Phantom Stock Case Studies

Here’s a question I get asked quite a bit from business owners who are looking forward to their business succession: “Can I use phantom stock as a way to facilitate my transition out of the business?”

Their intuition is pretty good. Phantom stock and other forms of deferred compensation can be part of the toolkit you should consider—especially if your exit plan might include a sale to existing employees. Here’s how an internal sale usually happens.

Here’s a headline that states unequivocally that SAP (the huge business software company located in Germany) saw a drop in profits for 2012 because of its Phantom Stock plan. The article points out that sales rose by 14% but the Plan resulted in a charge to profits of 512 million Euros (combined with other executive pay). The implication of the article is that shareholders were damaged and profits were hurt because of the Phantom Stock plan.

Here’s my take: a good example of a writer failing to dig deeper to see what may have really happened. Note that I don’t have all the details on the Plan. And I’m also not an expert on German accounting rules. Neither of these is going to stop me from guessing about what is not being said.

Ok, I borrowed part of the title from this great article in last week's Wall Street Journal . It’s by Jeff Ubben, head of an activist investment fund. His main point? Corporate America pays its executives to be too cautious. Why? They orient their pay packages to short-term performance factors and they've moved away from stock options in favor of restricted stock units. Executives, endowed with this short-term perspective, become less concerned with growing actual market value.

To me, this means that private companies are in a better position to pay their executives than their public peers. By “better” I don’t necessarily mean “more.” (Although that could result as well.) “Better” to me means “more aligned;" i.e., better for bjoth the shareholders and for the employees.

As I wrote last time, a phantom stock plan should not be implemented if the goal is to improve employee motivation. Then why do it?

You might be surprised by my answer.

We’re always measuring costs. What’s the cost of that new piece of equipment? What will that new addition to our marketing plan cost? What’s the cost of that change in our product line?

I often have prospects ask: “What’s the cost of a phantom stock plan?”

You don’t—at least not in the traditional way.

With a regular stock option the employee is given a window of time to exercise—and it’s totally in his control. For example, he may have to wait three years or so (the vesting period) before he can exercise his options. And there will probably be an expiration date as well (commonly 10 years). Any time between the 3 years and 10 years he can voluntarily choose to exercise.

In a word, “yes.” Stock Appreciation Rights is a term that’s been around for a long-time, and is still in common usage.

SARs were formed decades ago in public companies as a way of providing cash to employees to be used to exercise their stock options. If the exercise cost of a block of options was to be $20,000, SARs were issued at the same time as the options to give the employee $20,000 in cash so that he or she could exercise. Of course, the cash from the SARs was taxable so sometimes the SARs value was “grossed up.”

Here’s a term that can carry multiple meanings: Deferred Stock Unit or DSU.

Some use it to refer to a plan that issues units which can be converted to actual stock in the future—sort of like restricted stock units. There’s no reason you can’t use this term for that type of plan, but I think it’s inaccurate. A DSU, in the traditional sense, is a combination of deferred compensation and full value phantom shares.

Although it’s possible, it’s difficult to avoid two significant pieces of federal legislation when adopting a phantom stock plan.

The first is ERISA—the 1974 pension law that looks upon every long-term deferred cash commitment as a retirement plan. To meet ERISA requirements, you’ll probably have to have your plan limited to a “select group of highly compensated employees” (what’s come to be known as a “top hat” group). ERISA will also require a document that includes certain specific language. The key for ERISA compliance is a plan that’s drafted carefully and administered properly.

One of the main questions business owners have about issuing phantom shares to employees is, “How do I determine the right number of shares to award to employees?”

Another way of saying this: “How do I give shares that are earned or justified in light of the contribution of the employees?” Owners don’t want to over-award. They’re pleased to award value that’s earned, but they don’t want to be locked into a situation that they later regret.

Selecting the right participants for a phantom stock plan can be tricky. We’ve looked at legal issues, impact considerations, and financial capacity. There’s one more: TALENT EXPECTATIONS

The final factor to consider when determining eligibility is the urgency associated with presenting a total compensation package that enables the company to attract the caliber of leadership needed to grow at the desired level. Certain levels of professional talent will expect their employer to offer meaningful wealth accumulation opportunities. Public companies are expected to provide equity or phantom equity packages as part of their overall rewards program. Private companies often compete with public companies or other successful private firms for talent.

So we’ve examined two things to consider when selecting participants for your phantom stock plan: (1) legal considerations and (2) impact issues. Today we’ll look at #3: CAPACITY.

As a company begins to analyze the amount of economic value available to be shared under the phantom stock plan it will need to forecast what that total value may represent to the participant group. This would be done by estimating or averaging that value across the potential pool of participants. Then the company decision makers can evaluate the potential value relative to the number of participants. They may discover that the opportunity appears too low (due to too many participants) or that they have room to expand the group.

Last time we looked at the legal issues to consider before selecting your plan participants. Today we’ll look at what I call the IMPACT ISSUES.

A phantom stock plan is intended to reward employees for long-term value creation. Sponsoring companies should determine which members of the organization are expected to be accountable for the creation of that value. Typically, company owners or directors will examine the levels of leadership in the company and discuss which employees will be essential to the fulfillment of the long-term business plan.

This is one of the most important decisions to be made when instituting a new phantom stock plan. There are four things to consider. Today I’ll outline the first (and most technical) issue. Let’s get the LEGAL CONSIDERATIONS out of the way first.

Commonly, phantom stock plans fall into the category of “nonqualified deferred compensation” programs. This term reflects a type of retirement plan referred to in the Employee Retirement Income Security Act of 1974 (ERISA). As a NQDC plan, a phantom stock program may be exempt from most of the formal retirement plan rules outlined in ERISA and subsequent related legislation. Consequently, the sponsoring company can select and utilize flexible vesting schedules, payout terms and grant levels without concern for government rules, minimums, annual tests and reports.