The Phantom Stock Plan: A Carrot Without the Stock

By Mark Fischetti

The increasingly popular plans allow you to give your best people long-term incentives.

Diane Montoya knew she had to sweeten her offer. As chief executive of States Industries, a plywood maker in Eugene, Oregon, she had found a top candidateto become the firm's new vice president of finance. But a good salary and benefits wouldn't be enough. Other companies had expressed interest in Dave Lenington, too, and would be offering him stockoptions.

Montoya knew how difficult it was to find hired guns as skilled as Lenington. But like many owners offamily businesses, she would not spread shares beyond the family.

She found an attractive alternative in what is known as “phantom” stock. Increasingly popular among family businesses, phantom stock enables nonfamily managers to share in the growing value of the company without actually owning any real stock. Phantom it may be, but its benefits are real; by the time he retires, Lenington can make tens of thousands of extra dollars if the company continues on its present growth curve.


A phantom stock plan is a contract between a company and an employee.The company promises to pay the employee a sum equal to the rise in value of a hypothetical amount of company stock over a specified period of time.


Say, for example, that Montoya assigns Lenington 1,000 units of phantom stock in States Industries,valued at the time of issue at $30 per share (these are fictitious numbers). The price of Lenington's shares would track that of the real ones. In five years, Lenington would receive a cash payout equalto the increase in value of his phantom shares; if the stock was worth $50 a share, he would receive the difference—$20,000—for a job well done.

The beauty of the plan is that Lenington now has a personal stake in the company's growth, yet poses no threat to the family as a minority shareholder of real stock. And because the Internal RevenueService treats the payout as regular compensation, the company can deduct the cash award when it ispaid.

The challenge, though, is this: States Industries must come up with the cash to pay Lenington in five years. If it doesn't put money aside in a reserve fund each year or come up with another plan, it could face a serious cash flow problem when it's time for Lenington to collect.

The use of phantom stock is not widespread, but it is a growing, according to Les Fahey, a taxpartner with KPMG Peat Marwick in Portland, Oregon. Before going ahead with a plan, families should consider several questions.


Which employees should be included? Because phantom stock ismeant to be a long-term incentive, it should be used sparingly, and should be given only to the top few employees of a company, says Ross Nager, worldwide director of family wealth planning for Arthur Andersen. The IRS considers phantom stock arrangements to be “nonqualified” plans, and, therefore, nodiscrimination rules apply, Nager says. The chosen employees should be in a position to have ameaningful impact on the company's future growth.

Companies have devised various ways to tie performance to reward. If there are three major divisionsof a company, for example, the manager of each would receive stock according to the performance of hisor her division, instead of the overall performance of the company.


How many shares should be given? The number is up to the discretion of the business owner. Often, there is a vesting schedule. If an employee leaves before the end of four years, he gets no shares. If he stays at least that long, he may earn one-third of the shares each year for the next three years. Additional shares may be granted any time, perhaps upon promotion, or in lieu of a salary increase.

Many companies choose not to pay until the employee retires or leaves the company. A well-defined compensation package should have short-, medium-, and long-term provisions, Nager says. He suggests bonuses tied to concrete objectives for the short term, a salary and benefits plan for the mediumhaul, and phantom stock for the long run. Just the same, some companies are starting to pay on phantom stock every five years, so executives don't get frustrated waiting for the benefits.


How will the value of the shares bedetermined? The stock price often is based on the company's book value, or on a multiple of earnings. Families can rely on a valuation of the company made by an outside appraiser. A routine appraisal of a company worth $5 million might cost from $5,000 to$10,000, though, so families may want to have an initial appraisal done and then use the appraiser's formula themselves in future years.

The phantom stock contract makes the employee a general creditor of the company. Once vested, an employee is owed the money, even if he quits on hostile terms.


How will the business come up with the cash to make the payments? Most companies create a cash reserve and contribute to it at a rate commensurate with the increase in the stock's value. Funding for the reserve should bemade an annual budget item. If some of the payment is to occur at the employee's death, the company can take out life insurance to fund that portion of the claim. Also, if the plan is linked to retirement, the employee may take payment over several years, lessening the cash strain on thecompany.

Family business owners should consider other factors before adopting a phantom stock plan. Managers who are not included may feel slighted, and it should be made clear to them whether they'll ever have a shot at phantom stock, too.

If dividends are declared on real stock, owners should consider whether they want to make a cash awardto phantom stockholders as well. And though an employee would not incur any liability if the stock decreased in value, some provision might be made to counter a decrease, especially if the employee hadperformed well during that time.

“A phantom stock plan” says Les Fahey, “can be a powerful way to attract and keep the best people andmake them feel part of the company they work for.”

The Basic Plan

A typical phantom stock agreement containsthe following provisions:


  • Start and termination dates. When the shares are given (and how many), and whenthey will be redeemed, typically at retirement, death, or termination of employment.



  • Payout schedule. The intervals at which the stock will be reevaluated, and payment made.Often, firms set up a vesting schedule and make payments every five years.



  • Valuation. How the shares will be valued (usually based on book value or a multiple of earnings), and who will do it.



  • Designation of beneficiary. As in most fiduciary contracts, beneficiaries should benamed.


In addition, the contract should note that the phantom shares cannot be transferred to another party. And the contract should be made binding on anyone who might buy the company.


Mark Fischetti is the former managing editor of Family Business.

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Winter 1992

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