What You Need to Know
Phantom Stock: What It Is and How It’s Used
If you are a business leader, you are likely aware of the increased interest in phantom stock among private company owners in recent years. However, despite that awareness, you may not fully understand what phantom stock is and the problems it solves for companies like yours. You may also wonder what kind of risks are associated with offering a phantom stock plan and how to determine whether your company is a candidate for such an offering.
Our articles will help you with each of these issues and make it easier for you to understand how phantom stock works as well as the kinds of plans private businesses typically offer their employees. We will also explain why so many organizations find this type of plan to be an ideal solution, and why they choose phantom stock over real equity.
Why Has Phantom Stock Become So Popular?
Phantom stock plans have been adopted by many private companies that are determined to incentivize employees without sharing equity. In our webcast, we discuss the three different types of plans and how they make your value proposition more attractive as you recruit and retain key talent.
Why Choose Phantom Stock?
Most business leaders want to align their employees with their growth ambitions. They also recognize employees will only embrace shareholder growth goals if they are allowed to participate in the financial value they help create. Therefore, wise CEOs and owners determine that incentive compensation—especially long-term incentives—must have a central role in their pay offerings. Rewarding sustained performance ensures that all stakeholders remain focused on driving both sustained and short-term results.
These same leaders conclude that their companies’ pay offerings cannot be limited to salaries, annual bonuses, employee benefits, and 401(k) plans. Why? Because none of those things reward fulfillment of the company’s growth objectives. And without long-term value-sharing, growth ambitions remain the sole domain of shareholders. Consequently, there’s no unified financial vision for growing the business.
This realization leads chief executives and other enterprise heads to search for a rewards plan that is tied to the increased value of the business. For public companies, the solution is simple: offer stock or stock options. But for private company owners, it’s not so easy. Sharing stock dilutes owner equity while simultaneously increasing the number of shareholders in the business. And most private company owners are reluctant to do either. They prefer a rewards approach that mirrors the effect of equity sharing without giving employees an actual stake in the business.
This is the problem that phantom stock solves.
Why Phantom Stock Is the Ideal Plan for Growing Private Companies
At VisionLink, we’ve helped hundreds of privately-owned businesses create both phantom stock and other types of long-term incentive plans. Phantom stock is an ideal way to share long-term value with employees, so they are aligned with shareholder interests. Our report will help you determine if this compensation strategy could be the right fit for your company.
Defining Phantom Stock
What Is Phantom Stock?
A phantom stock plan, also known as a phantom equity plan, is a long-term incentive in which the accrued benefit is tied to the value of the business. It is primarily used by private companies to reward employees for their contributions to company growth, without giving away actual shares of stock. Think of it as a deferred bonus—the value is ultimately tied to appreciation in the market or formula value of the sponsoring company.
In a phantom stock plan, an employer promises participating employees a certain number of phantom units or shares. Most companies tie the value of each share to a formula, such as a multiple of revenue, profits, or earnings before interest, depreciation, taxes, and amortization (EBIDTA). The plan is codified in a legal agreement between the employer and the plan participants. The agreement informs employees of the starting value of the shares they are receiving, as well as how and when they can be redeemed. The phantom stock contract also clarifies other elements and conditions of the plan: who is eligible to participate, when new shares might be granted, what the vesting schedule is, what constitutes a distribution event, and more.
Once the vesting period has been completed and the designated payout period or event for the plan has arrived, participants are eligible to receive a cash distribution in exchange for their phantom shares. The amount of the payment will depend upon:
- The number of vested units they hold
- The value of the units at the time of payment
- Whether the plan was for the full value of their units or strictly the appreciation in the value from the date of grant—see explanation of different types of phantom stock plans below
As indicated, phantom shares are usually redeemed as compensation. The payment is treated like a bonus. However, instead of a cash distribution, some plan terms allow the payout obligation to be satisfied by distributing stock to the participating employee.
Phantom stock plans require more than a verbal understanding with participants. They are supported by a formal document that describes the plan terms and articles. The document serves to confirm the plan operation, resolve questions, and satisfy certain minimum statutory compliance requirements.
The Key Distinction
How Does Phantom Stock Differ from Real Stock?
The primary difference between phantom and actual stock is the element of ownership. Phantom stock plan participants do not become shareholders in the company, unless the company decides to make payments with actual stock. The plan is a long-term incentive compensation arrangement, not an ownership agreement.
Because participants in phantom stock plans do not have ownership rights, sponsoring companies can either include or withhold a wide range of features that simulate the feeling and results of actual ownership. For example, a phantom equity plan can pay dividends, allow for redemptions at death, or include a variety of other terms typically associated with stock ownership. But with phantom stock, businesses are not required to include any of those elements, because real equity is not being shared.
Phantom stock also has a different tax and cash flow impact than real equity. When shares are granted, the sponsoring company experiences no cash flow consequence because there’s been no actual distribution of compensation or equity. Consequently, the organization just carries a liability on the books equal to what is owed to plan participants. And employees experience no income tax consequence when they receive phantom shares because no cash distribution has been made.
When a plan payout occurs, the business receives a tax deduction for the amount of the distribution. Those payments then represent additional income taxable compensation to participating employees.
Knowing the Right Options for Your Company
What Are the Different Types of Phantom Stock Plans?
Generally, there are three types of phantom equity plans that private companies offer. They differ in how phantom shares are earned and how they are valued. Businesses are not limited in the number of types of phantom stock plans they can offer. They can choose to offer just one type of phantom stock or any combination of the three–even for a given person or group of employees.
As indicated above, phantom stock plans do not result in shareholder dilution because actual equity is not being transferred and employees do not become owners. Instead, they are simply cash beneficiaries in a plan that is tied to the underlying company value. Phantom shares result in ordinary income taxation to participating employees when a distribution is made. These guidelines apply to all three types of plans.
Full-Value Phantom Stock
This kind of plan simulates restricted stock. In a full-value plan, a participant is awarded some number of phantom shares with specific terms and conditions, such as the vesting schedule, payout period, and grant eligibility. At the distribution time indicated in the plan agreement, participants receive a cash payment equal to the value of the original shares, plus any appreciation. For example, if a participant has 100 phantom stock shares with a starting value of $10, and at the time of distribution, the share price has risen to $18, the company will pay the employee $1,800 (100 shares times $18 per share).
Full value phantom stock is typically used when a company wants to reward employees for contributions already made to company growth, as well as incentivizing future performance that increases business value. It is also used in recruiting situations where an organization is trying to attract someone who had been given stock with their previous employer and expects his or her new employer to provide a similar benefit. Because the units have value the moment they are granted, companies should ensure they’re given to people who have already made significant contributions to enterprise growth.
Performance Phantom Shares
This type of phantom stock offering has two distinct performance-based elements. The first distinguishes it from a full-value plan.
In a performance phantom shares plan, employees must achieve certain predetermined targets before they are granted phantom units. The number of earned units can vary by employee and by the degree to which the targets are achieved. Performance standards that earn participants phantom shares are often tied to the formula measures that are used in the phantom unit valuation, such as revenue, profit, or EBITDA increases. However, additional or different performance requirements can also be set.
The second performance element is inherent in all phantom stock plans. Participants are incentivized to drive company growth so the value of their shares increases. So, employees earn shares by meeting certain performance expectations and those shares appreciate in value as employees sustain that performance.
Once earned, all other elements of a performance phantom share plan are the same as a full-value plan.
A performance phantom share plan is often used by companies who are trying to spur significant growth. They have key people that they need to motivate to take ownership of that outcome, and a performance phantom share plan is the incentive.
Phantom Stock Options
This approach is also known as a Stock Appreciation Rights (SAR) plan. Phantom stock options differ from full-value shares in one significant way. Instead of the payout being determined by multiplying the number of shares by the current unit value, participants are only paid on the appreciation in share value.
For example, if a plan participant has 100 phantom stock option shares with a starting value of $10 and an ending value of $18, they would receive $800. In other words, the payout is based on the increase in share value, not the current unit price (e.g., $8, or the difference between $18 and $10). All other elements and conditions of a phantom stock option plan are the same as a full-value plan.
A phantom stock option plan is often used when a company is bringing on new talent and wants to incentivize those people to focus on company growth. These kinds of shares are sometimes given to existing employees as well in combination with full-value shares. The purpose of giving regular shares is to reward past performance. The option plan is added to ensure legacy employees remain focused on building the future company.
How Do You Determine the Value of Phantom Stock Shares?
Some company heads shy away from offering a phantom stock plan because they assume it will require them to perform a formal business valuation at some regular interval. Organizations need not have this concern.
Most companies use a formula to determine the value of the phantom shares they are granting. Formulas can be tied to any financial metrics but the most common are multiples of either revenue, profits, or EBITDA. As long as the sponsoring company consistently uses the same formula, it is easy to track the value of the phantom shares and calculate both the individual and the total plan liability the company is carrying.
What You Need to Ask
To determine whether phantom stock is something your company should consider, there are a number of issues you will want to explore and questions you will need to answer. For example:
- How many people should participate in a phantom stock plan?
- Who is eligible?
- How do you determine whether phantom stock is a realistic consideration for your business?
- What kind of financial model will you need to create to envision the long-term financial commitment a phantom stock plan will require of your company?
- Once a plan is in place, how do you track and communicate plan values, promote interest in the plan, and otherwise ensure you are operating the plan effectively?
- Should you fund your phantom stock plan to ensure cash is available to payout benefits when a distribution event occurs?
- What kind of plan documentation is needed?
- Who should create the plan documentation?
Be Sure to Seek Expert Help
Because of the range of considerations that need to be weighed, most organizations need outside help to build and implement their phantom stock plan. Since 1996, VisionLink has built hundreds of phantom stock plans for companies in a wide range of industries. But whether you engage VisionLink or some other company, you will want help from experts. Please find additional resources on this page and throughout our site that address some of the considerations listed above.
Utilize VisionLink’s Additional Assessment Tools:
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