Edited on Feb 19, 2020
How do I generate ownership mentality while not giving up equity in my company?
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It's common to get this question from clients. In today's war for human capital, we continue to hear challenges relating to recruiting new talent and retaining key team members. There are certain situations where the long term strategic plans to transfer equity to key team members definitely make sense. When that is not the case, implementing a phantom stock plan may meet both the owners and key employees' goals.
A phantom stock is a contractual agreement wherein a company promises to make cash payments to employees upon the achievement of certain conditions.
The purpose is to generate an ownership mentality and reward key employees for helping grow the business value. It also allows the company to give the employee the economic benefit of being a stockholder without giving her the rights of a shareholder under state law.
An account is kept to track the number of shares/units per employee participating in the plan. Shares are not actually purchased or issued, therefore the account is mainly for bookkeeping. At the end of a deferral period, the employee is paid an amount equal to the market value at the time the shares are credited to their account (see example below).
Example:
Company does not want to provide real stock ownership to its key employees, but DOES want to provide an additional incentive through its compensation package to attract and retain valued employees.
The company decides to set up a phantom stock plan. Phantom stock plan units are valued at the market value of the company’s stock shares and a key employee is awarded 1,000 units when the fair market value of a real share of the company’s stock is $50. The phantom plan expires at the end of 10 years (example term) and the value per share is now $70. Since the price of the phantom shares tracks the price of the real shares, the employee would be entitled to a cash payment equal to the increase in value of 1,000 shares or $20,000. This creates a tight alignment with the shareholders without the pain and complication of dealing with a stock transaction.
Employers and employees can benefit from using phantom stock strategy in a number of ways.
Benefits to Employee:
• Provides incentive to the employee. Gives them a sense of personal interest in the company to assist in increasing productivity for the organization.
• Provides motivation to the participating employees to work harder and take “ownership” in the company.
• No cash outlay is necessary by the employee to obtain shares/units.
• Great way to attract and/or retain key talent.
• Does not recognize income when the shares are issued, only when converted.
Benefits to Employer:
• Avoids diluting the interest from the owners of the company.
• Current profits can be utilized to grow the company since this type of incentive plan is deferred until later years.
• The plan does not afford participants in the plan common shareholder rights such as voting on shareholder matters.
• The plan is Nonqualified, therefore its participation requirements are not the same when selecting which employees participate as under ERISA and qualified plans.
• Flexibility to link an employee’s performance to rewards.
• The company receives a deduction in the year the payment is actually made.
Potential Negatives of Phantom Plans:
• Employees do not recieve actual ownership in the company.
• Payments are considered taxable wages to the employee.
• Benefits reduce the company’s net earnings (as a deduction is allowed when benefits are paid).
• The company may have to pay for a valuation to be done to determine fair market value of the shares.
Potential Questions:
1) When are phantom shares given and when is payment made?
The company decides when the phantom shares are issued, how many will be issued, how often they will be re-valued, and when they will be redeemed. Payment is typically at end of phantom plan period.
2) Where does the company get the cash to make the payments?
Without proper planning the cash position of the company could be severely impacted when the time comes to meet the phantom stock obligations. A cash reserve and budget could be established. Depending on the situation and terms of the plan, hedging could be done to cover the obligations. For example, if some of the benefit is paid upon death, a life insurance policy could be taken out on the employee.How is the stock taxed?
3) The employee does not recognize income upon issuance of the shares.
The employee recognizes ordinary income and the employer will receive a deduction at the time the phantom shares are converted.
4) Can the company pay a dividend?
Dividends may be paid to the holders of phantom stock units or credited to their accounts and paid at a later date. This tends to align the financial benefit of the holders of phantom stock shares with those of real share owners. The company can turn around and take a deduction for these dividends.
5) What is the company’s obligation to participating employees?
Once vested, the company owes the employee the money, even if there is a hostile relationship between the company and employee.
6) What if the value of the stock decreases?
The employee in this case will not incur any liability (also a benefit). However, they also won’t receive any intended benefit of the plan. The company may consider implementing a provision that would counter the decrease, especially if the employee has performed well during the period.
Your phantom stock plan is a symbol of your commitment to a partnership relationship. Key employees want to know that they have a chance to participate in the value they help create. A phantom stock plan, properly designed, can enhance a company’s efforts to attract, retain, and motivate key employees by aligning their interests with those of the company.
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This article was originally written for the Goering Center, you may visit the original article here.