In VisionLink’s work with leaders of privately-owned, mid-sized businesses, we are commonly engaged to help engineer a long-term incentive plan (LTIP). The intent these companies have in setting up such a plan is to share value with those who help fuel organizational success over an extended period. However, the hope of shareholders in these private companies is to accomplish that without diluting equity—without giving away actual stock. That combination (sharing value without diluting equity) most often leads these enterprises to choose some kind of phantom stock plan. Let’s explore why.
Defining Phantom Equity
To grasp why this employee rewards approach has become so popular in the private company marketplace, you’ll need to first understand what phantom stock is and how it works.
Phantom Equity is a form of LTIP used primarily by non-public companies to award employees for the growth of business value without sharing real equity. In effect, it is a type of deferred bonus—the value of which is ultimately tied to appreciation in the market or formula value of the sponsoring company. In this kind of arrangement, an employer enters into an agreement with selected employees to grant them a number of units or phantom shares. The document informs the employees of the starting value of the shares along with other conditions of the plan such as the vesting schedule, payment events, phantom dividend availability (if any), and more.
Once the plan terms are fulfilled, participating employees are eligible to receive a payment in exchange for their units. The amount of the payment will depend upon (1) the number of vested units they hold, (2) the value of the units at the time of payment, and (3) whether the plan was for the full value of their units or strictly the appreciation in the value from the date of grant. For example, suppose an employee received 10 phantom shares with a starting value of $7. Assume the shares are valued on the payment date at $15. At the date of payment the employee would receive $150 under a “full value” plan and $80 under an “appreciation only” plan.
As described, phantom shares are usually redeemed in cash—the payment being treated like a bonus. However, should the plan terms allow it, the payment obligation may be satisfied by distributing actual stock to the employees. This kind of agreement with employees must be supported by more than a verbal commitment. It requires a formal document that describes the plan terms and articles. The document serves to confirm the plan operation, resolve questions and satisfy certain minimum compliance requirements.
Long-term incentive plans of this type may also be known by such terms as phantom shares, simulated stock, shadow stock or synthetic equity. Stock Appreciation Rights (SARs) are a form of phantom stock and are often referred to as phantom stock options. (SARs operate similar to regular stock options in that they reward for value increase only).
Why Phantom Equity is So Popular
The reason the distribution of phantom shares as a long-term value-sharing strategy has exploded in recent years is because of the multiple business purposes this LTIP approach helps organizations accomplish. There are at least four outcomes these plans enable.
Purpose #1: Goal Alignment
Participants in phantom equity plans are linked to the same business objectives as the owners because of the way they are being compensated. As a result, they are expected to view the company’s objectives through the same lens—producing satisfactory fulfillment of short-term results while building sustainable, profitable growth over time.
Purpose #2: Value Creation
The existence of a phantom equity plan sharpens the focus and increases the productivity levels of participants because there is a sense of partnership about building the future business. Increased focus creates greater execution. Sustained execution leads to sustained success and growth. Such a pattern generates improved profits and higher equity value which are foundational to value creation.
Purpose #3: Winning the Talent Wars
Successful companies find creative ways to attract and retain the best people. They are committed to a value proposition that appeals premier talent, not just good recruits. Many factors beyond compensation must be included in this proposition but the compensation offering must resonate with the people you want to attract and differentiate you from your competitors. For this reason, growth-oriented organizations utilize long-term value-sharing programs like phantom equity that enable top performers to build meaningful wealth.
Purpose #4: Fairness
The most important perception to avoid in any company’s compensation programs is a sense of unfairness. Once employees believe that compensation plans are unfair, engagement and productivity will immediately begin to decline. Owners and CEOs seek to rally employees around the organization’s growth objectives. Employees understand that growth in sales, margins and profits produce wealth for the shareholders. Those employees who recognize that they directly and meaningfully contribute to growth will begin to wonder how and when they get to participate in this value. Successful companies don’t let this happen. They send the right message: “At ABC Company, you participate in the value you help create!”
Owners and CEOs intuitively understand these purposes and principles. They know that sharing value through long-term plans is essential to capturing the loyalty and commitment of top achievers. But they especially like the idea of accomplishing all this without diminishing the equity value of shareholders.
To dive deeper into this topic, download our report: 4 Reasons to Have a Phantom Stock Plan.