These days, top executive candidates seek more from potential employers than a salary and bonus.
“In today’s work force, it is extremely difficult to find and retain top executive talent,” says Tyler Ridgeway, director of the Human Capital Resources Group at Kreischer Miller, Horsham, Pa. “As a business owner, you must ask, ‘How can I make it more attractive to work here without risking the financial success of my company?’”
Phantom stock is an alternative vehicle to traditional stock options, restricted stock or similar deferred compensation programs. The monetary incentive is real, and it’s a key retention tool for midsize companies.
Smart Business discussed with Ridgeway how phantom stock works and when these plans are a smart fit for a business.
What is phantom stock, and what employer might offer this benefit?
Phantom stock is a benefit plan that gives selected employees, usually senior management, the advantages of stock ownership without actually giving them company stock. The employee receives ‘fake’ stock that mimics the price movement of the company’s actual stock. The employee earns a bonus equal to the increased value of the company’s shares, but the employer does not have to pay out stock. The plan works like this: Say you decide to reward your top-performing CFO with a phantom stock plan. You implement a plan that promises to pay the CFO a bonus every five years that is equal to the increase of the equity of your company. As an owner, you retain the value of your company and please shareholders by not diluting their ownership rights. Remember, you’re not transferring actual stock to reward your CFO. You’re paying a cash bonus that is equivalent to the stock value increase. Phantom stock is treated as ordinary income, like any other cash bonus.
What advantages do employers enjoy by offering phantom stock as an incentive?
While large and publicly owned companies offer benefits, such as stock options, medium-sized businesses are not necessarily able to offer options. This may be because of prohibitive regulatory requirements or burdensome implementation costs. Either way, some businesses seek an alternative to traditional benefits they still want to offer an incentive to recruit and retain top executives. Perhaps this describes your business. You see that there are employees who are critical to your operation: a CFO, lead engineer, director of sales. Their efforts drive the success and, therefore, revenue of your company. To reward their performance and entice them to stay, you can give them phantom stock. You pay them a reward equal to the increase in value of your company over a given time period. Phantom stock is a way for you to share equity with employees without sharing the equity itself.
How do employees prosper?
Employees are paid based on the company’s performance, which is motivating because their hard work and contribution to the company’s success do not go unnoticed. They feel more tied in to the company and that what they do on a daily basis really matters. And it does. As the company grows, employees who are rewarded phantom stock make more money. This incentive is in addition to salary, health insurance and other fringe benefits, like automobiles. Phantom stock adds to the appeal of a recruitment package, and the promise of eventually earning phantom stock will encourage workers to stay on board. Shareholders also prosper because employee interests become aligned with their own.
Does phantom stock have certain limitations? Are there businesses that should not offer this incentive?
If you are considering selling or merging your business in a couple of years, you may rethink phantom stock. A potential buyer will see that you have promised to pay phantom stock, which is essentially tied-up cash. Limitations on phantom stock are mainly associated with administering the plan. Phantom stock must be carefully modeled by a professional who understands the program and the governing tax law, which includes Section 409(A) of the IRS code.
What steps are necessary before implementing a phantom stock program?
First, ask yourself why you want to implement a phantom stock program. If it’s because you want to share the economic value of the business and reward key managers for success and performance without diluting the value of the company, then you’re on the right track. Second, remember that these plans must only benefit a select group of management employees, otherwise it might make it an ERISA plan. Third, decide which key managers are performance-drivers whom do you consider critical to your future success? These should be your candidates.
Finally, you must determine the value of your business and quantify the financial impact of the company. Many business owners misjudge the value of their own businesses. At this point, enlist the aid of a tax and accounting consultant who is also well-versed in phantom stock and the tax law surrounding these programs. A program must be modeled so it complies with the Section 409(a) IRS code that governs phantom stock plans.
TYLER RIDGEWAY is director of the Human Capital Resources Group at Kreischer Miller, Horsham, Pa. Reach him at (215) 441-4600 or email@example.com.