United States: Phantom Stock Plans - Sharing The Upside; Preserving Ownership Exclusivity

There was a time when business owners jealously protected the exclusivity of ownership of their enterprises. Consider sharing the pie with an investor: heresy; talk to him or her about providing key employees with a piece of the action: treason! Today, however, savvy business owners are finding that there is a shortage of top managerial and technical talent. Worse yet, that talent is being heavily recruited by their competition with stock options and an assortment of other golden handcuff vehicles.

Other than the cash component of an employee’s compensation package, frequently, the most important element to an employee is the opportunity to participate in the appreciation in the value of the employer. Since most large companies today offer some form of ‘up side" participation to their key employees, luring such a candidate away from his or her existing company or retaining existing key employees may require that businesses seriously consider what type of "value appreciation" opportunities to offer to key or prospective employees.

There are many ways to offer a key employee (either for retention or recruiting purposes) the opportunity to participate in the future appreciation of the employer. The most straightforward and obvious means to this end is the direct sale or grant of stock to such persons or through the granting of stock options or warrants. The consequences of issuing actual equity (even of the non-voting variety) can be significant, including the need to comply with Federal and State securities laws, tax and balance sheet implications to the issuing company, cash flow considerations to the employee buying the stock and the dilutive effect on existing shareholders. Moreover, some states impose a fiduciary obligation upon majority shareholders to treat their shareholders like partners.

An alternative to the issuance of equity is the use of quasi-equity inducements such as phantom stock and stock appreciation rights ("SARs"). Phantom stock and SARs are frequently referred to in an inter-changeable manner because, in essence, each is a form of "golden handcuff" rooted in the notion of a deferred bonus arrangement. However, phantom stock is typically distinguished from SARs by built - in characteristics that allow the phantom stock to be adjusted for changes that occur in the underlying stock (i.e., stock splits, the payment of dividends, etc.), whereas SARs are typically fixed without adjustments. Thus, SARs are frequently issued in tandem with stock options to provide an employee with a means of paying for the exercise of the stock option. Notwithstanding this distinction, the rights of the issuer and the employee under phantom stock and SARs plans are far from carved in stone and are limited only by and to the extent of the imagination of the drafter.

Phantom stock provides the recipient with the economic attributes of owning stock but not the tax advantages. The employee is treated as receiving ordinary income upon cashing in the performance stock and is taxed as such at the federal and state levels. The company is also required to make necessary withholdings from its payments to the employee when cashing out phantom stock. In contrast, had the employee obtained actual equity, he or she would be taxed at the capital gains rate upon the sale of that stock. The typical phantom stock option plan works as follows:

• The plan is based on Performance Units wherein one (1) Performance Unit is equal to the value of one (1) share of the company’s stock on a specific date, adjusted in accordance with a formula set forth in the plan.
• There is a clearly defined start date (usually the commencement of employment for a new executive) and one or more triggering events (i.e., termination of the employment, sale of the company, implementation of an initial public offering, etc.). The employee is entitled to receive an amount equal to the increase in value of the Performance Units, if any, between the two events, subject to vesting rights.
• The plan clearly sets forth vesting rights that the employee has to meet in order to have the right to receive all or a part of the increased value of the Performance Units.
• The company maintains an "account" for each employee entitled to participate in the plan, wherein book-keeping entries are made to keep track of the award of additional Performance Units. Typically, the employee will be awarded additional Performance Units as he or she meets specified vesting targets (that are either performance and/or time based) up to a stated maximum amount. Additional Performance Units may be awarded to the employee as a performance bonus. As discussed above, appropriate adjustments are made in the employee's account to reflect changes made in the underlying stock (i.e., the payment of dividends, stock splits, etc.).
• When a triggering event occurs, the Performance Units are valued and cashed in. The company is then obligated to pay the employee the increased value of the Performance Units. Typically these payments are made in cash. However, the company may provide that it reserves the right (or give to the employee the option to take) payment in a combination of cash or actual stock if the company has gone public. Moreover, the company can provide that its cash payment be paid to the employee over an extended period of time, thus lessening the cash drain on the company.

Phantom stock plans can be customized to fit a single employee or apply to all or a designated group of employees. Under a typical plan, the value of the Performance Units is set by the company on an annual basis, perhaps utilizing an independent appraiser. Phantom stock awarded to an employee would vest at a rate of 20% for each year that the employee is employed after the units are credited to the employee's account. The payout to the employee on the cashing out of the phantom stock can be stretched, at the option of the company, over years, thereby reducing any drag on earnings and cash flow.

Phantom stock plans have to be carefully crafted so as not to alter the employee-at-will designation of the employees who are not otherwise under a written employment contract. The implementation of the plan, however, can be used to provide a non-competition covenant for existing employees who may not have been required to sign such a pledge at the beginning of their employment. For companies that failed to obtain non-compete agreements from key employees who otherwise are at-will employees, the implementation of a phantom stock plan may have the added benefit correcting this omission.