How does a company establish the price for phantom shares? The answer involves two variables: (a) the presumed value of the company, and (b) the number of shares to be used in the plan. Once these two answers are known, the phantom share price is calculated as the former (the value) divided by the latter (the number of shares).
The value of the company can be established by a variety of means, including:
- Stock exchange (for public companies)
- Third-party appraisal
- Book value
- Formula value (such as a multiple of earnings)
A public company would typically use the actual share price as determined by its listing exchange. Private companies usually use one of the other three approaches. As the Formula Value approach is most common, it is described below.
Most company owners have a sense for how their business would be valued by a willing buyer. Customarily, they have observed transactions within their industry and are aware of key indicators and multiples. For example, competitors may have sold to buyers for “6 times net income” or “5 times EBITDA” or “1 times revenue.” Such a formula may become the starting point for the discussion regarding the Formula Value. However, the company would not typically use the formula that might represent actual market conditions. Those conditions may change and it is possible the company may one day sell for less than what the assumed market multiple is today.
For these reasons, the possible market multiple value would usually be discounted. For example, if the assumed multiple value is “6 times net income,” for purposes of the plan Formula Value the company may use “5 times” or even “4 times.”
Further adjustments may be made to account for the level of long-term debt within the company. For example, the Formula Value could be expressed as “6 times net income minus long-term debt.”
Adjustments may be made for other elements as well (cash, net equity, etc.). The Formula Value should ultimately arrive at a value that can be easily calculated from the company’s financial statements and fairly represents underlying economic value.
Number of Shares
There are effectively two ways to handle the number of shares for the plan: (a) actual company share count (shares outstanding) or (b) hypothetical share count.
Some companies use their actual shares outstanding and “issue” new shares for the plan. For example, assume 1,000,000 outstanding shares in a given company. The shareholders might approve an additional 100,000 phantom shares. This results in a “value dilution” potential of 9.1% (100,000 ÷ 1,100,000). Should the company distribute all shares to employees, shareholders would be reducing their equity value of the company by 9.1% (assuming Full Value awards).
Using actual shares outstanding requires paying careful attention to internal share transactions. Redemptions of stocks or transactions between shareholders could alter the number of shares outstanding and affect the value of phantom shares even though these transactions are not related to employee performance. Ongoing adjustments can counter-act these events. Nonetheless, utilizing actual share count can lead to confusion and an unfair result for shareholders or plan participants.
An alternative approach is to use a hypothetical share count. This calls for the random selection of a number of shares to be used for the plan, such as 1,000,000 or 10,000,000. This method eliminates the need to track adjustments to the company’s actual share count. The number of shares to be allocated to employees simply becomes a fractional sub-set of the available hypothetical shares.
It is more important to track the percentage of value shared under a plan than it is to track the percentage of shares. This is because not all shares are commonly issued at the same time. A company may award annual shares for a number of years to a changing group of employees. The company should keep track of the dollar amounts owed and payable to employees and evaluate this amount relative to the increase in the company value since the date of plan inception. This is a better way to track value dilution than counting shares.