Phantom Stock Options
Business owners know it’s a challenge to recruit and keep talented employees. Your compensation and benefits package is a key retention tool. How do you make your benefits attractive without jeopardizing the financial success of your business?
Large companies have the advantage of offering employees stock options, but these may not be practical for startups and smaller businesses. A “phantom stock” plan---also called “shadow stock”--is a way to give employees the benefits of stock options without the actual stock.
Stock Paid as Cash Bonuses
Despite the name, there’s nothing spooky about phantom stock. It’s a perfectly legitimate form of deferred compensation. Each employee who participates in the plan is granted a certain number of stock units. Each unit reflects a percentage of the total value of the company. (A share of phantom stock would have the same value as a share of the company's common stock.) On maturity, the employee is paid a cash bonus based on how much the stock--and the value of the company--grows.
If structured properly, there are no tax consequences to either the company or employee when a phantom stock unit is granted. The employee gets nothing from the phantom stock account for a predetermined number of years. To promote retention of employees, it’s best to set phantom stock awards according to a vesting schedule.
Phantom stock option plans are “nonqualified” plans, which means that when the cash bonus is awarded, the employee reports it on his or her tax return. At the same time the company gets a tax deduction based on the amount the employee must recognize as income. So if t he stock was valued at $3 per share when the options were granted and is $8 per share when the bonus is paid, the employee must pay income tax on the gain of $5 per share.
Like Owning Stock, Without Actual Stock Transfer
A benefit of phantom stock is that it doesn’t dilute the ownership rights of existing shareholders. It’s helpful when companies are unable or unwilling to alter their ownership structure but want to give employees incentive compensation tied to how long they stay with the company and how well the business performs. Phantom stock gives employees the economic benefits of owning stock without any actual transfer of stock.
However, because phantom stock benefits are generally paid out in cash, they can pose a cash drain on the company. Another drawback is the financial accounting required. The value of phantom stock must be expensed on the books at the time it is credited and must be adjusted at least annually to reflect the change in its value. To determine the value of phantom stock units, you must appraise the equity of your company.
A Good Valuation Is Essential
Determining what your company is worth is essential when setting up phantom stock plans and making other financial arrangements. Owners often think they know their company’s value, but in reality they may be shockingly misinformed. For example, SPARDATA, a leading national business appraisal firm, surveyed 2,000 business owners in 2001 and found that most misjudged the value of their businesses by 50% or more—sometimes by millions of dollars. So be sure your business is properly appraised before implementing any financial plan.
