Diane Montoya knew she had to sweeten her offer. Aschief executive of States Industries, a plywood maker in Eugene, Oregon, she had found a top candidateto become the firms new vice president of finance. But a good salary and benefits wouldnt 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 amongfamily businesses, phantom stock enables nonfamily managers to share in the growing value of thecompany without actually owning any real stock. Phantom it may be, but its benefits are real; by thetime he retires, Lenington can make tens of thousands of extra dollars if the company continues on itspresent 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 ofcompany 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 Leningtonsshares 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 receivethe difference$20,000for a job well done.
The beauty of the plan is that Lenington now has a personal stake in the companys growth, yet posesno 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 fiveyears. If it doesnt put money aside in a reserve fund each year or come up with another plan, itcould face a serious cash flow problem when its 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 shouldconsider 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 topfew employees of a company, says Ross Nager, worldwide director of family wealth planning for ArthurAndersen. 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 companys 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 avesting schedule. If an employee leaves before the end of four years, he gets no shares. If he staysat least that long, he may earn one-third of the shares each year for the next three years. Additionalshares 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-definedcompensation package should have short-, medium-, and long-term provisions, Nager says. He suggestsbonuses 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 phantomstock every five years, so executives dont get frustrated waiting for the benefits.
How will the value of the shares bedetermined? The stock price often is based on the company's bookvalue, or on a multiple of earnings. Families can rely on a valuation of the company made by anoutside 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 appraisersformula themselves in future years.
The phantom stock contract makes the employee a general creditor of the company. Once vested, anemployee is owed the money, even if he quits on hostile terms.
How will the business come up with the cash to make thepayments? Most companies create a cash reserve and contribute toit at a rate commensurate with the increase in the stocks value. Funding for the reserve should bemade an annual budget item. If some of the payment is to occur at the employees death, the companycan take out life insurance to fund that portion of the claim. Also, if the plan is linked toretirement, 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. Managerswho are not included may feel slighted, and it should be made clear to them whether theyll ever havea 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 stockdecreased 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.
A typical phantom stock agreement containsthe following provisions:
In addition, the contract should note that the phantom shares cannot be transferred to anotherparty. And the contract should be made binding on anyone who might buy the company.
Mark Fischetti is the former managing editor of Family Business.