Owners of companies are always looking for creative ways to compensate and retain essential employees, while simultaneously retaining complete control and ownership.
Phantom stock, sometimes referred to as “shadow stock”, is a fairly popular mechanism to tie compensation for employees to the financial performance of a company. It is a company’s promise to pay an employee an amount equal to the value or increase in value of a certain number of shares of the company’s stock without actually giving the employee any company stock.
By allowing employees to participate in the equity (meaning, the net value) of the company, employees are incentivized to work harder.
The owners of the company are giving up some of the value of the company while retaining control of the company in order to achieve a greater overall value of the company. This is the old adage of trading a small slice of the pie for a bigger pie.
Because holders of phantom stock do not have voting rights, they are not able to influence the composition of the Board of Directors. In addition, holders of phantom stock do not have the statutory rights of shareholder. For example, a phantom stock holder cannot file a law suit to dissolve the company. On the other hand, they do have the contractual rights granted to them by the phantom stock plan.
How Phantom Stock Works In Practice:
Perhaps you want to incentivize a salesperson for your company. You give your salesperson units of phantom stock and each unit has a value of $10 based on the then value of the whole company. You either state a formula or schedule a valuation to determine the value of the company in the future. If the formula or valuation shows that your company’s stock value has increased by $15 a share, you send the executive a check for $15,000. For tax purposes, your company qualifies for a $15,000 tax deduction and your executive pays taxes on $15,000 worth of ordinary income.
These bonuses are paid in the form of current company shares or the increased value of company shares. An employee could be paid based on the percentage increase or simply paid equal to the value of the fixed shares at the time. There are multiple formulas that can be used; some even allow the stock to turn into actual equity. The opportunity for flexibility in designing a formula however, can also lead to conflict within the terms of the agreement.
Typical phantom stock benefits equal the appreciation in the value of the stock between the date the employee was given the units of phantom stock and a future date or an event (such as sale of the company).
A well crafted agreement addresses essential elements including: vesting schedules, valuation formula, termination terms, forms of payment, etc.
Typically, the phantom stock plan includes a non-compete agreement and a confidentiality agreement. From the company’s perspective, it is prudent to require an employee to stay with the company for a certain number of years or until the occurrence of an event (such as, achieving a certain revenue goal or installation of a certain project). An important term of the plan is the percentage an employee would receive upon the sale of the company.
Accounting:
Valuations are necessary for reporting purposes. This is the area where phantom stock plans become daunting. Accounting can become complicated because companies must deal with present values while projecting expected values. Typically, phantom stock is treated as another expense, which can prove tedious with the various payout formulas.
Payouts are usually in cash, allowing the company to maintain control of their ownership. However, cash payments can be draining on the company’s cash flow. Payments must be projected carefully in order to anticipate the needs of the company. A company must be careful of giving too much to initial employees and not saving any for latter employees.
Lastly, taxing these bonuses is similar to standard bonuses. Since the phantom stock units have no value until contingency or vesting terms are satisfied, the phantom stock units are taxable to the employee at the time it is actually paid out.
Incentives:
A major reason for considering phantom stock is that it creates a stronger sense of loyalty amongst employees and the company, especially executive employees. Phantom stock helps create a sense of ownership. The deferred payout component creates a long-term incentive to remain with the company longer.
Essentially, employees are rewarded with performance-based compensation, which directly correlates with the company’s overall performance while liabilities and risks are left to the owners. However, if the benefits of the plan are too parallel to that of a 401k or ESOPs, it could be considered an ERISA plan, thus making the plan illegal. Owners should consult with legal and accounting counsel to avoid violations of applicable federal or state employment or tax laws.
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This website provides information addressing legal topics of interest to the general reader. You should not consider this information designed or adequate to meet any of your particular legal needs, concerns or inquiries. You should consult with a lawyer licensed to practice law in the jurisdiction appropriate to your legal situation to assess your situation and provide you with appropriate legal advice.