Top talent expects top compensation. And in today’s hyper-competitive job market, that means CEOs have to offer more than just BIGGER numbers on a paycheck. Millennial employees in particular want to feel like the work they’re doing, their company’s progress, and the way everyone makes money are all reinforcing each other and building towards a common good. The best CEOs are finding more creative and motivating ways to attract the best talent, encourage high performance, and leverage those assets for BIG results.
Tom Miller, founder and president of VisionLink Advisory Group, is an expert at helping CEOs set up long-term incentive plans that create that crucial alignment between employee and employer goals. He shared with me a five-step plan for creating a phantom stock program that will incentivize top employee performance without sacrificing control of your company.
Throughout this post, you’ll find information on what a phantom stock plan is, how phantom stock is different from real stock, how phantom stock works, phantom stock pros and cons, and how it can benefit your company.
What Is a Phantom Stock Plan?
Phantom stock, also known as shadow stock, is a type of stock plan that offers an employee a cash award equivalent to a certain number or fraction of a company’s shares, multiplied by the current share price. The award amount is frequently tracked in the form of hypothetical units, also known as “phantom” shares, that resemble a company’s actual stock price.
These deferred compensation plans are usually tailored to senior executives and higher-up staff. They are often flexible, making them an excellent form of compensation if offering real stock isn’t an option.
Because phantom stock is a type of deferred compensation plan, it’s awarded after a delay mechanism, which is a set date where an employee will be paid their share of phantom stock. In most cases, payment is deferred between two and five years after the agreement is made. It will depend on the stipulations written in the agreement.
Payment can also be received if the employee is terminated, passes away, retires, or becomes disabled. Payments can be made as a lump sum or installments.
Phantom stock is not…
Phantom stock is not real stock, which means an employee receiving it isn’t getting any ownership of the company. Phantom stock is based on the rise and fall of an employer’s common stock without giving the employee any equity ownership.
Is phantom stock a good idea?
There are several reasons why it may be wise to implement phantom stock into your organization’s compensation package. Take a look at some of the benefits that can arise when you provide a phantom stock plan as a private company:
- Motivation: Do you want to motivate your employees? Phantom stock is a way for you to reward high-performing executive employees for the work they’re doing.
- Legality: Issuing real stock often requires more legal work, such as signing a shareholder’s agreement, which can increase the fees you pay. With phantom stock, you can skip some of the legal processes associated with providing real stock.
- Loyalty: As we mentioned, issuing phantom stock can encourage employees to work harder and boost productivity. In turn, the better the company’s performance, the more loyal employees will be. This is because they’ll see their hard work pay off when they’re issued higher-priced phantom stock.
- Prevent dilution: Offering real stock options to every employee can dilute your company’s stock and make them less valuable. By issuing phantom stock, you can provide employees with many of the benefits of real stock without cutting the value of your organization’s common stock by giving employees more voting power.
- Performance: Phantom stock is often given to executives and senior leadership to encourage them to produce better results. The higher up an executive is, the more phantom stock they’ll receive based on their team’s performance.
These are just some of the many reasons why compensating employees with phantom stock is a good idea.
How is phantom stock different from real stock?
Phantom stock is a deferred compensation plan, which is an arrangement where an employee receives income after the income was earned. Examples of deferred compensation include phantom and real stock, along with retirement plans and pensions. As for the value of phantom stock, it’s based on the value of an employer’s real stock.
Real stock, also called common stock, is a type of corporate equity ownership. Anyone who has common stock in a company has some ownership in the organization, and in some cases, might have voting powers on corporate decisions. While common stock has many similar benefits to phantom stock, such as increased motivation and productivity, there are a few notable drawbacks.
One of the main reasons why an organization may prefer offering phantom stock plans over common stock plans is that employees receiving common stock can become minority shareholders. Minority shareholders can cause roadblocks in a corporation’s plan, such as denying a merger or other corporate transactions. Additionally, minority shareholders might have different expectations of the organization as senior executives, which can result in a deadlock.
So, what’s the main difference between phantom stock and real stock? Phantom stock is a deferred compensation plan that provides compensation to an employee based on the value of real stock, which is a security that provides shareholders with ownership of an organization.
How Do Phantom Stocks Work?
The value of phantom stock units is determined by the company’s stock price. The value might be stipulated, calculated using a written formula, or determined by an appraisal. Additionally, it’s important to note that adjustments can be made based on agreements between all parties.
Organizations should also note that the value of phantom stock isn’t set in stone. Similar to common stock, the price fluctuates based on how well the company is performing. So, if an organization has a down year, the value of its stock will decline, and so will the value of phantom stock. A down year can be the result of a variety of factors, such as laws and regulations, like the Tax Cuts and Jobs Act, or global events like the coronavirus pandemic.
Because phantom stock isn’t real stock, companies need to make a plan for what events can affect the valuation of phantom stock. For example, a triggering event that impacts the valuation of phantom stock might be a change in control or a specified date, which will determine when phantom stock can be paid out.
What are the different types of phantom stocks?
As an employer or executive, such as a CEO, it’s important to know that there are different types of phantom stocks you can offer your employees. Here’s a breakdown of each type of phantom stock:
Appreciation only phantom stock.
An appreciation stock prevents receivers from obtaining the phantom stock’s present value. Instead, employees receive any profit generated by the phantom shares over a certain time period, such as the amount the stock price has appreciated over time.
Consider this phantom stock example: An employee received 1,500 phantom shares on January 1, 2015, at $65.00 per share. To receive the benefit of these shares, the employee needs to stay employed for five years. Five years later, on January 1, 2020, the company’s share prices were valued at $95.00 per share. Through appreciation only phantom stock, the employee will receive the difference between the current value of $95.00 and the initial value of $65.00, which is $30.00. Multiply this by 1,500 shares, and the employee will receive a bonus of $45,000.
Full value phantom stock.
Whereas appreciation only stock pays the difference between a phantom stock’s initial value and current value, full value phantom stock pays out both the stock’s current value and any appreciation it accrues once the due date has been reached.
Let’s continue with the phantom stock example above. Rather than the employee being paid $45,000, which is the difference between their phantom stock’s initial and current value, they would be paid $142,500. That is the sum of the initial value of $65.00 and the amount of appreciation, which is $30.00 multiplied by 1,500 shares.
What Is a Phantom Stock Agreement?
A phantom stock agreement is a contractual agreement between an organization and the recipients of a phantom stock plan—typically employees. The phantom stock agreement guarantees the right to a cash payout after a designated date in the future. The price of the phantom stock is based on the market share of an organization’s stock, and can rise and fall depending on how well the company is performing.
Phantom stock pros and cons
Phantom stock offers many great benefits that are worth exploring. However, there are drawbacks you should be aware of as well. Let’s dive into phantom stock pros and cons so you can determine whether they’re a good option for your organization.
Pros of phantom stock:
- Incentivize: Phantom stock can motivate employees to boost productivity and accomplish goals. Depending on how valued an employee is at an organization, they may receive more phantom stock.
- Fewer logistics: When an employee receives real stock, they’ll need to purchase the stock on the open market. With phantom stock, employees don’t have to worry about dealing with any transactions, so they can reap the rewards of a stock’s profit without having to pay for it.
- Control: Phantom stock also gives more control to employers compared to real stock. With phantom stock, employers have full control over the structure of their agreement, such as the dividends paid out to employees or provisions for forfeiture if an employee exits the company before the agreed-upon vesting date.
Cons of phantom stock:
- Cost: Companies often have to use an outside appraisal company to value the price of the stock, which can be an additional expense.
- Risk: Employees are at the most risk when receiving phantom stock because they have little control over any deal triggers. So, if the price of phantom stock drops, employees are often out of luck.
- Taxes: When it comes to phantom stock, companies must adhere to IRS 409A Statute, which limits how a company distributes phantom stock payouts and prevents employers from accelerating payouts if they anticipate financial collapse.
These are some of the phantom stock pros and cons you need to weigh while deciding whether offering these plans is the right move for your company. For example, if you don’t anticipate your organization growing in the near future, phantom stock might not be a great idea, as issuing it can cause more financial stress and lower morale.
However, if you’re growing at a steady rate and are looking for ways to motivate executives and members on the leadership team, phantom stock plans may be beneficial.
5 Tips for Creating a Phantom Stock Plan
Creating a phantom stock plan can help ensure you offer competitive compensation packages to your top executives as a way to incentivize excellent performance. Take a look at five tips for creating a phantom stock plan below:
1. Understand what you are — and aren’t — offering.
Phantom stock is essentially a contract in which you promise to pay cash to an employee once certain conditions are met. Usually, those conditions are tied to specific business growth metrics, such as a higher EBITDA or hitting a new net income goal. This agreement creates an ownership mentality in employees who are participating in the program: “If I do my job well it helps the company succeed, and when the company succeeds, I get paid more.”
What phantom stock does not create is a path for employee ownership of your company. You and any partners you have retain 100% of your existing shares of the company. Phantom stock owners aren’t entitled to see your company’s books or have a voice in major decisions (like, say, your salary) the way owners of actual stock would be. And from the employee’s perspective, it’s usually less expensive and less of a tax burden to accrue and cash in on phantom stock.
Ultimately, setting up a phantom stock program should align with the kind of culture you’re trying to create. If you want to provide key employees with an extra motivation to commit to your vision over time and execute at a high level, phantom stock is an excellent option.
2. Set a proper valuation.
Another advantage of phantom stock is that you have more control over how your company is valued and what you ultimately pay out to employees. A tsunami on the other side of the world might send a public company’s stock prices into a tizzy. But your phantom stock price and the conditions on which owners get paid aren’t subject to market swings.
Instead, you can either pay for a formal appraisal of your company or use your own formula to set a value. Most companies choose to use a formula, such as a multiple of EBITDA or another key metric. Just make sure your formula keeps the value of your phantom stock below the company’s actual market value. That way, if you decide to sell the company someday, the price of employee phantom stock won’t be higher than the value of your ownership stock.
3. Create your shares.
A common misconception is that your number of phantom shares should be equal to the number of company shares. Remember, phantom stock is an incentive program tied to the valuation and long-term goals you want stockholders to help you accomplish. It’s not meant to shadow your company’s actual value, even if your company is publicly traded. You just need enough shares to cover the kind of plan you want to create and the number of employees you want to compensate.
As an example, let’s say your company’s current EBITDA is $10,000,000, and you decide to value your company at 5X that number. Based on that multiple, you could create 5,000,000 phantom shares at $10 per share, for a total valuation of $50,000,000.
4. Decide how to award stock.
There are three different ways to award phantom stock:
1) Full value grant. Give employees shares valued in full at the price you established in your valuation. In the example above, an employee given 5,000 shares would be entitled to cash in those shares for $50,000 at a future date you determine. If EBITDA is higher at that date, the value of the phantom stock would be proportionally higher as well.
2) Sell phantom stock. Give employees the opportunity to defer some of their income into phantom stock. Under this arrangement, an employee earning $200,000 annually who wanted $50,000 worth of phantom stock would defer 25% of his or her salary.
3) Phantom stock options. Give employees the right to buy phantom stock when it’s reached a higher valuation of your choosing. An employee with phantom stock options at $10 would receive $40,000 once EBITDA value rises high enough to bring the phantom stock price up to $18.
When in doubt, phantom stock options are usually the best way to award stock. There’s no risk to options, and if the metric that’s driving the value of your phantom stock doesn’t go up, there’s no payout to stockholders.
5. Set a reward schedule.
Your goals for the company will go a long way towards determining how many shares you want to grant employees and when you want to pay them for those shares. It’s usually best to create a schedule with annual rewards over a predetermined course of years. But if you want to reward a trustworthy, longtime employee who’s integral to your future plans, an upfront one-time grant might be appropriate.
Whether you’re weighing health care options or exploring revenue sharing, your employee compensation requires careful consideration and professional planning. Get in touch with experts like Tom’s team at VisionLink to make sure your comp package will attract, retain, and inspire the people you need to make BIG happen.
Learn More
To learn more about setting up a phantom stock plan or other long-term incentive plan, visit Tom Miller’s firm VisionLink here or call them at 888-703-0080. Additionally, if you’re looking to take your business to new heights, it’s time to look into COO coaching.
At CEO Coaching International, we offer private equity coaching and executive coaching services tailored for senior executives looking to broaden their leadership skills and grow their company. Whether that’s finding ways to motivate employees, such as offering phantom stock plans, or understanding how to become more self-aware, our executive coaches will work with you to change behaviors and accomplish your goals.
About CEO Coaching International
CEO Coaching International works with CEOs and their leadership teams to achieve extraordinary results quarter after quarter, year after year. Known globally for its success in coaching growth-focused entrepreneurs to meaningful exits, CEO Coaching International has coached more than 1,000 CEOs and entrepreneurs in more than 60 countries and 45 industries. The coaches at CEO Coaching International are former CEOs, presidents, or executives who have made BIG happen. The firm’s coaches have led double-digit sales and profit growth in businesses ranging in size from startups to over $10 billion, and many are founders that have led their companies through successful eight, nine, and ten-figure exits. Companies working with CEO Coaching International for two years or more have experienced an average revenue CAGR of 31% (2.6X the U.S. average) and an average EBITDA CAGR of 52.3% (more than 5X the U.S. average).
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