Plan Overview
Phantom stock is a right granted by the company to an employee to receive an award equal to the value and appreciation of a share of stock from the date of grant to the date it matures. The award is typically paid in cash and vests to the employee over a period of years. The award may be of two types:
-
A "full-value" award where the participant receives the value of the stock plus any post-grant appreciation, or
-
An "appreciation" award where the participant receives only the increased value since the grant date. This type of award is also called a stock appreciation right (SAR) or phantom stock option that is similar to a stock option award.
Phantom stock is typically used in private companies where owners desire to:
-
Motivate and reward executives based on long-term value creation, and
-
Restrict the actual ownership of company stock.
Plan Objectives
Typical objectives for a phantom stock plan are:
-
Promote management planning and actions that support long-term financial success
-
Motivate employees to increase the total value of the company
-
Retain key executives through long-term vesting
-
Reward employees for the creation of long-term value
-
Promote teamwork among plan participants
-
Create long-term wealth and capital accumulation opportunities for employees
Primary Advantages
-
Rewards employees for company value increases similar to stock or stock options, without the use of actual equity.
-
Does not create minority shareholders.
-
Does not result in ownership dilution.
-
Provides strong retention incentives.
Primary Disadvantages
-
Requires cash payments upon maturity
-
Initial and increased value is charged as compensation expense over vesting period (vs. no income statement recognition for stock options).
-
Requires an outside valuation or formula value determination.
-
Unpaid value is not secured to employees.
Eligibility
Phantom stock is necessarily granted to a select group of executive employees. Payments are usually made from 5 to 10 years following the initial grant and possibly over a longer period or at retirement. This payment timing may subject phantom stock to the ERISA regulations and the requirements of a qualified benefit plan. To gain exemption from ERISA regulations, the plan should be limited to a select group of "top hat" employees. While there is no clear safe harbor regarding what constitutes the top hat group, we would consider the following issues to determine the proper eligibility:
- Percentage of workforce
- Ownership interest
- Each participant's compensation
- Combined compensation of participants.
Independent of ERISA regulations, the company would want to focus the award value and compensation on individuals who:
-
Can directly impact overall financial performance and company value
-
Value stock-like ownership in the company
-
Have a significant role in the long-term success of the company
Grant Frequency and Size
Grants are commonly made on the annual basis, but may be made less frequently or only once. Periodic grants with vesting requirements may provide stronger retention incentives since the participant will lose the value of forfeited stock upon a voluntary termination.
Grants may be of equal size to all executives at the same organizational level, or may differ by individual based on performance, salary, organization impact, or other reason.
Vesting and Award Payment
Phantom shares may vest similar to stock options over a 3-5 year period. Vesting in private companies may be longer than is typical in public companies. The company has wide discretion over the vesting of phantom stock. However, unusually long vesting periods may cause participants to minimize the expected value of the award since they may not be employed when vested.
Awards are typically paid in cash upon exercise or maturity and may be in a lump sum or in installment payments. Phantom stock may be valued and paid upon a re-capitalization or change in control such as a public offering of stock or company sale. Alternatively, it may be converted into another vehicle in the new company such as stock options or restricted stock. Earlier payments may also be made upon early retirement, death, or permanent disability.
Valuation
The value of phantom stock must be determined upon grant and at the final payment date to facilitate the calculation of the award. The grant should also be valued during interim periods to effectively communicate the increasing value of the award to participants, and to properly recognize the value accrual in the financial statements.
It may be useful to think of the following three levels of valuation methods. There is generally an inverse relationship between the cost to perform the valuation and the precision of the estimate.
Information Valuation
The company may use an information method to value the stock, including any and all available indicators in a non-structured way. This may include factors such as: past valuations, outside advisor opinions (e.g. accountants, lawyers, investment bankers, etc.); past stock sales and purchases, growth, informal ratio analysis, etc. The factors used and the weights applied to each factor may change over time.
This method carries a low cost and may be done quickly. However, it may lack the precision and credibility desired by participants and decision makers.
Valuation Formula
The company may establish a predetermined method or formula for determining the company value. A typical formula would entail a multiple of book value, assets, earnings, EBITDA or other financial measure. The financial results may be adjusted for other factors such as owners' distribution and compensation.
The multiple would be determined based on an analysis of similar public companies, outside advisors' opinions, or other method. The multiple may be fixed over the valuation period or may vary based on changing ratios in the public market. A fixed ratio is simpler to calculate and communicate but may not reflect the actual Fair Market Value of similar public companies over time.
Third-Party Valuation
The company may hire an outside appraisal firm to conduct the valuation of the company. This method will result in a more accurate and credible value determination but may be costly, especially if done frequently. Appraisal firms typically combine two approaches to determine the value: 1) a financial ratio analysis of similar publicly traded companies, and 2) a discounted cash flow analysis (DCF) based on the company business plan modified by the appraiser's knowledge and total industry performance. These two approaches are then weighted to derive the final value estimate.
A short-cut method combines the third party and formula valuation approaches. The valuation would be conducted by an outside firm initially, and then the company would use those ratios and/or methodologies to derive the value internally in future periods. While the company may use the actual number of authorized shares to determine the "per share" value, an arbitrary number of shares may also be applied.
Accounting and Tax Treatment
Accounting Treatment
Tax Treatment
-
Employee - No tax prior to maturity. Taxed at ordinary tax rates when actually paid to employee. Tax withholding is required.
-
Company - Receives a tax deduction when paid to employee equal to the employee payment.
(888) 703 – 0080
