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What private company leaders should know about phantom stock
Most CEOs of private companies are focused on business growth, but they can’t achieve it unless their employees are equally committed to their goals. They need their employees to think like owners and execute the company’s business plan as they would.
Instinctively, these leaders know that those who help create growth should reap financial benefits from the results they produce. The problem is, they are reluctant to share equity because they don’t want to dilute shareholder value or add more owners. In other words, they don’t know how to incentivize their employees to drive growth without giving them a “piece of the action.”
It’s a dilemma—one most business heads struggle to resolve. But it’s a problem that can be easily remedied by offering phantom stock.
Phantom stock, also known as phantom equity or phantom shares, mirrors the benefits of real equity without actually giving away stock. It provides participants with a long-term benefit tied to business growth, while producing a better financial outcome for both employees and owners than equity sharing.
This article will help you better understand how phantom stock plans work and the potential impact they can have on business leaders’ ability to achieve their business growth goals. You will learn:
What phantom stock is, and why so many private company leaders are embracing it
Key considerations for companies exploring this performance-based incentive
What Is Phantom Stock?
Essentially, phantom stock is a deferred compensation plan, where the employee’s ultimate benefit is tied to the enterprise value of the business. It is considered a long-term incentive plan and is usually made available to select employees such as management and key contributors.
Phantom stock has value similar to actual stock. However, no ownership rights are exchanged when issuing phantom shares to employees. Instead, the employee is given a contractual promise to receive the value of the phantom shares at a future date or event.
As indicated, phantom stock plans mirror the effect of restricted stock and stock grants. Phantom shares can be awarded as part of an employee’s compensation package or granted only upon the achievement of certain performance metrics or standards.
The advantage of a phantom stock plan is it inspires employees to adopt an ownership mindset and contribute to business growth—without the company actually having to grant them equity.
Phantom Stock vs. Equity: How Are They Different?
While phantom stock has many of the same benefits as equity, it is not the same. Phantom stock plans do not involve any transfer of shares, and participants do not become owners. Also, since no real stock is awarded to employees, phantom stock does not dilute shareholders.
Phantom stock simulates ownership, whereas stock is actual ownership. Generally, employees cannot sell, transfer, or buy more phantom stock like they potentially would be able to do with stock or stock options.
Despite this distinction, phantom stock positions the employees in financial alignment with shareholders. Their economic futures are linked.
Who Can Offer a Phantom Stock Plan?
A company of any size can adopt a phantom stock plan, whether they are a C corp, an S corp, or an LLC. Only nonprofit organizations are subject to certain restrictions that prohibit them from utilizing all the features of a phantom stock plan.
What Is the Purpose of a Phantom Stock Plan?
The primary purpose of a phantom stock plan is to reward employees for hitting long-term performance targets. The idea is to create an incentive that helps the company achieve its business growth goals, while also making employment at the company more attractive to top performers.
The reason this is so important is because there is precedent for value-sharing that private companies must compete with. Public companies freely offer restricted stock units (RSU) or stock options to their key employees, which creates the expectation among top talent that they should participate in the value they help create. Consequently, private companies need to be able to offer an incentive plan that approaches the financial opportunities offered by public companies if they want to be able to attract and retain these employees.
Additional reasons for adopting phantom stock plans include:
- Incentivizing a new group of employees to drive future company growth
- Providing employees with a significant wealth-building opportunity for retirement
- Deferring some portion of current cash compensation into the future
- Linking employee pay with shareholder value creation
Usually, all of those desired outcomes are what prompt companies to adopt a phantom stock plan.
How Does Phantom Stock Work?
The creation of a basic phantom stock plan typically includes these steps:
- An employer enters into an agreement with select employees via a formal plan document. This agreement itemizes the commitment the company is making to share phantom equity with eligible participants. The plan documentation informs the employees of the starting value of phantom stock units along with any other conditions such as vesting schedules and payment events.
- In accordance with the plan’s terms, the employer grants each employee a number of phantom stock units. Typically, phantom shares are awarded annually rather than all at once.
- Upon fulfillment of the plan’s terms, the employees are eligible to receive a payment in exchange for their phantom stock units. The amount of the payment depends upon:
- The number of vested units they hold
- The value of the units at the time of payment
- The type of phantom stock plan, described in more detail below
Phantom stock units are usually redeemed in cash, and the payment is treated like a bonus for tax purposes. However, some plans allow phantom stock to be redeemed for actual stock at the discretion of the company.
How Do Companies Determine the Value of Phantom Stock?
The value of the shares can be tied to a formal company appraisal. However, it is simpler, less expensive, and more common to tie the value to a formula that determines how much employees are owed when receiving a plan distribution. For example, the formula value might be expressed as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA), operating income, revenue—or some combination.
Formal valuations are only required when the plan is structured as a pure stock appreciation rights (SAR) program—an approach that is not common for private companies. A formula-based method works well, allowing the company to track the formula consistently over the lifetime of the plan. Then, they can quickly and easily determine what they owe to participants.
What Are Key Considerations for Offering a Phantom Stock Plan?
If you are evaluating whether or not to implement a phantom stock plan, ask yourself these questions:
- How fast do you expect your company to grow within the next five years? That is, are you on track to create significant enterprise value in the future?
- As your company’s value increases, what fraction of that value are you willing to share with employees? 5%? 10%? 15%?
- How many employees are you considering for participation?
If your answers suggest phantom stock is a viable path forward for your company, you will need to decide:
- Who will you invite to participate in the phantom stock plan?
- What type of phantom stock plan should you offer? (More details in the section below)
- How many units of phantom stock will you grant?
- Will the value of phantom stock units mirror your company’s actual stock performance?
- Will you tie the number of phantom stock awards to an employee’s performance-based metrics?
- What vesting schedule will you use? (When will employees receive their value?)
To help determine your answers to these questions, use our tool—Are You Ready for a Phantom Stock Plan?
Are There Different Types of Phantom Stock Plans?
Yes, there are three different types of phantom stock plans:
Each one is outlined below.
Full-Value Phantom Stock Plans
A full-value phantom stock plan functions similarly to a restricted stock plan, in that employees receive the full value of the units on the date of grant.
In a full-value phantom stock plan, an employee gradually becomes vested—typically over a period of three to five years, though it could be longer—and forfeits some or all of the phantom stock units if they leave before that time. Here’s an example:
- Imagine an employee is awarded 200 phantom stock units valued at $10 each. The employee has immediate unvested value of $2,000.
- The vesting schedule for this plan is 25% a year for four years, and the full amount will vest after four years.
- The employee stays for four years.
- At that time, the phantom stock units are valued at $18.
- The employee receives a cash payout of $3,600
- $18 x 200 = $3,600
If the employee left the company after two years, they would be entitled to receive a cash payout of 50% of the value of the shares at the two-year mark.
Once the phantom stock units become a cash payout, they are subject to ordinary income taxation like any other bonus.
Appreciation-Only Phantom Stock Plans
This type of phantom stock could also be called “phantom stock options.” They are quite similar to formal stock appreciation rights (SARs).
In an appreciation-only (AO) plan, a company measures the value of a phantom stock unit based on its appreciation in value over time. In other words, employees receive an increase in the value of the unit from the date of grant. If the company’s value does not increase, then these units have no value. This is outlined in the example below:
- Imagine an employee is awarded 100 units with a starting value of $10 each.
- The vesting schedule for this plan is five years, and the employee stays for the entire time period.
- Assume the unit value is now $18.
- As a result, the employee receives a cash payout of $800.
- $18 - $10 = $8
- $8 x 100 = $800
Performance Phantom Share Plan
A performance phantom share plan contains two distinct performance-based elements. First, in order for employees to receive grants, they must earn them by achieving predetermined performance goals such as:
- Revenue growth
- Profitability goals
- Market-share expansion
- Cost reduction and operational efficiency
Should the goals be achieved, the employees are awarded phantom shares. The number of shares may vary by employee and by the degree to which the targets were achieved.
The second performance element relates to the potential improvement in value that may come through phantom stock value appreciation. Once awarded, the phantom shares may still remain subject to vesting schedules or other restrictions. A performance phantom share plan may use either full-value units or appreciation–only units. Full-value units are more common.
What Are the Advantages of Phantom Stock?
When phantom stock plans are carefully designed and communicated, they have strong benefits that help companies incentivize their employees to reach business growth goals and contribute to the organization’s overall success.
1. Employee and shareholder goals are aligned under a phantom stock plan.
Companies often use short-term incentive plans, such as annual or quarterly bonuses, to recognize valuable employee achievements. But incentive plans work best when they focus on both short-term and long-term results–the way shareholders do.
Participants in phantom stock plans know and understand that they are not only expected to fulfill short-term results; they need to work toward building sustainable, profitable business growth over time. As a result, employees are better linked to the same business objectives as owners and begin to view the company’s objectives through the same lens.
2. Phantom stock plans foster ownership and improve employee retention.
Top performers want to share in the economic value they help create. And if they are given a stake in the company’s future, they will be more inclined to stay and more incentivized to achieve growth goals.
Companies can offer phantom stock plans to more employees than equity-based incentives because they do not involve the actual issuance of company shares. This eliminates concerns about stock dilution and voting rights. Under the right conditions, this allows companies to provide shares to a broader range of employees, including those in non-executive roles. And when plans are designed with vesting schedules and performance targets in mind, employees are less likely to depart for a competitor, since they would have to forfeit some or all of their plan value.
Overall, phantom stock plans help provide employees with a stronger tie to the company’s success, fostering a greater sense of ownership.
3. Phantom stock plans offer the value and flexibility to attract top talent.
Companies also need to attract premier talent. When an organization offers employees the chance to accumulate meaningful wealth with a phantom stock plan, it enables potential hires to envision a compelling future where more value is earned over time. In turn, the organization’s value proposition becomes a differentiator.
Since phantom stock plans can be tailored to fit certain needs and preferences, they also allow for a more flexible, personalized approach to incentive structures.
Any investment in incentive plans should ultimately produce a positive return for shareholders. When companies create well-constructed, well-communicated phantom stock plans that attract top talent, the plans become self-financing. Better talent leads to better performance, which leads to higher profits and enterprise value. In essence, plan redemptions are financed by business growth that may not have been achieved without the plan.
Are There Other Ways—Aside from Phantom Stock Plans—to Reward Employee Performance Without Sharing Equity?
Yes, there are long-term cash incentive plans other than phantom stock. Employers can use other performance-based incentive plans that are tied to financial metrics, like the following:
- Performance unit plans (PUPs)
- Profit pools or bonus pools
- Strategic deferred compensation plans
- Deferred stock units (DSUs)
Each one is outlined below.
Performance Unit Plans (PUPs)
In a PUP, employees are granted units that begin with a specific monetary value, such as $10 or $100. The value of the units may rise or fall based on the achievement of two or more predetermined performance goals.
Payouts in a PUP generally occur after three years. The value is determined by how well the performance goals are met. A PUP is a simple three-year bonus plan reflecting company performance that is not directly related to enterprise value.
Companies might award new PUPs each year with either the same or different targets. Alternatively, new PUPs may be issued at the end of the first payment to begin a new cycle.
Profit Pools or Bonus Pools
A profit pool is the simplest long-term incentive plan. In a profit pool, a company selects a percentage of annual profits to contribute to a pool that is allocated among participating employees. The minimum threshold should be set at a level that ensures the viability and sustainability of the program. The company may be discretionary when determining the allocation formula, and the pool may or may not be credited with interest.
Let’s assume the allocation period is three years. At the end of year three, the company would pay one-third of the accumulated value to each employee and carry the remaining two-thirds forward. The idea is that each employee’s pool would grow as profits grow. Likewise, their annual payment, after the third year, would also increase. If employees leave the company, they would customarily forfeit any remaining amount.
Rather than sharing a percentage of profits, a company may create a pool established as a dollar bonus for employees tied to other performance factors. The bonus is contributed to the employee’s account annually, and the payment method would be managed the same way as a profit pool.
Strategic Deferred Compensation Plans
A strategic deferred compensation plan is a performance-based, non-qualified retirement program. In it, individual retirement accounts are created for the plan participants, which are typically limited to executives and senior managers.
A company sponsoring a strategic deferred compensation plan annually establishes performance targets. If the goals are met, contributions are deposited into the participants’ accounts. Better performance precipitates higher contributions.
Once a contribution has been made, employees can self-direct their account allocation among a variety of investment options. The investments are handled the same way as a standard deferred compensation plan, typically subject to vesting schedules and risks.
With so many options, the careful selection of the right type of long-term incentive plan should be based on the circumstances of the company, the intentions of the programs, and the company’s competitive environment for talent.
Deferred stock units (DSU)
DSU plans are not very common, and the term is sometimes (and inaccurately, in our opinion) used to refer to a plan that issues units that can then be converted to actual stock in the future. However, a more accurate way to describe DSUs, in the traditional sense, is as a combination of deferred compensation and full-value phantom shares.
With a DSU plan, highly compensated employees have the opportunity to defer a portion of their cash income—either their salary or a traditional bonus—to a future date. The deferred amount is then credited with full-value phantom stock.
A DSU plan is like allowing employees to purchase shares of company stock—with two significant differences: 1) the employee is credited with phantom shares, not actual shares; and 2) the “purchase” is pre-tax.
Because DSU plans can be administratively complex from an accounting and tax perspective, most companies do not choose this option.
How to Get Started
If you are curious about exploring the benefits of a phantom stock plan in greater detail, check out our resource on the logistics of choosing and creating a plan.
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 expert.
To speak with one of our Compensation Consultants, please call us at 1-888-703-0080.
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