Understanding Phantom Stock Agreement Templates: A Guide for Employers
What is a Phantom Stock Agreement?
Phantom stock agreement templates are one component of an executive compensation package that provides executives with potential value in lieu of (or in addition to) actual equity ownership of a company. Unlike actual stock ownership, phantom stock allows employers to provide executives with the exclusive right to receive cash or stock that is tied to the value or future appreciated value of the stock or other equity interest of the company.
Phantom stock is an idea where the company and its employees agree that the employee’s remuneration is partly tied to the value of the company’s stock. This phantom plan acts like an option because it allows the participants in the plan to buy into the plan at a later date at a pre-established price. Phantom stock enables the compensation committee or appropriate board of directors to promise stock or stock appreciation rights to executives at a future date, which will result in a payout if specific performance criteria or a change in control occurs.
Phantom stock option plans work like traditional stock options. An employee may elect to receive phantom stock options at a specific point in time in the future, usually at the time of termination of employment or termination of the phantom stock plan . The employee’s stock options are then based on the value of the underlying stock on the date he or she terminates employment or the phantom stock plan. The employee is then entitled to the stock, or to the value of the stock minus the grant date exercise price.
In order to align phantom stock values with actual stock values, phantom stock plans often include a formula for converting value into shares. For example, in the case of a stock or options grant, phantom stock could be paid out on a stock-for-stock basis at the time or following a change in control. This requirement to pay out stock on a stock for stock basis makes sense if the purpose of the phantom stock plan is to retain executives. Phantom stock makes little sense if the purpose of the phantom stock plan is to provide an incentive reward to the executives, in which case a bonus arrangement would be more appropriate.
In many circumstances deferred compensation is appropriate, and phantom stock plans directed at executives can be very tax-efficient. The employer’s deduction for phantom stock is reported on W-2s or 1099s, which eliminates the deduction timing problems. The phantom stock plan also provides the employer with flexibility under the Code Section 409A rules.
Advantages of Utilizing Phantom Stock Agreements
The use of phantom stock agreements can benefit both employers and employees. For employers, they represent an attractive, flexible way to attract and retain top employees without having to reward them with ownership in the company. If structured properly, phantom stock grants can also help align employee interests with the long-term goals of the business and build overall employee engagement.
Phantom stock plans can incentivize employees by giving them an ownership stake in the company while maintaining more control and flexibility than an actual stock plan. For instance, these plans allow employers to decide whether or not to grant phantom stock grants, as and when they see fit. Because phantom stock grants do not require any immediate payment from an employee, they are essentially "free" – until the employee exercises the option after a specified vesting period and is either paid the total difference between the phantom stock price and market price (at times referred to as "appreciation only") or reimbursed the full value of the stock (which is known as "full value"). As a result, these plans generally do not create immediate accounting liability for the company as do traditional stock option grants.
Another benefit of phantom stock grants is the fact that they can help an employer implement an incentive program to both retain employees and strengthen the link between employee performance and the company’s financial growth. Since phantom stock employees become both owners and employees, any increase in the value of the company stock is linked directly to the employee’s efforts. In addition, the vesting period can be extended over a substantial period of time (e.g., 10 years) instead of being five or more years.
Finally, because phantom stock agreements do not constitute an actual ownership interest in the employer company, phantom stock recipients do not have the right to vote on any matters relating to the company or to make any other claims against it. Overall, phantom stock agreements provide employers with a way to provide ownership-like benefits without giving away actual equity in the company.
Essential Elements of a Phantom Stock Agreement Template
A phantom stock agreement template is a document that outlines an agreement between an employer and employee related to a long-term incentive program. Other documents that are sometimes confused with its usage are stock bonus agreements and stock appreciation rights.
There are a few different ways to structure a phantom stock plan, including the following:
There are several important elements a phantom stock agreement template needs to include:
A vesting schedule – For a phantom stock plan to work effectively as a retention tool, the vesting schedule must be aligned with the objectives of the program. For example, if you want to reward a select group of employees, you may create a three-year vesting schedule with a minimum threshold based on the role. In this case, an employee may have a portion of their phantom stock vest at the end of an annual period. This vesting plan would be ideal for incentivizing management to stay in the same position for several years.
If the company’s goal is to retain the employment of all employees with an incentive plan, a vesting plan that vests quarterly, semi-annually or annually could work well.
Payout triggers – The most common payout triggers in a phantom stock plan are (1) termination of employment, (2) changes in corporate structure, and (3) a sale of the company. Payout triggers should be established in the phantom stock agreement template, so both the employer and employee understand how and when payments will be made.
Valuation methodology – Each phantom stock agreement should contain a valuation methodology that allows the company to determine how a phantom stock is valued. There are several approaches to business valuations that are used in phantom stock plans:
Phantom stocks primarily benefit the employer because the company receives the full value of the phantom stock without having to issue shares. The employer does not grant ownership of the underlying shares, which means outstanding phantom stocks do not affect the percentage of ownership a stockholder has.
Developing a Tailored Phantom Stock Agreement
Companies that wish to implement a phantom stock plan will often combine elements of the different types of phantom stock plans to come up with a hybrid version that suits their needs. Companies also have complete flexibility in drafting the plan, and should consider them like a menu of options that best suit their needs. Many companies choose the option of having an annual payout of a lump sum figure. In this case, the employer might choose a profit target amount and then repay 6%, 60% or 100% only of the compared amount after deducting phantom shares. The company can also choose to add deference, which would allow participants to earn more return on their investment by not receiving payouts for a period of time .
It is useful for employers to keep in mind that they are not restricted to using a standard whistle clock for the vesting periods. Vesting is, again, flexible to meet the needs of the company. Some companies use a cliff vesting schedule where a participant may not receive any payment if they have not fulfilled the necessary vesting time, while others use a gradual vesting schedule that gives participants the ability to receive payouts on a pro rata basis. There is flexibility in balance vesting as well, which allows participants to share in surplus profits but not deficit losses.
Before making the decision on which phantom stock arrangement to use, employers should talk to legal counsel or other advisors to ensure the arrangement complies with governing laws and meets applicable tax and accounting requirements.
Pitfalls to Avoid
Many "new" compensation plans start with the best intentions, but poorly drafted plans can lead to an array of headaches. Phantom Stock programs are no exception. Among the most common mistakes are:
- Failure to adequately address the issue of sufficient funds in the event of termination of employment. Phantom Stock is often payable, for example, only if the employer is sold. That leaves, however, an open question as to whether amounts are payable upon termination of employment. The failure to address this issue adequately can leave an employer vulnerable to claims by terminated employees.
- Failure to address tax. Phantom Stock is usually taxed as compensatory income to a participant. The employer should consider the tax cost of a Phantom Stock award. If the employee elects to defer taxation by rolling over the award, the employer should consider the administration and fiduciary costs to maintain the award.
- Failure to define compensation. Phantom Stock is intended to approximate the financial benefits of stock ownership. It fails, however, if the amount payable under the Plan is not tied to the company’s stock value. For example, a plan which gives an employee a phantom share after three months of employment and then pays him $500 at termination of employment could be considered a bonus, rather than phantom stock.
- Failure to include a forfeiture provision. This oversight can be extremely costly. In the absence of a forfeiture, the employer may be required to pay a phantom stock award after a participant has been terminated for cause.
- Failure to tie vesting to service. Phantom stock is typically longer-term incentive that is designed to keep employees with the employer for a period of years. For example, a phantom stock award may vest over a period of five years. In the absence of vesting, the employer will have a large cash payment due to a terminated employee.
Some of these issues are not easily resolved, and often require some compromise. A company, for instance, might feel strongly that phantom stock awards should not become vested if the employee is terminated for cause. In such a circumstance, a compromise could be reached by extending the vesting schedule (say, from 12 months to 18) as a trade-off for a limited forfeiture condition in the event of termination. The goal is to give both parties something that they want.
Effective Implementation of Phantom Stock Agreements
To effectively implement phantom stock agreements into a company’s compensation plan, employers must first address the following critical aspects:
• When and how to communicate the value of the phantom stock agreement to the employees.
• When and how to communicate the potential value of the phantom stock agreement to the employees.
• Methods for measuring performance for purposes of phantom stock vesting, and how to implement those methods.
• When to include valuations in the phantom stock agreement , and whether to include them in bonus checks.
• How to manage growth and terminations of employment under a phantom stock agreement.
• How to address change of control events in the phantom stock agreement, and payment of the phantom stock agreement after the occurrence of a change of control event.
• Tax treatment to the employer and to the employee under the phantom stock agreement.
• Cost/benefit analysis of different forms of phantom stock plans, including stock appreciation rights (SARs), preferred stock, phantom stock, stock options, and restricted stock.