the plan. At VisionLink, we call this “the value-sharing budget.”  

The size of your value-sharing budget will depend on your strategic goals, hiring expectations, retention urgency, and how motivated you are to offer a powerful incentive to employees. Establishing your value-sharing budget will help you determine the number of participants and the potential value of their awards.

You should also consider other ways of budgeting your plan:

  • Impact on the Company Financial Statements. You will likely be accruing a liability on the balance sheet. And this accrual will affect your book income resulting in an annual expense. Your plan forecast will enable you to assess this impact.
  • Cash flow. You may also want to assess the plan’s cash flow expectations. Your financial model can predict participants’ payouts and compare them against expected company profits or cash flow.
  • Funding. Many companies informally set aside dollars to create a plan funding account. This establishes an asset account on the books designed to offset the plan benefit liability. The amount of annual funding serves as another means of assessing the overall cost of the program. While phantom stock plans do not require cash funding, having a cash reserve instills confidence in both owners and plan participants. 

After establishing a framework for measuring the size of the financial investment, you can begin to consider additional elements of plan design such as award types, grant levels, vesting, payment schedules, and other factors. As you test different assumptions, you’ll be prepared to study the accrual, cash flow, and funding impacts. 

How Will You Communicate the Plan to Participants?

If employees don’t understand or value the phantom stock plan you create, it’s a wasted investment. Unfortunately, a common failure of many plans is a lack of clear, ongoing communication with plan participants. 

Without a proper communication strategy, participants might forget how the plan operates, how vesting works, when payouts either are or could be made, and other pertinent information. Worse, they may not have an accurate understanding of the potential value the plan could produce for their individual benefit, which undermines a plan’s ability to incentivize performance.

To prevent communication failures, we encourage companies that sponsor phantom stock plans to follow a simple acronym: CAM. 
  • Clear. Participants understand how the plan works and what has to happen to optimize its value.
  • Achievable. Participants should acknowledge that the stipulations for reaching maximum plan value are feasible, even if they are challenging.
  • Meaningful. The value of the plan for each participant must be seen as significant.

Proper communication is what makes CAM possible, especially the ”clear” principle. If participants aren’t able to explain the plan and the value they can earn from it, the communication strategy has fallen short.

Communication shouldn’t just occur when the plan is launched. There should be ongoing education, promotion, and dialogue to assure employee appreciation and motivation. 

How Can You Be Sure That the Phantom Stock Plan Will Produce a Positive ROI for Shareholders?

Over time, shareholders will want to see that a phantom stock plan leads to: a) the retention of premier talent, b) an increase in ownership mindset among employees, and c) meaningful growth in company value.

  • Talent Retention. One of the most important indicators of a phantom stock plan’s success is how well it attracts and keeps talented employees at your company. In simplest terms, make sure the value of the plan is significant and a solid vesting schedule communicates: “If you want to optimize your plan value, stay with us long term.” 
  • Ownership Mindset. This outcome is inherent in the very essence of phantom stock. Phantom shares only increase in value if the company owners’ shares increase. If share values decrease, employees are experiencing the same thing as the company owners. This is true alignment. With a successful phantom stock plan, your company should hear comments and observe behaviors that confirm that employees who participate in the phantom stock plan are demonstrating increased accountability and ownership.
  • Growth in Company Value. Can you attribute all company growth to the existence of a phantom stock plan? Of course not. However, over a period of years, owners will be able to evaluate the investment in the plan relative to enterprise value growth. If the plan is performing as expected, owners will notice positive financial results. For example, plan payments may decline over time as a percentage of profits or total plan costs may be less than the value-sharing budget, indicating an excess return on investment.

To ensure a positive return for shareholders, you should carefully consider how to allocate the value you are sharing with employees via the phantom stock plan. To do that, construct a financial model that illustrates the amount of value your company will potentially share with employees under varying performance results. These projections should align with your company's strategic goals and illustrate, for comparison, different payouts.

In your modeling, assess the impact of various grant levels (i.e., the number of phantom stock units granted to individual participants) to see how alternative performance possibilities impact the value of the employees’ accounts: 

  • How much will shares be worth under different sets of growth assumptions? 
  • How would they be impacted by slow growth versus rapid growth or cyclical growth?

Our Tool

Can Your Company Support a Phantom Stock Plan?

Can give you a snapshot of what this type of analysis can do for you. 

Careful testing will assure your shareholders that they are not overcommitting to payouts that exceed the financial return they are expecting from the plan.

Are You Prepared to Operate Your Phantom Stock Plan?

Your phantom stock plan doesn’t just require careful planning; once launched, you must carefully operate it to ensure its success and alignment with your company's objectives. 

After a plan is rolled out, your company should adopt an operating system that accounts for the following responsibilities:

Annually

Periodically

  • Create a system for tracking all awarded grants
  • Record company performance and update the value of historical awards
  • Calculate the accounting expense and record it on the company’s books
  • Communicate the value of outstanding grants to employees
  • Reforecast company expected growth to assess plan expectations against the budget
  • Identify new participants who should enter the plan
  • Determine new grants to be awarded.
  • Create grant certificates or agreements for the new awards
  • Assess whether payments are due to participants and, if so, process them
  • Review plan operations and plan documents to ensure compliance with the Tax Code 
  • Evaluate the employee communication process to enhance participant appreciation and understanding of the plan
  • Consider new plan features that enhance value for employees and shareholders

It’s wise to make sure you have a system in place to operate your program. Some of these duties can be performed by your finance or human resource team. However, you will want ongoing guidance from a consulting firm or third-party administrator, particularly since some operational errors can result in significant tax penalties. Alternatively, a limited number of software platforms are available to help. 

Our article on operating phantom stock plans can offer you additional information on this topic.

How Much Outside Assistance Should You Seek When Building and Operating a Phantom Stock Plan?

Phantom stock is a relatively simple concept, but ensuring a plan has the best possible impact on your business takes concerted effort. You should be familiar with the best-practice choices that can make or break your plan while maintaining sufficient flexibility to adapt it to changing business needs and circumstances over time.

That’s why most successful plans are designed and maintained by third-party advisors with specialized phantom stock expertise. When choosing a phantom stock advisor, look for one with:

  • Demonstrated experience leading a phantom stock plan design process
  • Fluency in the financial, accounting, and tax implications of implementing phantom stock plans as well as the potential influence of legal regulations like those stipulated in ERISA and Internal Revenue Code Section 409A.
  • Experience optimizing phantom stock plans to drive employee performance in service of business growth

In addition to hiring a specialized phantom stock advisor, it’s wise to have a lawyer review plan documentation before launch. They can provide extra assurance that your plan meets legal standards, but they are not typically experienced in plan design, modeling, communication, and administration issues.

The Nuts and Bolts: Important Phantom Stock Design Considerations

Once you understand what you are trying to accomplish with your phantom stock plan and the impact it will have on your employees, it is time to move from the big-picture, strategic decisions to setting your plan’s terms and provisions. You will need to determine: 

Below, we provide information to help you arrive at answers to each of these considerations.

Valuation: How Will You Determine the Price of the Phantom Shares?

Determining the price of your company’s phantom shares involves two variables: 

  • The presumed value of your company 
  • The number of shares that will be used in the plan 

You calculate the phantom share price by dividing the presumed value of your company by the number of shares in your plan.

Public companies should use their published share price for a phantom stock plan. For private companies, there are three possibilities:

  • Third-party appraisal
  • Book value
  • Formula value

A third-party appraisal might be appropriate in situations where the company already acquired an annual valuation–such as an employee stock ownership plan (ESOP) or in other situations where the plan requires a 409A Valuation. Book value methods are used by banks or other financial institutions. However, most private companies will find the formula value approach to be the most practical for a phantom stock plan.

How Do You Determine Formula Value? 

The specific criteria selected for formula value will vary company to company, but the concept is simple. You can determine a formula value quickly and easily from your company’s financial statements. Remember you are not trying to determine the actual market value of your company. Rather, the formula value is a reasonable assertion of value that can be easily explained to employees. And it will likely be somewhat lower than actual enterprise value. You will want your employees to focus their attention and performance on the key elements within the formula.

You likely have a sense for how your business might be valued by a serious potential buyer. For example, maybe some of your competitors have sold for one of the following formulas: 

  • 6x their net income
  • 5x their earnings before interest, taxes, depreciation, and amortization (EBITDA)
  • 2x their revenue

These indicators could become the starting point for your discussion regarding your phantom share valuation. You could also make further adjustments to account for other factors like long-term debt, cash, and more. 

You want to explain the plan to your employees as follows: “Increase X and reduce Y, and your share value will increase.” Focus your employees on the core performance factors that are important to the company.

Allocation: How Will You Set the Number of Phantom Shares? 

There are two ways to handle the number of shares for your phantom stock plan: 

  1. You could use actual company share count, also known as shares outstanding.
  2. You could use a hypothetical share count.

Shares Outstanding

Some companies use their actual shares outstanding and “issue” new shares for the phantom plan. For example:

  • Assume there are 1,000,000 outstanding shares in a given company. 
  • The shareholders might approve an additional 100,000 phantom shares. 
  • This results in a “value dilution” potential of 9.1% (100,000 ÷ 1,100,000). 

In this situation, if the company distributes all phantom shares to employees under a full-value phantom stock plan, their shareholders would reduce their financial stake in the company by 9.1%.

Tying phantom shares to actual shares outstanding requires paying careful attention to internal share transactions. Redemptions of stocks and transactions between shareholders could alter the number of shares outstanding and affect the value of phantom shares, even though these transactions are not related to employee performance. While ongoing adjustments can counteract these events, utilizing actual share count could lead to confusion and an unfair result for plan participants or shareholders.

Hypothetical Share Count

An alternative approach is to use a hypothetical share count. This calls for the random selection of the number of phantom shares used in the plan, such as 1,000,000 or 10,000,000. 

This method eliminates the need to track adjustments to your company’s cap table. The number of shares you allocate to employees simply becomes a fractional subset of the available hypothetical shares.

Keep in mind that it is more useful to track the percentage of value shared under a plan than it is to track the percentage of shares awarded. Track the dollar amounts owed and paid to employees, and then evaluate this amount relative to the increase in company value since the date of the plan’s inception. This is a better way to track value dilution than counting shares.

Allocation: How Will You Determine How Many Grants to Award?

To understand how many grants your plan can support, you should turn to your long-term forecast. The value-sharing budget will offer a guideline regarding the dollar amount you should consider paying out, but that value is spread across a number of years in the future. You will need to “back into” a number of shares available to award that will, under the forecast, approximate the dollar value you’ve budgeted. 

Once you arrive at a total grant pool for all employees, you can calculate the average value per participant. You might discover that the opportunity appears too low or too high for the number of participants you’re considering. 

Here’s an example: 

  • You anticipate new enterprise value growth of $20 million over a period of years. 
  • You have 10 possible participants for a phantom stock plan. 
  • If your value-sharing budget is 10%, the average amount per participant would be $200,000. 

Now you can assess if the average amount would be meaningful to the 10 participating employees. 

Our Tool

Can Your Company Support a Phantom Stock Plan?

Helps you envision your company’s future, so you can better evaluate the merits of sharing value with plan participants.

Distinguishing Between Employees

There are several ways to distinguish between employees when allocating grants under a phantom stock plan. Common approaches include:

  • Grant as a percentage of salary: Tier one employees (e.g., senior leaders) might receive units equivalent to 40% of their salary, tier two employees (e.g., vice-presidents) might be awarded units at 25% of their salary, and so on.
  • Grant level amounts by tier or position: Tier one employees might be scheduled to receive 10,000 grants per year, tier two employees 6,000 grants per year, and so on.
  • Grant based on relative value of individual positions: The CEO might receive 20,000 grants per year, the CFO might receive 10,000 grants per year, the COO might receive 8,000 grants per year, and so on.

You can total the number of grants and consider them within a budget to track the potential shared value. Once you have decided how to allocate grants, you are ready to establish a grant schedule. It’s best to consider issuing grants annually as part of the total compensation package for the participants.

You could also structure your plan as a performance phantom share plan and set annual performance targets which, once achieved, trigger the issuance of awards. This requires employees to achieve certain financial goals to become entitled to awards.

Distribution: When Will Employees Receive Payouts?

Distributions occur when a specific date or event outlined in the plan agreement calls for a payment. For example, a plan agreement may indicate that a payment is due five years after the date of award. In that case, once that date arrives, you would calculate the amount due and make a payment to the employee. The payment is processed as bonus compensation.

Customarily, a plan will call for payments under a variety of circumstances. For instance, most plans allow for payment after satisfaction of a vesting period such as 3-5 years. Plans also typically (but not necessarily) pay out in the event of a sale of the company. 

Your plan should address all the following events at a minimum:

  • Fixed-date redemptions, or when shares are paid out upon the achievement of a certain future date 
  • Voluntary separation of service 
  • Involuntary separation of service 
  • Termination for cause
  • Retirement
  • Disability
  • Leave of absence
  • Change-in-control

You will also need to decide if you are making payments in a lump sum or in installments. For example, you could make payments over a two- to three-year period or even longer. If you go this route, you will also need to determine whether these installment payments include interest or whether they remain subject to fluctuations under the plan’s formula value.

If the plan permits, payments can also be settled in actual company stock.

If your employees are accustomed to stock option programs in public companies, they might have trouble understanding why they are not allowed to choose the date when their phantom shares will be distributed. That’s because, in stock option programs, employees have control over when they exercise their vested options for a set maximum period, such as 10 years. Phantom stock plans, however, are subject to different rules than stock option programs. 

The Implications of  Internal Revenue Code Section 409A for Distribution

One of the most consequential rules most phantom stock plans are subject to is Internal Revenue Code Section 409A. Congress passed Section 409A in 2004 to regulate the timing of compensation payable on a deferred basis and to restrict executives from obtaining distributions on an accelerated or discretionary basis. 

Congress’s intention was to address perceived abuses by executives who used their authority to accelerate distributions in deferred compensation plans even while they knew that their companies were in financial jeopardy. If they could accelerate plan distributions before the company went bankrupt, they could still receive all of the compensation that was supposed to be paid out to them at a later date. However, these actions unfairly benefited those executives over the interests of other employees and the company’s creditors. 

Since Section 409A’s adoption, both employers’ and employees’ control over the timing of phantom stock plan payments has been severely limited to particular circumstances with strict definitions.

It is possible to allow limited employee choice—as long as that choice occurs at the time the shares are awarded.

For example, suppose you grant an employee 100 phantom stock units on a given date. You could allow the employee to designate a future date of payment that falls within a specified time period. Then, if the employee wants to change that date and assuming your plan allows it, they must do the following: 

  • Inform you at least one year in advance of the scheduled payment date
  • In most situations, postpone the new deferral date at least five years from the date the original payment was scheduled

You should only adopt these types of allowances after careful guidance from an advisor who is well-versed in IRS rules. For the sake of simplicity, and to avoid accidental violation of the tax code, most plans specify the date of payment without allowing employee alterations.

It’s worth noting a plan can be “compliant” (i.e., subject to Section 409A) or “exempt” (not subject to all of the Section 409A rules). If your plan is exempt, you have more flexibility, but you still have to adhere to certain rules regarding vesting and payment timing

Vesting: What Schedule Will You Use?

Vesting refers to the amount of value, if any, an employee may receive under each defined distribution event. Meanwhile, a vesting schedule indicates the percentage of value that a participant in a phantom stock plan would receive upon a separation from service or certain other triggering events. 

A vesting schedule is typically displayed as a table of time periods and percentages. Here is a simple example: Consider a single grant of 100 units given at the beginning of year one of a phantom stock plan. The plan agreement might state that the participant will be fully vested in three years. The vesting schedule for this grant would be as follows:

Years from Date of Grant

Percentage Vested

1

0%

2

0%

3

100%

Strategically speaking, the point of a vesting schedule is to increase employees’ motivation to perform well and remain with your company. 

Issues you should consider when deciding on a vesting schedule include but are not limited to:

  • How many years will constitute the full vesting period?
  • Will you choose graded or cliff vesting?
  • When will your vesting time period begin and end?
  • What events would result in accelerated vesting?

Vesting Periods and Graded Vesting vs. Cliff Vesting

As a plan sponsor, you may choose any vesting period. The most common choices for vesting periods are three, four, or five years, and the most common approaches to vesting are graded and cliff vesting.

With graded vesting, participants earn their phantom shares incrementally over time until they are fully vested. For example, they could become vested in 25% of their phantom shares per year over four years or 20% per year over five years. Any combination of annual vesting amounts is permitted.

With cliff vesting, there is no build up. Participants do not earn any portion of their shares until the vesting period end date, at which point they are fully vested.

Note that earning value doesn’t necessarily mean the employee receives the payout automatically. As stated above, the vested percentage is applied when a payment event occurs.

Choosing between a graded or cliff vesting schedule is a matter of balancing participant and company interests. Participants tend to prefer graded vesting because they may receive some payout even if they do not remain employed for the entire vesting period. Companies may prefer cliff vesting because it provides greater incentive to employees to stay with the company longer. The downside to cliff vesting is that premier talent will almost certainly consider it less attractive—especially if the vesting period is longer (e.g., greater than three years). A long-term cliff vesting schedule will be viewed as uncompetitive. 

To find the balance between attractiveness to participants and the retention power you are looking to generate, you might consider offering two distinct award types, one that offers cliff vesting and one that uses graded. Use cliff for the shorter-term awards (e.g., three years) and graded for longer-term awards. 

The other factor to keep in mind when choosing between cliff and graded vesting is whether you want your phantom stock plan to be exempt from some of the rules of IRC Section 409A. If this is your goal, you must (generally speaking) opt for cliff vesting, and you must pay benefits within 2 1⁄2 months of the end of the year in which the awards vest (i.e., by March 15). A qualified phantom stock consultant can advise you on the intricacies of this approach.

When Do Vesting Schedules Begin and End? 

Most commonly, your vesting period would commence on the first day of the plan year. Otherwise, you could tie it to the date of award or the participant’s employment date.

Typically, each vesting period will either conclude one-year from the vesting commencement date or the start of the next calendar year.

What Events Could Result in Accelerated Vesting?

Suppose your company or a plan participant experiences an unplanned event prior to the completion of a vesting schedule. This event might be the employee’s death or disability, or the sale of your company. Based on the circumstances, you may choose to accelerate vesting in order to give the participant (or beneficiary) the benefit of the full value of the award.

Section 409A provides some allowance for deferring the decision about acceleration of vesting until the time the event occurs. However, it is considered a best practice to make these decisions in advance and express them in the plan document.

How to Get Started

If you are a business leader who has been struggling to develop an effective long-term compensation strategy, it might be the right time to have a conversation with a VisionLink consultant.  

To speak with one of our expert Compensation Consultants, please call us at 1-888-703-0080.


Ready to Get Started?

When it comes to building a compensation strategy, you can trust that VisionLink knows what works and what doesn’t. We are ready to share that knowledge with you.

Ken Gibson

Ken is Senior Vice-President of The VisionLink Advisory Group. He is a frequent speaker and author on rewards strategies and has advised companies for over 30 years regarding executive compensation and benefit issues.