Most business owners have immediate goals for generating a respectable income and long-term goals of retiring to a comfortable, secure lifestyle. To accomplish the latter, you’ll likely want to either sell the business or structure a buy-out from key employees. Whichever route you chose, building the value of the business can generate game-changing rewards when you reach retirement.
The good news is you don’t have to go it alone. Having one or more top employees who truly act as junior partners can help you grow your company’s value. Tests of an individual’s ability to play this role include demonstrated skills and dedication, as well as a willingness to swap some immediate financial gratification for the longer-term prospect of rewards linked to the growth of the business.
To this end, you may want to consider offering key employees “phantom” stock. In a nutshell, this is a form of compensation that gives employees access to stock ownership without actually owning the stock. Of course, just because you give an employee phantom stock (or actual stock) doesn’t mean he or she will magically start thinking like an owner. Candidates must act the part already. But once you have one or more key players who have proven themselves worthy, you may be able to devise a workable equity-based long-term compensation strategy that includes phantom stock.
Financial Disclosure Concern
Giving out actual corporate stock in a privately held company comes with serious challenges. For starters, even though the amount of stock would be too small for you to give up control of the company, you’d need to share all your financial information with minority shareholders. This might lead to difficult conversations about your compensation and that of any new shareholders. Plus, from an information security standpoint, you wouldn’t want key employees to leave your company and go to work for a competitor while still having access to your financial data.
Also, there can be tax issues. When an employee fully owns a stock, the value of that stock is fully taxable. (Often, stock grants are subject to vesting schedules, which delay the employee’s full entitlement to the stock.) The employee might need to have a lot of cash on hand, or borrowing capacity, to handle the resulting tax bill. And because privately held stock isn’t marketable, the employee would need some assurance that it can be sold one way or another to get any real value out of it (and possibly to pay any tax related to the stock).
Valuing Phantom Stock
Phantom stock eliminates most of those problems. It generates essentially the same financial rewards as regular stock, without the complications. The value of a phantom stock share is typically determined using a straightforward model based on company profits — the same model you would use to estimate the value of your actual stock.
Let’s suppose that formula is to value your company at a multiple of ten times earnings before interest, taxes, depreciation and amortization (EBITDA) for the most recent year. And say that EBITDA was $1 million. For phantom stock valuation purposes, the company would be worth $10 million.
Further suppose total shares of real stock outstanding is one million. That sets the value of a share of phantom stock at $10 — again, in principle, the same as the value of actual stock.
If the value of the company doubles over the next decade, so too would the value of the $10 phantom stock awarded to an employee.
Options on phantom stock, also called “equity appreciation rights” (EARs), operate on the same principle as regular stock options. The EAR is equal to the positive change in the market price of the underlying phantom stock over the time period when the EAR is redeemed. If the stock price went down instead of up, the EAR would have no value.
Phantom stock plans are governed by Section 409(a) of the Internal Revenue Code. If your plan is compliant, the employee isn’t taxed on the value of the phantom stock until it’s cashed in (though the employee might be subject to payroll taxes as it accumulates). Your company takes the tax deduction when it “buys” the phantom stock or redeems the options.
You have a lot of flexibility in how you design a phantom stock plan. You can decide not only how much of the stock to issue, but also under what conditions and over what period. You may also set a vesting schedule so the employee isn’t entitled to the stock until a certain period has elapsed — like the vesting schedule of a 401(k) plan. In addition, you can:
- Stipulate a condition that would lead to forfeiture of phantom equity rights, such as a key employee being terminated for cause,
- Set a date for the earliest time the employee can redeem vested phantom stock (for example, upon retiring at age 65 or older), and
- Decide to distribute the cash over a series of years, instead of all at once.
Ensuring you have enough cash on hand to deliver payouts when the time comes is critical to making a phantom stock plan work. This can be accomplished in various ways, including the use of corporate-owned life insurance. The accumulating cash value in such an insurance policy can provide some tax advantages, but there are pros and cons to all approaches.
Phantom stock and options are just one tool to help you build your company over the long haul, but it may be worthy of a place in your toolbox.