Construction business owners are well aware that motivating and retaining their most experienced and productive employees is essential to their company’s bottom line. But smaller, privately-held businesses may find it difficult to compete for talent with larger firms that provide stock options or an employee stock ownership plan (ESOP). A potential alternative is to offer key employees phantom stock options, which can incentivize employees to stay with the firm and grow the business, but do not dilute the shares of the existing equity owners.
Phantom stock is a form of non-qualified deferred compensation in which the employer promises to pay the employee a bonus that is the equivalent of either the value of company shares or the increase in the value of those shares over a specified period of time. Broadly, the value of the phantom equity tracks the value of the underlying shares of company stock, LLC units, partnership interests, or other forms of equity. The value of the phantom stock can be established using a range of valuation methods, such as the book value divided by the number of shares, a multiple of company cash flow, or an outside valuation.
The employees selected to participate in the phantom equity plan sign an award agreement, which stipulates the number of phantom equity units awarded and any terms and conditions. Phantom shareholders vest, or become full owners of the phantom shares at a specified point in time in the future, such as in three to seven years, or upon a triggering event, such as after meeting certain benchmarks. For example, a manager may be awarded 1,000 phantom shares valued at $20 per share for a total award of $20,000 in the year shares are granted. After seven years, the value of those shares may have risen to $50 each, for a total appreciated award of $50,000.
When the vesting date arrives, employees are generally entitled to receive a cash payment in the amount of the value of their phantom equity units at that time, or, if the plan permits it, through the conversion of the phantom equity shares into actual stock. The payment can be disbursed in a lump sum, or in installments over a number of years.
From the perspective of the employee, being granted phantom rather than actual equity offers certain benefits. First, while phantom equity closely mirrors the payoff of actual equity or options, the employee receives cash rather than stock, which could have an uncertain future value. Moreover, the employee is not required to invest in the company, or to take on the risks and liabilities associated with being an actual shareholder. However, like any other cash bonus, the phantom stock bonus is taxed as ordinary income at the time it is received, rather than as a capital gain.
From the standpoint of the business owner, setting up a phantom equity plan has several advantages. Because a phantom equity plan is a non-qualified arrangement, the owner has total flexibility to choose the employees invited to participate, the number of shares granted, the vesting period, and the payout terms. In addition, employees forfeit the entire benefit if they leave the company prior to the vesting date.
It is, however, important to note that phantom equity is an unfunded liability, with future obligations generally paid out of the company’s operating income in the year the award is made. To ensure that sufficient funds are available to make payments under the plan when due, an employer may choose to put cash aside in a “rabbi” trust. Employers should also avoid offering the phantom equity to too many employees, as the plan might then be considered a de facto tax-qualified plan by the IRS, and could thus be subject to penalties.