Building Unified Financial Visions

This is actually my 11th blog on doing phantom stock right. If you haven’t followed the series you may want to start here.

For those who’ve hung out until the end…or the near end, congrats.

You now are armed with all you need to build a phantom stock plan. But if you’re trying this on your own, make sure you avoid some of the pitfalls.

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 risk. No increase in value results in no payments to employees. Even if your share 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 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. This is important. Get help.
9. That said, don’t use your attorney as your principal 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.”

Watch next time for my last tips on how to make a phantom stock plan inspire your employees.

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.

So what’s the best way to award phantom stock to employees? In my view it’s through Phantom Stock Options.

This one is my favorite, and it’s the most popular plan we design at VisionLink. Stock options (real ones) are attractive because they’re “win-win.” Employees only win if the other shareholders win (by seeing their stock price go up by a value that exceeds the amount by which they were diluted). 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. And there’s no “cashless exercise” arrangement that permits the employee to get a reduced number of shares by surrendering a portion of his options to cover the strike price.

So let’s use phantom options. Easy. Recall that phantom stock is a cash compensation arrangement. Assume we give Sally (remember her–our top sales executive?) 5,000 phantom options with a starting value of $10. What will she really have at that point? Nothing—because the options must go up in value before she realizes any gain. But later, when the phantom share price reaches $18 and it’s time for redemption, Sally is simply handed a check for $40,000 (($18-$10) X 5000). No muss, no fuss. Sally doesn’t need to scrape together the $50,000 to exercise the options. She simply receives a nice payment that reflects a reward for her contribution to growth in company EBITDA.  Sally has tight alignment with the shareholders without the pain and complication of dealing with a stock transaction. (And you have a happy employee without the headaches of another shareholder.)

By the way, what’s described here as a phantom stock option is also known as a Stock Appreciation Right. However, some find the term phantom stock option more appealing and descriptive.

So have you picked the right plan for your company? Next we’ll look at how you begin to set it up.

Can Sally (our national sales leader) buy phantom stock from the company? Is such a thing possible?

In fact, we can sell Sally phantom shares. Let’s see how it would work.

This is referred to as a Deferred Stock Unit plan—a form of deferred compensation. Sally would be given the opportunity to defer some of her cash compensation (e.g., salary or bonus) into units of phantom stock. Said differently, Sally would “convert” some of her future pay to phantom stock.

An example: Assume Sally makes $200,000 in annual salary. She might defer up to 25% (or more, or less) of her salary into the plan. Assuming she does so she would acquire a deferred compensation interest that would have $50,000 worth of starting value. In other words, she would have 5,000 units of phantom stock (at $10/share) credited to her deferred comp account.

In reality, you’re not selling shares to her. That is, she’s not acquiring an ownership right in exchange for writing you a check. She’s deferring some of her income into an unsecured bookkeeping account that is measured by the growth of the phantom share price. But it has the same essential effect as selling Sally phantom shares. She is voluntarily foregoing wages in order to ‘invest’ in the company! That’s a pretty serious commitment. We’re definitely building an ownership mentality.

Plus, it’s much better for Sally tax-wise than buying actual stock. Why? Because she gets to do it with pre-tax dollars.

Tax-wise for you it’s not perfect, but it’s not so bad. You (or the company) will forego the current tax deduction on the income Sally chooses to defer. However, it’s a delayed deduction, not a lost deduction. Instead, of getting the deduction today of $50,000 (wages) you’ll get the future deduction on $90,000 (assuming our EBITDA growth example given in my previous blog).

This is a pretty flexible and promising arrangement when you have employees who believe in the future of the company and an owner who’s willing to share that growth—for a price.

So we’ve agreed (haven’t we?) that some form of phantom stock is likely to be better for private businesses. I mentioned that there are
three types of plans that may fit. Here’s the first.

Full value grant. We could give Sally (our senior sales executive) some shares that are valued, in full, at $10 per unit. We’re going to specify some conditions and restrictions (to be discussed later). Nonetheless, we’re committing the full $10 in value times the number of shares we decide to give her. If we give her 5,000 shares she’ll start with a true value of $50,000 (subject to vesting and other restrictions). At some future date she’ll redeem those awards for real cash. Assuming EBITDA grows to $18mm (from $10mm) on her
redemption date, Sally will receive a check for $90,000.

What about Sally’s taxes? Well, remember that with actual stock awards Sally would pay taxes when she received the grant or when the vesting lapsed. With phantom awards, Sally pays no taxes until she actually receives her award value (e.g., the $90k). In this way, she
never has to pay income taxes until she’s in receipt of the actual cash. It’s true that had she received actual stock (and paid the taxes up front) she might have saved some taxes in the long run. However, with phantom stock your tax deduction (i.e., the company’s) is higher than it would have been with actual stock. In the first case (actual stock), your deduction was for $50,000, thus a tax benefit of $20,000 (assuming 40% bracket). With the phantom stock example, you get to deduct the full $90,000, resulting in a tax benefit of $36,000. If
you’re feeling guilty about Sally’s taxes go ahead and give her more shares, enough to result in your “after-tax cost” being the same.

A full-value award of phantom stock may be just right for Sally. But generally, we suggest it only for those special employees who have been involved with the company for some time (i.e., they’ve earned some of the value that exists now). There are better ways for most employees.

Next time: Can we sell phantom shares to employees?