Phantom Equity Can Motivate Top Employees

Small business owners who are trying to build up their companies typically can't afford to pay generous executive-level salaries. But the idea of giving away company stock is also usually unappealing, unless the game plan is to take the company public within a few years.

A middle ground is provisionally granting one or both of these alternate forms of ownership:

Caution: Like stock options, EARs can become worthless if the value of your company and its stock declines. Because of that risk, and the fact that the employees' holding gains value only if your holdings do, you might be inclined to be more generous with EARs than PEUs.

Non-Qualified Plans

Group of business people

Phantom stock-based arrangements are non-qualified plans, which means they're not governed by the Employee Retirement Income Security Act which regulates "qualified" plans such as 401(k)s and profit-sharing arrangements. Non-qualified plans also give you a lot of flexibility in how they are set up. But the flip side is that the tax and security features aren't quite as attractive.

Note: Non-qualified plans are subject to Section 409(a) of the Internal Revenue Code, which covers, among other issues, the timing of deferrals and distributions.

You would only want to grant PEUs or EARs to managers who you have full confidence in and want to keep on board for the long haul. Plus, the recipient should be someone who is privy to all the financial ins and outs of your company.

The Details

Here are some key features of PEUs and EARs:

As you can see, phantom equity programs give you a lot of flexibility. And that's a good thing, because what makes sense both in terms of the plan design itself, and how generous you need to be to provide the necessary motivation, will vary from one company to the next.

Different Strokes

Keep in mind that not every highly valued top manager will be motivated in the same way. The prospect of a big future payout based on your company's financial success could be enticing and inspiring to one executive and not so much to another.

Finally, if you launch a phantom equity program, you aren't obligated to keep it going forever. If it doesn't seem to be working, you can always pull the plug, although you'll still be contractually obligated to deliver on any future payout grantees are already vested in.

Talk to a specialist in nonqualified executive compensation for a more in-depth briefing on phantom equity, as well as alternative motivational pay systems.

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