Phantom Stock Plans As An Alternative To The Issuance Of Stock To Key Executives

By: Dan Pettit

We often receive calls from business owners to discuss the possibility of issuing stock to a key employee to incentivize the employee to grow the business.  We find that once the ins and outs of issuing minority stock to employees are explained, owners are often hesitant to offer actual stock ownership to employees outside their immediate family.  The main reason for the hesitancy to bring on minority stockholders is that the rights associated with minority stock ownership can be intrusive.  Such rights include: (i) the right to demand financial information; (ii) the right to participate in meetings; and (iii) the right to enforce fiduciary duties (i.e. challenge compensation or other uses of corporate assets as wasteful or to claim a termination of the employee is a “squeeze-out”).  Where the owners decide that the issuance of stock is not for them, we generally turn the conversation to other “non-stock” deferred compensation programs that can be used to retain and incentivize key employees in a similar manner as stock ownership, such as: (1) individual supplemental executive retirement plans (i.e. “SERPS”); or (2) phantom stock plans.  The remainder of this blog provides a short explanation of phantom stock plans.

1. What is a Phantom Stock Plan?

   
   

   1. It is a form of long-term non-qualified deferred compensation paid to a key employee or a select group of key employees as an incentive for long-term value creation.

      
      

   2. Phantom stock is a contractual right offering similar financial benefits as stock ownership in that the benefit paid is measured directly by the future performance of the business.

      
      

   3. Phantom stock creates a win-win situation where the key employee has a “piece of the action” thereby providing an additional incentive to grow the business.

      
      

   4. Example.  Four key employees are issued phantom stock in a company entitling them to each share in 5% of future increases in the value of the company.  The company’s book value was $1,000,000 when the phantom stock was issued.  Over the next 15 years, the book value increases to $3,000,000, at which time the plan terminates.  20% of the increase/growth (i.e. $400,000) is divided among the four key employees, with each receiving $100,000 of additional compensation paid out in accordance with the plan.

   
   

2. Benefits to the Employer.

   
   

   1. Phantom stock provides a method to incentivize growth by giving key employees a piece of the action.

      
      

   2. A vesting schedule can be included in a phantom stock plan incentivizing key employees to stay with the business. 

      
      

   3. Non-compete restrictions can be built into the plan to protect the company if the key employee chooses to leave.

      
      

   4. The employer can pick and choose which employees are allowed to participate.

      
      

   5. The key employee is not entitled to the legal rights of a minority shareholder (i.e. no legal right to detailed financial statements, to object to the owner’s compensation as a waste of corporate assets, or to vote regarding the sale of the business).

      
      

   6. If the business is successful, the resources will be available to fund the phantom stock plan benefits as the payout is directly related to business performance. 

   
   

3. Benefits to the Employee. 

   
   

   1. The employee shares in growth of the company without a cash investment.

      
      

   2. There is no downside risk to the employee if the company fails to increase in value.

      
      

   3. A phantom stock participant is not generally required to sign bank guarantees.

      
      

   4. The employee is provided with additional income at retirement or upon sale of the business. 

   
   

4. Income Tax Consequences.

   
   

   1. There is generally no tax to the employee on creation of the plan and during the build-up in its value.

      
      

   2. Upon an event triggering the payout of benefits, payments to the key employee will be taxed as ordinary income to the employee and will be fully deductible by the employer.

      
      

   3. The plan can be structured to permit the deferred payment of benefits so that payments to the key employee are made over a period of time to avoid the bunching of income in a single year.

   
   

5. Structure of Plan.

   
   

   1. The owners generally pick executive level employees to participate.  The percentages received can differ.  For instance, the president might receive a 10% interest in future increases in the value, while the CFO might receive a 5% interest.

      
      

   2. The owners choose a simple, consistent methodology for valuing the company.  A book value based formula may be appropriate.  Sometimes annual appraisals are used.  In any event, out of fairness to the employees, the valuation procedure generally includes adjustments adding back items such as above market bonuses, salary, rent or distributions paid to the owners.  Participants are provided annual valuation statements. The vested potion of the benefits is booked as a liability on the corporation’s financial statements.

      
      

   3. The owners choose a vesting schedule.  For instance, the plan could provide that the employee is vested with 10% of his or her interest each year that the employee remains employed.

      
      

   4. Benefits under a phantom stock plan would generally be payable to the employee after the employee reaches normal retirement age, or sooner upon death, disability, or sale of the business. 

      
      

   5. Once a payment event happens, the plan can provide that benefits will be paid out over a period of years.

      
      

   6. The plan would generally include competitive restrictions with a violation resulting in the forfeiture of benefits. 

Phantom stock provides a means for key employees to participate in the growth of the company, without the issues that come with actual stock ownership. If your company is considering ways to incentivize key employees to grow the company, phantom stock may be right for you.  Please call Dan Pettit, Brett Ekes or Nick Verhaalen at Demark, Kolbe & Brodek, S.C. if you are interested in learning more about phantom stock for your key employees.