Phantom stock is used by companies as an approach to long-term incentive plans and as a mechanism for creating additional performance-based awards. Private and public companies utilize long term incentive plans as a retention tool, to align key employees with company performance over a three-to-five-year period and to be more competitive for attracting key talent. According to a 2019 WorldatWork survey of private companies, 2019 Incentive Pay Practices: Privately Held Companies 6th Edition, the prevalence of private companies using long term incentives has been increasing over time. Long term incentives in private companies are primarily offered to senior level employees. Cash-based performance awards are most prevalent (65% of survey respondents), followed by real equity (36%), non-qualified deferred compensation plans (21%) and phantom equity (15%).
Phantom Equity
Organizations like to use phantom equity when they want key employees to have “skin in the game” but real equity is not available, or the owners do not want to dilute real equity or share ownership. If the owners want to simulate equity (but not use actual equity), a phantom stock plan whose value tracks the actual share price of the company is an attractive alternative. For example, if real share price is valued at $10 per share one year and $12 per share the next year, then phantom stock value reflects the same two values. Similar to real equity, as the company can use an option-type unit (where the value is based on the gain in stock price) or full value-type unit (that has a value to start with). The option oriented Phantom stock plan, where the only value is based on the stock price increases ($2 increase in the prior example), is also called a Stock Appreciation Right (SAR) plan.
Without the existence of real equity, phantom equity can track to the value of the business, either done by a formal valuation of the company or as a multiple of earnings, such as a three-year weight average of EBITDA times a market multiple. The number and value of shares are based on the enterprise value and how many shares of phantom equity will be used in the plan. For example, say the company has an enterprise value of $20,000,000. They might decide to create a phantom unit plan that has a value of $10 per unit. This plan would establish a “theoretical number of authorized phantom shares” of 2,000,000, and divide this into the company’s enterprise value, creating the $10.00 per unit in this example. Then, let’s say that the value of the enterprise has grown to $30,000,000 in 5 years, each unit is now worth $15 (or $30,000,000 divided by 2,000,000).
By doing this, the company establishes how much value each participant in the long-term incentive plan can expect to receive over time and can determine whether that amount is competitive, meaningful for the participant and the payment is affordable by the company. It is important that the time period and expected value are appropriately proportioned-shorter periods can be supported with relatively smaller values and longer periods need to be supported with larger income opportunity. There are several other alternatives to establish unit value, but this is an effective and relatively easy to understand.
Questions for LTIP Design Based on Phantom Stock
Other questions that are to be answered in the design of a long-term incentive plan that is based on phantom stock include:
- How to allocate – What percent of the “authorized units used to calculate the unit price” should be awarded? What about shares to current and future (shares in reserve) eligible participants? The more senior position, the higher the number of shares because their income is higher.
- How often to award shares? Should the plan make awards every year, over several years, only at hire, etc.?
- Will there be performance requirements that determine how many shares a participant will be allocated based on performance? For example, one can be granted 100 shares for at-target performance based on a financial goal, such as revenue growth, but if performance is less or better than target, the number of shares varies. The value of the shares is still based on the value of the business, while a second performance measure determines the number of units that may be awarded in a given year.
- When do the units vest and the individual will receive payment for their units? Typically, this includes 3- or 5-year period of graduated vesting or cliff vesting at the end of the award period. In these plans, tax regulations require that when the units vest, and the individual is eligible to receive the income. Then, this is a taxable event and income taxes must be paid based on the income received. The payments may be made in a lump sum or paid out over a two-to-three-year time period; when the payment is made, it is treated as a compensation expense and taxed accordingly. Alternatively, the company could make the vesting contingent on a corporate performance (e.g., achieving $XXX revenues), and thereby use performance rather than time to cause vesting.
- How will the company fund the liability? It can be funded with any asset including mutual fund, whole life insurance, sinking fund account or from general working capital of the company.
Phantom stock is often a very attractive alternative to providing higher salaries or bonuses to support the firm’s ability to attract and retain the senior leadership team. It emphasizes the growth in the value of the business tied to the price of their phantom units. It retains your executives through vesting and redemption provisions. Phantom stock is a deferred compensation plan and must comply with the requirements set forth by the Internal Revenue Service (IRS) code 409(a). Consequently, these plans can be simple, but they should not be simplistic. The design requires finding the right balance between income and cost (the company, not the market, pays for these plans), meaningful and challenging, forward-looking and performance-based. If you are interested in how to make a plan work well for your organization, and realize the powerful benefits of these plans, contact Wilson Group. We can do this with you.
