Phantom Stock: Shedding Light on a Key Employee Retention Tool

It’s an ongoing challenge for many contractors and construction firm owners in virtually any phase of the business cycle – how to motivate and retain employees who are essential to the company’s success, yet without granting them an actual ownership stake.

True, during this prolonged economic downturn, any serious thinking by owners about long-term employee incentive programs has probably slipped to the bottom of the to-do list. But as the construction industry slowly climbs out of the doldrums, it may be time to think ahead.

Keeping this rare and valuable category of employees in the fold may require certain innovative incentives beyond the traditional 401k, health insurance and other typical perks. But at the same time, the business owner may not [yet] want to enter the “no-return zone” of ceding true ownership control.

One solution is the seemingly little known practice of issuing so-called “phantom” stock. As mysterious as it may sound, the technique has numerous and comforting benefits for both the employer and the key employee.

For owners, that list of benefits includes:

  • Less hassle to set up and monitor – unlike its more conventional brethren, the issuing of phantom stock is considered a non-qualified benefit. As such, it avoids much of the paperwork, restrictive rules and reporting requirements that are typical of traditional qualified benefit plans.
  • Complete control of plan terms – as a non-qualified arrangement, owners have total flexibility to determine how the plan contract is drawn up, which employees participate, when and how many shares are granted, terms of vesting, payout schedules and similar details.
  • Protects ownership control – since phantom shares come with none of the statutory shareholder rights under corporate law, the full authority for company decision making remains with the owner(s). Any rights of the “phantom shareholder” are limited to rights specifically stated in the phantom plan.
  • Spurs employee motivation and productivity –high-value workers now have more than just a job and a paycheck to keep them interested. They are in it for the long haul, especially if payout terms are tied to long-term company performance.

A Sense of Ownership, With Little Down-Side Risk

At its core, phantom stock is a highly effective compensation tool that allows key employees to enjoy a sense of “ownership” in the company – to share in its future success without necessarily sharing in the voting control, profits, dividends or distributions that normally come with the issuance of legal equity or stock options.

From the employee’s standpoint, the potential financial reward of participating in a well-designed phantom stock plan will closely mimic the payoff of actual equity or options: hence, the names “mirror stock” and “shadow stock” that are sometimes used to refer to these plans.

Yet many of the risks and liabilities that ordinarily come to executives and others with direct, legal equity ownership are avoided with this pseudo version of company stock. For instance, the employee isn’t required to infuse cash into the business, isn’t exposed for corporate governance issues, and isn’t required to personally guarantee company debt.

Here’s an example: Let’s say the business owner awards one of his high-value executives 5,000 shares of phantom stock. Rather than having actual equity value, the phantom shares mirror the value of real company stock at, say, $20 a share.

The phantom stock plan that the owner has devised beforehand typically spells out a customized formula or generally accepted method for valuing the shares at some point in the future, say three years down the road. When the time comes, the company schedules a valuation and determines that the owner’s stock is now worth $40 a share. The employee receives a payment of $200,000 – his or her reward for staying with the company and contributing to its growth.

When it comes time to reconcile the tax implications of the transaction above, the company benefits from a $20,000 tax deduction, and the employee declares the amount on his or her tax return as ordinary income.

Notice that the original grant of phantom stock by the company is not a taxable event; nor was the eventual receipt of the proceeds from the stock considered a capital gain on the employee’s tax return. These are two of the ways that phantom stock differ from actual equity and options, and are factors that need to be considered when contemplating the pros and cons of establishing a phantom stock plan.

The Story of Acme Construction

But in many respects, the benefits of this arrangement outweigh the drawbacks for both sides, which was the case for a company that, for the sake of the story, we’ll call Acme Construction, Inc.

The company, a family-owned and operated commercial construction firm, was enjoying years of steady growth and profit, thanks in part to two dedicated executives – its chief estimator and its lead project manager. Recognizing their value to the company’s success, the owners set up a phantom stock plan, and issued each executive phantom units equivalent to 5 percent of outstanding common stock as an incentive to stay with the company.

The vesting schedule was built around a combination of time periods of continued employment and certain economic milestones. The units would be re-purchased (i.e., the executives would receive their payouts) only in the case of certain triggering events – their eventual retirement at age 65, liquidation of the company, or the merger or sale of Acme Construction to another owner.

Sure enough, about six years later the company was approached by a national player in the commercial construction industry that was attracted by Acme’s track record and prospects for further growth. Buy/sell negotiations ensued, and within the year, Acme was sold.

As a result, the value of the owners’ original equity increased nearly three-fold. And because the value of the phantom units held by the two key executives mirrored the owner’s common stock, both benefited handsomely when one of the triggering events that had been planned for (the sale of the company) eventually came to pass.

A Unique Benefit at a Comparatively Modest Cost

To be sure, there are some administrative costs to establishing and maintaining a phantom stock plan –legal fees, accounting fees and periodic reviews to help determine the value of these pseudo shares. However, these costs compare favorably with those of a relatively inflexible ESOP or a qualified or nonqualified stock option plan.

Furthermore, the set-up and administrative expenses are no match for the price of losing just one of your key managers or executives. In fact, some experts estimate the cost of turnover at the senior level to be between 100 and 150 percent of the person’s annual salary.

Rather than face that type of financial burden, most business owners would agree – it’s far better to retain your top people with a thoughtful approach to compensation that truly benefits them and keeps them engaged, productive and happy.

For both the company and the key employee, the phantom stock “option” can truly be a win-win solution.

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