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Phantom Stock Plans - Pros and Cons for Business Owners

 

As your business grows, it becomes increasingly important to structure compensation plans that attract, retain and incentivize key executives. One approach that is growing in popularity is the use of phantom stock plans. 

Phantom stock plans provide cash bonuses to executives that are tied to the value of company shares, without actually granting real ownership in the company. The executive is awarded a certain number of hypothetical "phantom" shares which they can redeem for cash payouts based on the determined value of the shares. This allows them to financially benefit as if they held equity, providing incentive to increase the company's value. 

Phantom stock plans can be an attractive middle ground between salaries and ownership through stock options. By reviewing the pros and cons, business owners can determine if this type of executive compensation structure makes sense for their organization.

In this article, we’ll explore the potential key benefits and drawbacks of phantom stocks as an executive incentive program. Understanding these dynamics is crucial for designing a phantom stock plan that attracts, retains and rewards leadership talent appropriately. 

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Table of Contents: 


Pros of Phantom Stock Plans 

Align executives' interests with shareholders' interests 

One major advantage of phantom stock is better aligning executives with the interests of shareholders. Since payouts are tied to share value, executives are incentivized to make decisions that will increase the company's market value.

This discourages excessive risk-taking or prioritizing short-term gains over long-term growth. Executives become focused on building fundamental value rather than quick fixes to boost stock prices temporarily.

Reward executives for increasing shareholder value

Similarly, phantom stock rewards executives when they boost tangible value for shareholders. Metrics like revenue, profitability and market share growth directly translate to share price appreciation.

Phantom stock payouts will increase accordingly, promoting strategies, investments and initiatives that drive growth and returns for investors. Executives are compensated for making the company more valuable.

Flexible vesting schedules possible 

Phantom stock plans allow flexibility in vesting schedules not seen with stock options. While options often vest over 3-5 years, phantom stock can vest incrementally each year, monthly, or based on achieving milestones. This allows companies to tailor the timetable to meet retention goals.

Shorter vesting means payouts come sooner, while longer vesting requires loyalty over time. Vesting can also be performance-based, only earned by hitting target metrics.

No dilution of company ownership like real stock options

A key benefit for private companies is phantom stock does not dilute ownership like real equity compensation. There are no new shareholders or board members.

Founders maintain full control and ownership of their company while still using phantom stock for incentives. This avoids struggles down the road if a large portion of equity goes to employees.

Can be less costly than stock options for private companies

For private firms, implementing and managing real stock options can be expensive. There are legal, accounting and valuation costs tied to granting private company stock. Phantom stock plans avoid most of these costs.

There is more flexibility in setting internal valuation methods versus determining fair market value for options. Overall, phantom stock removes complexity and costs for private companies. 

Cons of Phantom Stock Plans

No ownership rights for executives like real stock options 

The main drawback of phantom stock is that it does not grant actual ownership or equity. Executives do not obtain voting rights, dividend payments, or other shareholder benefits.

While they are rewarded for increasing share price, they do not gain the rights and control true shareholders have. For some executives, actual equity and ownership may be preferable.

Requires setting valuation methods which can be complex

Phantom stock plans require companies to establish valuation methodologies, which can be complicated, especially for private firms. Common approaches include independent 409A appraisals, book value formulas, discounted cash flow models and more.

Companies must determine an accurate, justifiable valuation method aligned with phantom stock incentives. This may require financial modeling expertise.

Harder to understand and quantify value than real stock

Since phantom stock does not represent actual shares, the value can be more difficult to quantify and track. Executives may have a hard time understanding the realizable value of their phantom shares compared to exchange-traded stock options. Communicating the purpose and value of phantom stock takes effort and financial literacy.

Need careful plan design to achieve retention goals

If vesting schedules or payouts are too fast, phantom stock loses retention power. Executives may cash out quickly then leave the company.

Vesting should balance driving performance with requiring loyalty over time. Poor plan design can lead to quick payouts without long-term retention.

Risk of overpaying executives if valuations inaccurate

Inaccurate or inflated phantom stock valuations can overpay executives not aligned with true value creation. If valuation methods are flawed, phantom stock costs may exceed appropriate compensation.

Private companies in particular must ensure internal valuations match reality. Otherwise, substantial phantom stock grants could divert too much capital. 

Key Considerations for Phantom Stock Plans

What valuation method makes sense for your company?

Example: Book value, market value, or investor value

Choosing an appropriate valuation method is crucial for phantom stock plans. Private companies often use book value formulas based on assets and liabilities. This provides a measurable valuation tied to financial statements.

Some establish valuations based on periodic fair market value assessments or 409A independent appraisals. Others may use discounted cash flow models to determine present value. Valuations based on recent funding rounds or investor interest also align with value creation. 

What vesting schedule meets retention goals but isn't too fast or slow? 

The vesting schedule requires balancing incentive goals with retention needs. Short 1-2 year vesting provides quick rewards but less retention power. Long 5-10 year vesting promotes loyalty but delays meaningful compensation.

Hybrid approaches like annual vesting over 4-5 years or milestone-based vesting can provide a middle ground. The schedule can also combine time-based and performance-based vesting for well-rounded incentives.

What performance metrics will grants be based on?

Example: EPS growth, revenue growth, etc.

Tying phantom stock grants to performance metrics like revenue, profitability, EPS or other goals allows payouts to be earned, not just given with time. Metrics like revenue growth rate over X% or EBITDA over $Y annually can be defined.

Grants can increase when stretch performance is achieved. This enhances the pay-for-performance element of phantom stock programs.

How will grants be calculated? As a multiple of salary or other formula?

Typically grants are calculated as a multiple of base salary, such as 1x or 0.5x salary converted to phantom shares. This provides a clear formula for determining grant sizes.

Some plans base it on a percentage of cash bonus or a fixed phantom share award not tied to salary. Having a consistent methodology promotes transparency and alignment across the executive team.

Are Phantom Stock Plans a Good Fit for your Business? Your Next Steps

For leadership teams motivated by value creation over just compensation alone, phantom stock is an intriguing option.

Structuring an effective phantom stock plan requires expertise in executive compensation, financial modeling, valuation methods, legal considerations and more. Business owners should partner with specialist firms versed in phantom stock plan design to develop programs tailored to their executive talent and company goals.

With the right plan, phantom stock can help attract, retain and reward leadership while aligning them with the shareholder experience.

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