A long-term incentive vehicle that provides equity-like awards—without using actual shares
August 25, 2010
Dan Moynihan, Hay Group
There are signs of a specter walking the halls of corporate America. A tool that has languished in obscurity at public companies—phantom stock—has shown signs of emerging. The reasons for turning to phantom stock are varied—uncertainties in the financial markets and insufficient authorized shares for actual stock awards are among them. Phantom stock can provide valuable attributes of equity and can help with motivation, focus and retention of recipients.
What Is Phantom Stock?
The basic concept of a phantom stock program involves a company's agreement or promise to pay a recipient of an award an amount equal to the value of a certain number (or percentage) of shares of the company's stock. Commonly structured through the award of units, a phantom stock program enables a company to make an award that tracks the economic benefits of stock ownership without using actual shares. Since phantom stock is a contractual right and not an interest in property, the tax event for the executive and the employer occurs at the payment in settlement of a properly designed phantom stock arrangement.
Phantom stock plans are shadows that mimic their real equity counterparts; phantom stock and shadow stock are terms that often are used interchangeably. Although shares of real stock can be traded at will, phantom shares or units take on value only when key contingencies or vesting conditions are met. A phantom stock plan typically does not require investment or confer ownership, so its recipient does not have voting rights. It is essentially an upside opportunity, as participants' investments typically are limited to their services; they stand to gain from any upside growth of the company.
In making awards under a phantom stock plan, there is a determination of the value of a phantom share or unit in connection with awards to one or more participants. Valuations will be needed for periodic reporting to participants (and to actual shareholders and the U.S. Securities and Exchange Commission if used by a public company) as well as for determinations of amounts payable at the time of settlement.
Phantom stock programs can be designed simply. However, they should be created to meet the company's needs and objectives in protecting the knowledge and skill base that is represented by the key employees selected for awards. The two types that are most prevalent are:
• The "appreciation-only" plan (much like a stock appreciation right).
• The "full-value" plan, in which the award includes the underlying value of the unit (as with restricted stock).
Generally, a phantom stock plan or agreement spells out how the program operates and how payments are determined along with various other details, often including:
• Eligibility criteria.
• Vesting schedule.
• Valuation method or formula.
• Settlement and payout events.
• Handling of various termination events, including retirement, death, disability, dismissal and resignation.
• Restrictive covenants.
• Form of payment.
• Provisions for the sale of the company.
• Any funding vehicle.
Spooky Designs and Accounting Monsters
One of the key challenges of inviting a phantom into your offices is that it might come with another ghoul—the accounting monster. Historically, phantom plans have been viewed as undesirable from an accounting perspective because of the resulting liability (variable) accounting treatment. This creates volatility on the company's income statement, which is something that concerns most chief financial officers.
Generally, for financial accounting purposes, phantom shares must be treated as an expense over the required service period and the company does not receive its income tax deduction until the benefits are paid out. This timing is similar to other equity awards but can prove to be not as advantageous in periods where the value of the award increases.
With liability accounting, the accounting expense and corresponding tax deduction will be the same. When real equity is used, the company might get a tax advantage as the expense can be locked in at grant while the tax deduction can grow as the value of the equity grows.
In addition, coming up with cash to cover phantom payouts can be tricky. Phantom stock plan gains (in appreciation-only programs) or current fair value (in full-value programs) must be paid by the company versus the public markets which is the case when using publicly traded equity.
Finally, phantom stock programs typically are subject to the often complex rules applicable to non-qualified deferred compensation under Internal Revenue Code section 409A, so care must be taken in their design.
Phantom Stock for Long-Term Incentive Awards
Phantom stock can help in getting an executive team to think and act like equity partners. It creates a sense of ownership in the success of the business. The concept of being an equity partner by having phantom stock can create the same feeling of connection as with more traditional equity tools such as stock options and restricted stock.
In addition to its incentive components, a phantom stock program involves deferred compensation and can act like golden handcuffs in retaining key executives. Phantom stock most often is used by privately held companies, but some publicly traded organizations are using phantom stock or similar cash-based long-term incentives as well.
Phantom stock plans can be especially useful in providing the economic benefits of equity without diluting shareholder value. Because recipients of phantom units lack voting rights, a company can issue these units without altering the governance of the company or worrying about dilution issues.
---------------------------------------------------- Phantom stock plans can provide the benefits of equity without diluting shareholder value. ----------------------------------------------------
While phantom stock does not dilute the value of real outstanding shares directly, phantom stock awards do have a significant effect on cash flow at payout. This is why some plans have a conversion feature and might pay out in actual stock.
Another advantage to a company is the ability to design an award so that an executive receives no benefit unless vesting conditions are met and, under the appreciation-only model, the company's value has increased. The fair market value of the stock is commonly used by public companies, while private companies have various approaches. For example, a professional valuation might be preferred but viewed as too costly; many companies then turn to book value.
Other approaches include a formula using revenue, EBIDA (earnings before interest, taxes, depreciation and amortization), net income, or a combination of relevant measures; a formula can help with consistency of the valuation over time.
There are many reasons a company would consider a phantom stock arrangement:
• A public company might find that it has insufficient authorized shares to award the desired amount of awards that require actual stock.
• A company's leadership might have considered other plans but found their rules too restrictive or implementation costs too high.
• The owner(s) might desire to maintain actual and effectual control, while still sharing the economic value of the company.
• There might be ownership restrictions for certain types of entities (i.e., sole proprietorship, partnership, limited liability company), such as the S corporation 100-shareholder rule.
• The objective is to provide equity-type incentives to a restricted group of individuals. For instance, phantom stock can be used in situations involving:
✔ A corporate division that can measure its enterprise value and wants its employees to have a share in that value even though there is no real stock available.
✔ A desire to focus on an event or contingency, such as a sale, merger, initial public offering, etc.
A phantom stock plan typically provides a more flexible alternative that is not subject to the same restrictions as most equity ownership plans. For many, the simple desire to use an “equity-like” vehicle without giving up true ownership might be reason enough to implement a phantom plan.
Pros and Cons of Phantom Stock
Allows employees to share in the growth of the company’s value without being shareholders.
If paid in cash, can be a financial drain on the company’s cash flow.
No equity dilution as no actual shares are awarded.
At a private company, might require outside valuation on an annual basis.
Powerful retention tool when combined with vesting.
Company needs to communicate financial results to participants.
Board/compensation committee has flexibility to design plans based on their own discretion.
Payments to employee are taxed as ordinary income.
Can be tied to overall company or business unit results.
Might impact the overall value of the business in a transaction.
No employee investment required.
IRC section 409A rules add complexity and difficulty in achieving objectives.
Can provide for dividend equivalents.
Design can permit phantom stock to be converted into actual equity.
No income tax until proceeds are converted to cash or real stock.
Potential tax deferral of employee compensation.
Retirement benefit opportunity.
Source: Hay Group
Moreover, phantom stock is not only a private company phenomenon. According to our research of proxy filings, some well-known, publicly traded companies are using this tool to attract, retain and motivate select groups of employees.
No Need to Fear the Phantom
Phantom stock is a traditional long-term incentive vehicle and not a fad du jour. While trends might come and go, cash-based long-term incentive plans have a place in the executive compensation portfolio. While these plans are generally simple and provide flexibility to the company, they raise issues that must be considered carefully.
In the appropriate situation, a phantom stock plan can keep the company spirit alive in the executive suite.
Dan Moynihan is a consultant in the executive compensation practice of Hay Group, a global management consulting firm. This article appeared in the August 2010 issue of Hay Group's The Executive Edition, and is reposted with permission.
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