Phantom Stock

It’s an ongoing challenge for many small business owners in virtually every sector of the economy: figuring out how to motivate and retain employees who are essential to the company’s success without granting them an actual ownership stake.

During the recent recession, you probably moved consideration of long-term employee incentive programs to the bottom of the to-do list. However, as the economy slowly climbs out of the doldrums, it may be time to think ahead.

Keeping this rare and valuable category of employee in the fold may require certain innovative incentives beyond the traditional 401(k), health insurance and other typical perks. But, at the same time, you may not be ready to enter the “no-return zone” by ceding true ownership control.

One solution is the seemingly little-known practice of issuing phantom stock. As mysterious as it may sound, the technique has numerous comforting benefits for both the employer and key employee.

For you as an owner, that list of benefits includes the following:

• Less hassle. Unlike its more conventional brethren, the issuing of phantom stock is considered a non-qualified benefit. As such, much of the paperwork, restrictive rules and reporting requirements that are typical of traditional qualified benefit plans are avoided.
• Complete control of plan terms. As a non-qualified arrangement, you have the flexibility to determine how the plan contract is drawn up, which employees participate, when and how many shares are granted, terms of vesting, payout schedules and similar details.
• Ownership control protection. Since phantom shares do not include any of the statutory shareholder rights under corporate law, the full authority for company decision making remains with you. Any rights of the phantom shareholder are limited to rights specifically stated in the phantom plan.
• Increased employee motivation and productivity. High-value workers now have more than just a job and a paycheck to keep them interested—they are in it for the long haul, especially if payout terms are tied to long-term company performance.

A sense of ownership, with little down-side risk
At its core, phantom stock is a highly effective compensation tool. Employees are allowed to enjoy a sense of ownership in the company and share in its future success without necessarily sharing in the voting control, profits, dividends or distributions that normally accompany the issuance of legal equity or stock options.

From the employee’s standpoint, the potential financial reward of participating in a well-designed phantom stock plan will closely mimic the payoff of actual equity or options (hence the names “mirror stock” and “shadow stock” that are sometimes used to refer to these plans).

Yet many of the risks and liabilities ordinarily incurred by executives and others with direct, legal equity ownership are avoided with this pseudo version of company stock. For instance, the employee isn’t required to infuse cash into the business, isn’t exposed for corporate governance issues, and isn’t required to personally guarantee company debt.

Here’s an example. Let’s say a business owner awards one of his high-value executives 5,000 shares of phantom stock. Rather than having actual equity value, the phantom shares mirror the value of real company stock at, say, $20 per share.

The phantom stock plan the owner devised beforehand typically spells out a customized formula or generally accepted method for valuing the shares at some point in the future, such as three years down the road. If, when the time comes, the company schedules a valuation and finds that the owner’s stock is now worth $40 per share, the employee receives a payment of $20,000. This payment is the employee’s reward for staying with the company and contributing to its growth.

Then, when it comes time to reconcile the tax implications, the company benefits from a $20,000 tax deduction, and the employee declares the amount on his or her tax return as ordinary income.

Notice that the original grant of phantom stock by the company is not considered a deduction. Nor was the eventual receipt of the proceeds from the stock considered a capital gain on the employee’s tax return. These are two of the ways phantom stock differ from actual equity and options. These factors must be considered when contemplating the pros and cons of establishing a phantom stock plan.

The story of Squeaky Clean, Inc.
In many respects, the benefits of this arrangement outweigh the drawbacks for both sides. This was the case for a company that shall be referred to as Squeaky Clean, Inc.

The company, a family owned and operated commercial cleaning outfit, was enjoying years of steady growth and profit, thanks in part to two dedicated sales executives. Recognizing their value to the company’s success, the owners established a phantom stock plan, and issued each executive phantom units equivalent to five percent of outstanding common stock as an incentive to stay with the company.

The vesting schedule was built around a combination of time periods of continued employment and certain economic milestones. The units would be repurchased (i.e., the executives would receive their payouts) only in the case of certain triggering events—their eventual retirement at age 65, liquidation of the company, or the merger or sale of Squeaky Clean to another owner.

Sure enough, about six years later, the company was approached by a national player in the commercial cleaning business that was attracted by the outfit’s track record and prospects for further growth. Buy/sell negotiations ensued and, within one year, Squeaky Clean was sold.

As a result, the value of the owners’ original equity increased nearly three-fold. And because the value of the phantom units held by the sales executives mirrored the owners’ common stock, the two benefited handsomely when one of the triggering events that had been planned for (the sale of the company) eventualy came to pass.

A unique benefit at a comparatively modest cost
Of course, there are some administrative costs associated with establishing and maintaining a phantom stock plan, such as legal fees, accounting fees and periodic reviews to help determine the value of these pseudo shares. However, these costs compare favorably with those of a relatively inflexible employee stock ownership plan (ESOP) or a qualified or non-qualified stock option plan.

Furthermore, the set-up and administrative expenses are no match for the price of losing just one of your key managers or executives. In fact, some experts estimate the cost of turnover at the senior level to be between 100 and 150 percent of the person’s annual salary.

Rather than face that type of financial burden, you, as a small business owner, would probably agree it’s far better to retain your top people with a thoughtful approach to compensation that truly benefits them and keeps them engaged, productive and happy.

For both the company and the key employees, the phantom stock option can truly be a win-win solution.