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Think Twice Before Using Stock to Lock in Key People

Think Twice Before Using Stock to Lock in Key People

July 10, 2023

A healthy alternative to Stock options.

While Stock options can be an enticing to employee devotion, nine out of ten times the perceived value of employee ownership is not nearly worth the price. Stock options carry baggage that ties a key employee within your business directly to the future growth of your business.

A Phantom stock plan is a contractual agreement wherein a company promises to make cash payments to employees upon the achievement of certain conditions. What’s the Purpose? Just as with stock awards, the purpose of a phantom stock plan is to generate an ownership mentality and reward key employees for helping to grow the business value.

However, phantom stock has one big advantage-there is no sharing of actual equity with the employees. No requirement to open the books. No ownership rights. No need to pay dividends (although some plans do). The existing owners stay in control of 100% of the stock or interest in the company. While at the same time, phantom stock can create comparable or even identical value as actual stock.

How to Entice Key Employees Without Giving Away Ownership
Phantom stocks are a healthy alternative to stock. Enticing key employees to stay apart of the business while not giving up ownership. As to what setting up a phantom stock plan would look like for your business here are some examples and an overview of the general process.

First you must establish a way to value the phantom share. In essence, you’re trying to identify the value of the company. You can obtain a formal appraisal or you can establish the value by a formula. The latter will work best for most. Any Reasonable formula can work, but to be safe use a formula that would beless than the actual fair market value. This is because if you sell the company one day you don’t want the employee’s phantom shares to be valued higher than your own.

The next step is to create some phantom shares. Pick a number-1 million, 10 million-the number doesn’t matter as long as you have enough to make the plan work with the number of eligible participants you anticipate. Remember we are not trying to replicate the actual shares so do not feel obligated to pick the same number of outstanding shares the company has. Rather you the business owner are trying to provide an attractive award for employees at a future date.

Once you have decided how many phantom shares you are going to have it is time to determine in which manner you would like to award your employees. In similar fashion to stock plans, phantom stock plans have three options as well, including (a) give shares, (b) sell shares, (c) give options (to buy in the future at today’s price).

Which Phantom Stock Plan is Right for Your Business?

A. Full value grant. Within this example you the business would give your valued employee a hypothetical 5,000 shares that are valued at $10. Meaning that your key employee has a true starting value of $50,000. At some future date the key employee will redeem those awards for real cash. Assuming the business had grown, and the 5,000 shares were now worth $100,000 then at the redemption date the key employee would receive a check for $100,000. Because these are phantom awards, taxes work differently than they would normal stock. Income taxes are not paid until the valued employee is in receipt of the actual cash (and paid the taxes upfront). Another benefit to this phantom stock is that this will reduce the taxes your company would have to pay, because you will be able to write off the full $100,000.

B. Sell Phantom Shares. Or commonly referred to as Deferred Stock Unit Plan – a form of deferred compensation. In this example your key employee would have the opportunity to defer some of their cash compensation (e.g., salary or bonus) to units of phantom stock. Hypothetically if your employee made $200,000 annually and were to put 25% into the phantom stock that was valued at $10 a share then they would have 5,000 shares valued at $50,000. This amount would be credited to her deferred comp account. Technically your employee is not acquiring an ownership right. Rather deferring some income into an unsecured account that is measured by the growth of the phantom share price, voluntarily foregoing wages in order to ‘invest’ in the company! Similarly to Full value grant, this phantom share plan the taxes are deferred to the point in which the employee has withdrawn. Assuming the same growth as the previous
example your company would be able to write off the $100,000.

C. Phantom Stock Options. A favorite of many private business owners. This plan is attractive because your key employee only wins if the other shareholders win. In a public company environment there are markets that help to handle the exercise of the option. However, in a private company no such market exists. Instead, the employee and the company sponsor have to work out the cash flow mechanics of the exercise. Easily recall the example in full value grants where your key employee was given 5,000 shares valued at $10 dollars a share for a total of $50,000. Under a phantom stock option plan the true value your employee has at this point is nothing. But later when the phantom share price reaches $20 and it’s time for redemption your valued employee is handed a check for $50,000 (($20-10$) X 5000). Phantom stock options are beneficial because your employee does not need to scrap together the initial $50,000 but rather is rewarded for their contribution to growth in the company EBITDA.

Now that you have selected a plan it is time to fine tune the plan and provisions. Select a vesting schedule for full value and option awards. Determine the year in which they’ll be paid out, and over what period of time do you want them paid out? In a lump sum? Or over 3 or 4 or 5 years? Then there are possible scenarios to define and refine: change-in-control, separation of service, disability of
participant, death, termination (for cause or not for cause), and so forth. This plan will need to be pulled into a document that outlines what will occur under each of these circumstances. You’re going to want some help with these issues. Seek advice from an expert in developing phantom stock plans to ensure you are making the best decisions for your business.

As a final step it is now time to award your key employee with these phantom stocks. However, how many should you be awarding to any individual? Instead of focusing on the number of shares you award. Focus instead on the potential future value of the shares as a percentage of the growth in the company.

Typically, this requires some spreadsheet modeling. First project the possible future value of the company over some period of time under your favorite growth assumptions. Now carve out a percentage, for example 15% of the growth (not the total value) that you’d consider sharing with your key employees. Then allocate that to the positions or people you’d consider for participation. Now calculate the number of grands that will produce the targeted values. In other words, the number of grants is a device that is used for generating the dollar value you feel is appropriate for the people who are helping you build the company.

This approach to grants ensures the following results.

  • That the guidelines and budget of the grants are pre-approved, simplifying the annual award process.
  • Shareholders are assured that value dilution is being managed with reasonable limits.
  • Employees can receive a forecast of value that demonstrates potential personal earnings tied to company growth.

Best Practice 
As with any rewards strategy there are plans that work well and others that fail. To ensure your approach to Phantom Stock has a greater chance of success, here are some “do’s and don’ts” to consider.

  1. Don’t do one-time grants. Schedule and award grants annually. Make each grant a celebration. One-time grants always lead to regrets (e.g., “I shouldn’t have given him so many.”)
  2. If you’re not sure which type to use, go with phantom options. There’s less rick. No increase in value results in no payments to employees. Even if your chare price goes down in some years employees can still come out ok (as long as you’re doing annual grants – see #1).
  3. That said, consider some full value grants for the key long-term employees who’ve been with you “through thick-and-thin.” This will give them some starting credit for prior contributions. Perhaps you’ll just do this in the first plan year, and then include them in your annual option awards. (This could be done for as few as one employee.)
  4. Start With a small group and expand participation as time goes by. It’s always easier to add participants than to subtract.
  5. Schedule payouts every five to six years. (Sooner is ok, but longer is not.) Unlike regular stock options and restricted stock, employees cannot (with some exceptions) choose when they’ll “exercise” or “redeem” their shares. You, the plan sponsor, decide. The temptation will be to push the payment date out too long. This has two negative results: (a) the value may compound for a long time resulting in very large payouts, and (b) employees will have no way to access their money unless they quit—not the ideal scenario.
  6. Don’t make your formula ( for share price calculation) too complicated. We’ve seen plans where the company officers don’t even understand the formula ( or can’t remember why some things were included). Keep it simple. “Hey gang, if we grow profits we will all make money!”
  7. Don’t ignore the rules. Most phantom stock plans will be subject to ERISA (the Fed’s 1974 rules on pensions) and Internal Revenue Code Section 409A . Sorry. There are rules. Fail to know and follow them at your own peril.
  8. Don’t try this at home. Get advice. It’s risky to decide upon the best choices for a phantom stock plan without the guidance of someone who’s done it before, a lot. You may intend to give away 10% of the growth of your company to your employees and you wind up giving away 30% via bad design and operation. That is important. Get Help.
  9. That said, don’t use your attorney as your professional advisor. Your lawyer will be needed in the process—towards the end –to make sure the documents are in order. But, your attorney will not be experienced at the realities of plan operation. Find someone who’s lived with, slept with and eaten with phantom stock over the years. Let them put the structure on your important decisions. Then use your attorney to “cross the t’s and dot the i’s.
  10. Manage the plan effectively. Don’t start the plan and forget about it. Keep it fresh. Be flexible. Communicate it . Give the employees statements that show their value. This is a big investment. Use it wisely.