The Phantom Has Returned!!!

Phantom stock – it's alive! 

There are signs of a spectre walking the halls of Corporate America. A tool which has languished in obscurity at public companies – phantom stock – recently has shown signs of emerging. While the reasons for turning to phantom stock are varied – uncertainties in the financial markets and insufficient authorized shares for actual stock awards are two for public companies – we believe that the compensation device deserves more consideration. Phantom stock can provide valuable attributes of equity and can help with motivation, focus, and retention of recipients.

What is phantom stock?The basic concept of a phantom stock program involves a company's agreement or promise to pay a recipient of an award an amount equal to the value of a certain number (or percentage) of shares of the company's stock. Commonly structured through the award of units, a phantom stock program enables a company to make an award that tracks the economic benefits of stock ownership without using actual shares. Since phantom stock is a contractual right and not an interest in property, the tax event for the executive and the employer occurs at the payment in settlement of a properly designed phantom stock arrangement.

Phantom stock plans are shadows that mimic their real equity counterparts; phantom stock and shadow stock are terms that are often used interchangeably. Although shares of real stock can be traded at will, phantom shares or units take on value only when key contingencies or vesting conditions are met. A phantom stock plan typically does not require investment or confer ownership, so its recipient does not have voting rights. It is essentially an upside opportunity, as participants' investments are typically limited to their services; they stand to gain from any upside growth of the company.

In making awards under a phantom stock plan, there is a determination of the value of a phantom share or unit in connection with awards to one or more participants. Valuations also will be needed for periodic reporting to participants (and to actual shareholders and the Securities and Exchange Commission if used by a public company) as well as for determinations of amounts payable at the time of settlement.

Phantom stock programs can be simply designed. However, they should be created to meet the company's specific needs and objectives in protecting the unique knowledge and skill base that is represented by those key employees selected for awards. The two types that are most prevalent are (1) the 'appreciation-only' plan (much like a stock appreciation right), and (2) the 'full value' plan, where the award includes the underlying value of the unit (like a restricted stock unit).

Generally a phantom stock plan or agreement spells out how the program operates and how payments are determined, along with various other details, often including:

Eligibility criteria

Vesting schedule

Valuation method or formula

Settlement and payout events

Handling of various termination events, including retirement, death, disability, dismissal and resignation

Restrictive covenants

Form of payment

Provisions for the sale of the company

Any funding vehicle

Spooky designs and accounting monsters...
One of the key challenges of inviting a phantom into your offices is that it may come with another ghoul – the accounting monster. Historically, phantom plans have been viewed as undesirable from an accounting perspective because of the resulting liability (variable) accounting treatment. This creates volatility on the company's income statement, which is something that concerns most chief financial officers. Generally, for financial accounting purposes, phantom shares must be treated as an expense over the required service period, and the company does not receive its income tax deduction until the benefits are paid out. This timing is similar to other equity awards but can prove to be not as advantageous in periods where the value of the award increases. With liability accounting, the accounting expense and corresponding tax deduction will be the same. When real equity is used, the company may get a tax advantage as the expense can be locked in at grant while the tax deduction can grow as the value of the equity grows.

In addition, coming up with cash to cover phantom payouts can be tricky. Phantom stock plan gains (in appreciation-only programs) or current fair value (in full value programs) must be paid by the company versus the public markets which is the case when using publicly traded equity. Finally, phantom stock programs typically are subject to the often complex rules applicable to non-qualified deferred compensation under Internal Revenue Code section 409A, so care must be taken in their design.

Why use phantom stock for LTI awards?Phantom stock can help in getting an executive team to think and act like equity partners. It creates a sense of ownership in the success of the business because having phantom stock means the participants have 'skin in the game.' The concept of being an equity partner by having phantom stock can create the same feeling of connection as the more traditional equity tools such as stock options and restricted stock.

In addition to its incentive components, a phantom stock program involves deferred compensation and can act like golden handcuffs in retaining key executives. Phantom stock most often is used by privately held companies, but some publicly traded organizations are using phantom stock or similar cash based long term incentives as well.

Phantom stock plans can be especially useful in providing the economic benefits of equity without diluting shareholders. Because recipients of phantom units lack voting rights, a company can issue these units without altering the governance of the company, or worrying about dilution issues. Phantom stock does not directly dilute the value of real outstanding shares. Phantom stock awards do, however, have a significant effect on cash flow at payout. This is why some plans have a conversion feature, and may pay out in actual stock.

Another advantage to a company is the ability to design an award so that an executive receives no benefit unless vesting conditions are met and, under the appreciation-only model, the company's value has increased. The fair market value of the stock is commonly used by public companies, while private companies have various approaches. For example, a professional valuation may be preferred but viewed as too costly; many companies then turn to book value. Other approaches include a formula using revenue, EBITDA, net income, or a combination of relevant measures; a formula also can help with consistency of the valuation over time.

There are many reasons a company would consider a phantom stock arrangement:

A public company may find that it has insufficient authorized shares to award the desired amount of awards that require actual stock

A company's leadership may have considered other plans but found their rules too restrictive or implementation costs too high

The owner(s) may desire to maintain actual and effectual control, while still sharing the economic value of the company

There may be ownership restrictions for certain types of entities (i.e., sole proprietorship, partnership, limited liability company), such as the S corporation 100-shareholder rule

The objective is to provide equity-type incentives to a restricted group of individuals
     -  A corporate division that can measure its enterprise value and
       wants its employees to have a share in that value even though
       there is no real stock available

     -  A desire to focus on an event or contingency, such as a sale,
       merger, IPO, etc.

A phantom plan can typically provide a more flexible alternative that is not subject to the same restrictions as most equity ownership plans. For many, the simple desire to use an 'equity-like' vehicle without giving up true ownership may be reason enough to implement.

Pros and cons of phantom stock
  1. Allows employees to share in the growth of the company's value without being shareholders

  2. No equity dilution as no actual shares are awarded

  3. Powerful retention tool when combined with vesting

  4. Board/compensation committee has flexibility to design plans based on their own discretion

  5. Can be tied to overall company or business unit results

  6. No employee investment required

  7. Can provide for dividend equivalents

  8. Design can permit phantom stock to be converted into actual equity

  9. No income tax until proceeds are converted to cash or real stock

  10. Potential tax deferral of employee compensation

  11. Retirement benefit opportunity

  1. If paid in cash, can be a financial drain on the company's cash flow

  2. At a private company, may require outside valuation on an annual basis

  3. Company needs to communicate financial results to participants

  4. Payments to employee are taxed as ordinary income

  5. May impact the overall value of the business in a transaction

  6. IRC section 409A rules add complexity and difficulty in achieving objectives

Who is using phantom stock?Phantom stock is not only a private company phenomenon. According to our research of recent proxy filings, some well-known, publicly traded companies are using this tool to attract, retain, and motivate select groups of employees.

No need to fear the phantom
Phantom stock is a traditional long-term incentive vehicle, and not a fad du jour. While trends may come and go, cash based LTI plans do have a place in the executive compensation portfolio. While these plans are generally simple, and do provide flexibility to the company, they can also raise various issues that must be considered carefully. In the appropriate situation, a phantom stock plan can keep the company spirit alive in the executive suite.

a reprint from the Hay Group - August 2010


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