Most CEOs and other business leaders feel pressure to contain costs. As a result, when it comes to compensation they are wary of “adding” plans to their pay mix because they don’t want to add expense to their cash flow or P&L statements. It is certainly a valid concern and one we address with our clients often when they are considering various kinds of value-sharing plans. However, when it comes to compensation, “expense” has to be carefully defined or a business may keep itself from implementing a plan that is ideal for its employees because those safeguarding profits make the wrong assumptions about “costs.” Here’s what I mean.
When pay plans are built with the right financial framework, they (technically) shouldn’t “cost” the company anything. Variable plan benefits in particular (such as short and long-term incentive plans) should only be paid out when a superior value has been created. They should be paid out of productivity profit—the amount of net operating income that is attributable to the contributions of the company's people after accounting for a return to shareholders on their capital investment. This ensures that compensation is structured to preserve and enhance shareholder value rather than dilute it through additional pay “expenses.”
This approach treats all non-guaranteed compensation as value-sharing. This term is important because it eliminates the idea of “cost” from the pay equation and puts the focus squarely on what it should be. Corporate "wealth sharing" is a function of value creation. It forces an organization to get more precise in defining how value is created in its business and what thresholds have to be reached for value-sharing to occur. For example, one company defined value creation this way:
- The first $80 million of net operating profit goes back to the company and shareholders to fuel future growth.
- The next $20 million of net operating profit is shared with employees through short and long-term value-sharing programs.
- After that, all profits are divided 50/50 between company investment and employee rewards (further value-sharing).
No Current Cash-Flow Impact
A second way to look at “cost” in evaluating pay is in the actual cash outlay a company has to make in the present year to fulfill a pay obligation to its employees. In this context, there are three value-sharing plans that a company can offer without incurring a current cash flow expense. Each of these plans also assumes benefits will be paid out of productivity profit—so that participants are only eligible for benefits if the productivity profit has reached a pre-determined level.
Following are the three incentive plans. I’ll first describe each and then explain why these long-term rewards offerings don’t “cost” the company anything.
1. Phantom Stock. This is a deferred cash bonus program that creates a similar result as a restricted stock plan. The sponsoring company determines a phantom stock price through either an internal (formula) or external valuation of the company. Employees are awarded some number of phantom shares that carry specific terms and conditions. At some point in time active employees will receive a cash payment equaling the value of the original shares plus the appreciation thereon. For example, assume an employee receives 100 phantom stock with a starting price of $10. At a pre-determined future date, the company will calculate the value of the phantom stock price and pay the employee the full value. Assume, for our example, that the share price grows to $18. The company will pay the employee $1,800. Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the underlying company value. Phantom shares result in ordinary income taxation to the employees only when they turn into an actual cash payment.
2. Stock Appreciation Rights Plan (SAR). This is a deferred cash bonus that is sometimes called a phantom stock option program because it mirrors the effect of a stock option plan. As with a traditional phantom stock approach, the sponsoring company establishes a phantom stock price (through either a formal valuation or by formula). Employees are awarded some number of phantom options that carry specific terms and conditions. Should the company phantom stock appreciate over time, employees will receive a cash payment equaling the difference between the original price and the appreciated price. For example, assume an employee receives 100 phantom stock options (PSOs) with a starting price of $10. At a pre-determined future date the company will calculate the value of the phantom stock price and pay the employee any positive difference. Suppose, for this example, that the share price grows to $18. The company will pay the employee $800. Again, these types of plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the appreciation of the underlying company value.
3. Performance Unit Plan (PUP). A PUP allows the sponsoring company to select two or more financial metrics to be used to value units that are awarded to employees for meeting certain performance targets. The units will be converted to cash payments at a future time (commonly three or four years). For example, a company establishes a unit price of $100 (the determination of the starting value is completely arbitrary). Next, the company creates a table that illustrates targeted improvements in two important metrics—such as margin improvement and sales growth (any metrics will do—even department level ones). The table will show the employees how much the value of the PUPs would grow to assuming achievement of the specified metrics. The employees are rewarded for achieving the targets outlined. Commonly, the company will award new PUPs each year with either the same or different targets. Alternatively, new PUPs may be issued at the end of the first payment, thus beginning a new cycle.
(There are variations on each of these pay approaches, but they are treated similarly from both a cash and tax standpoint.)
In each of these long-term plans, the sponsoring company has no cash outlay at the time participants are awarded shares or units under the agreement. The cash outlay only occurs when the payout period has been reached. And in the case of a SAR, there is only a payout if there has been an increase in value. At the time of payout, the company is able to tax deduct the payments as a compensation expense and the employee receives the benefits as taxable income. (Disclaimer: You should check with your CPA or accounting firm for exact tax rules.)
The budgets for each of these plans should be tied to the organization’s productivity profit. This simply means a certain level of value should be created before employees become eligible for shares or units under the plans as well as before benefits are realized. This ensures they remain “self-financing.”
Because these plans don’t “cost” your business anything from a current cash flow perspective, they offer you tremendous flexibility in fluid economic environments. For example, if profits are down in a given year—leaving the company unable to pay out bonuses—the organization can increase the number of phantom shares for participating employees. Similarly, a PUP plan could be instituted with metrics that keep employees focused on the performance needed to pull the company out of the trough it’s in. In both cases, the business has not current cash outlay—and won’t until the results have been produced. In each instance, the increase in productivity profit becomes the means of fulfilling obligations under the plan—but no obligation exits if a certain pre-determined threshold has been reached.
The lesson here is that you should not assume you can’t “afford” to add to your rewards offering because of the “cost.” Through a creative and strategic approach to compensation design, you can put plans in place that support the performance culture you are trying to build and sustain while still protecting the cash flow interest of shareholders.
For more information on phantom stock plans, visit www.phantomstockonline.com.