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:

  • Phantom equity units (PEUs), which represent an economic interest whose value is equivalent to a share of the company's stock — but isn't actually stock, or
  • Equity appreciation rights (EARs), which are the equivalent of a stock option whose value is determined by the increase in the value of the company's stock after the date the EAR is granted.

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:

  • Distribution timing. You can distribute PEUs and EARs whenever you want, but annual distributions are typical.
  • Conditions. You can decide yearly whether to grant any PEUs and EARs, and how many. Although they're intended as long-term compensation and they aren't a substitute for an annual incentive bonus, you can vary the grants based on the company's financial performance.
  • Vesting. You can (and most companies do) establish a vesting schedule that delays the time when actual ownership of the PEUs or EARs is deemed to occur. Retirement plans use a similar schedule for vesting, which is generally based on time. A vesting schedule for PEUs or EARs may be based on performance metrics of the company or the executives involved.
  • Payout timing. In keeping with the goal of making grantees think like owners, PEUs and EARs typically aren't paid out until the executives reach retirement age, or after a relatively long period of service, for example,15 or 20 years. However, some circumstances could trigger a payout obligation. Among such potential triggers are the sale of the company or change of control, termination of the senior manager "without cause" or the inability of the manager to work, such as becoming disabled.
  • Benefit forfeiture. You can stipulate that the grantee forfeits accumulated PEUs and EARs for such reasons as a termination for cause or violation of a non-compete agreement.
  • Tax treatment. The company takes a tax deduction when cash payouts are made and the executives are taxed on the amounts as ordinary income.
  • Stock valuation. This is an area where you have flexibility. You could do an annual appraisal or choose a formula such as a multiple of earnings before interest, taxes, depreciation and amortization — including a rolling average to smooth out upward or downward spikes. You could even have your board of directors make a good faith estimate every time PEUs and EARs are granted. But the more predictable the formula, the more tangible the benefit will appear to grantees, and thus the more motivational.
  • Funding. The better your company performs, the larger the ultimate cash payment you'll need to fulfill your end of the bargain. But because these are nonqualified plans, you can't salt away funds every year in a trust that's tax-sheltered and impervious to the claims of creditors. Also, even without creditors to worry about, you'll need to be able to have plenty of cash on hand to make the payouts. And for PEUs and EARs to be motivational, their recipients will need to be confident that they'll ultimately get their payout. Certain insurance contracts and a "Rabbi trust" can help to mitigate the funding issue to some degree. Ask your insurance advisor for details about this specific tax-deferred, irrevocable trust, which is similar to a 403(b) plan.

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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