As the owner of a fast growing company, you’ve worked hard to attract some rock star talent to your rolls. While you offer super competitive salaries and world class benefits, it’s a good idea to look for other ways to retain the best of the best and keep your company moving forward. Lots of other companies offer equity stakes to top-tier employees, but you may not be totally comfortable giving up shares of ownership. Enter phantom stock plans!
Phantom stocks plans are a way to reward your best employees without offering controlling stake in your growing business. These plans can be a tool to help you drive growth whether your goal is to seek an exit or continue to build a profitable company. You want to increase the value of your business so that you can sell when your goals are met. When used as a bargaining chip in salary negotiations, or as an element of your employee bonus plan, these virtual stocks allow you to reward the commitment of your key employees, while attracting top talent to help you reach your goals.
In this article we will simplify the concept of phantom stocks, discuss the pros and cons, and share helpful insights so you understand how they can benefit your small business.
Getting Started with Phantom Stock Plans
What are phantom stock plans?
A phantom stock plan is a deferred compensation plan in which virtual shares mirror the value of company stock.
Phantom stock plans acknowledge the dedication of key employees who help drive growth, giving them many benefits of actual shares without controlling stake in your closely-held company.
What are the benefits of phantom stock?
Mock stocks that are not available to all employees protect your capital reserves.
Employees benefit without having to purchase stock, increasing motivation and loyalty.
Phantom units are forfeited if an employee leaves the business before their units vest.
What are the disadvantages of phantom stock plans?
Payouts are subject to payroll taxes, potentially affecting your company’s cash flow.
Plans that are not competitive enough may lead to loss of top candidates or employees.
Market downturns or other external factors may reduce the effectiveness of the plan as an incentive.
What are my next steps in devising phantom stock plans?
Be aware of the complexity of plan design, legal compliance, tax considerations, and industry-specific best practices.
Consult with professionals specializing in compensation, employee benefits, legal matters, and HR.
What is Phantom Stock?
Phantom stocks are virtual stock units that shadow the value of your company’s stock value. They are awarded to top employees and paid from a portion of company profits based on the number of phantom shares awarded. Your key employees are valuable in meeting the growth goals you’ve set for your business. Given their key positions, it’s important to retain them, along with their skills and expertise to help drive future growth.
When these goals have been met, the employees you’ve granted phantom stock to are then compensated for helping you get there with a profit share bonus.
When your company stock increases in value, so do phantom stocks. But keep in mind that the reverse is also true. When it’s time for your employees to cash out, the payout reflects the value increase from when the units were granted to when they vested. Some plans payout in cash while others are awarded in true stock.
You may be thinking that these sound similar to Restricted Stock Units (RSUs). While their aim to attract and retain talent is the same, there is a key difference. RSUs grant tangible ownership while phantom stock units offer a financial stake without voting rights or actual equity in the company.
Benefits of Phantom Stocks
Phantom stock plans appeal to employers for various reasons. They enable you to reward employees without transferring ownership, making them popular for closely-held corporations and some publicly traded firms. Like other stock options, these plans can increase employee motivation and loyalty, but employees benefit without shelling out cash to purchase stock.
As the owner of your business, offering phantom stock comes with a number of benefits:
- If an employee leaves the company before their units vest, the units are forfeited and you aren’t required to pay out.
- Employees have no voting rights, so you retain full control of your company’s direction.
- Invested employees tend to stay longer, allowing you to hold onto the people who help grow your company the most..
- Because you’re not shelling out actual cash to attract and retain talent, your company maintains capital reserves.
- Phantom stocks are not taxed until cash out, meaning there is even greater incentive for the employees to commit to your company.
Risks & Disadvantages of Phantom Stock Plans:
You guessed it, the decision to institute a phantom stock plan comes with potential risks requiring careful consideration. Understanding the risks associated with phantom stock is crucial for fostering a successful employee incentive program.
- Financial Liability: If the company’s stock value decreases, the business owner may still be obligated to pay out phantom stock units at their agreed-upon value. Additionally, large cash payments to employees are taxed as ordinary income, meaning they are subject to payroll taxes which can potentially affect your company’s cash flow.
- Employee Expectations: Misunderstandings or unmet expectations among employees can lead to dissatisfaction. Clear communication is crucial to ensure employees understand the terms and conditions of the phantom stock plan.
- Retention Challenges: The primary goal of most incentive plans is to retain key talent. If the phantom stock plan is not attractive enough, or if you have a difficult time demonstrating the potential value of your company, you may lose top candidates and employees.
- Market Volatility: If the value of the phantom stock is highly sensitive to market conditions, economic downturns or other external factors could reduce the effectiveness of the plan as an incentive.
The Bottom Line
Phantom stocks are a way to reward your best employees without offering controlling stake in your growing business. These phantom stocks do not come with voting rights or all the red tape of ownership, helping you to maintain your capital reserves. It’s important to remember that if your company is not doing well, or the plan you offer is otherwise limited or underwhelming, a phantom stock plan will not be attractive enough to attract or retain the talent you’re looking for.
Conclusion
For business owners eyeing phantom stock plans, consulting with professionals specializing in compensation, employee benefits, legal matters, and HR is highly recommended. These experts can provide insights into plan design, legal compliance, tax considerations, and industry-specific best practices.
At SK Wealth, our financial planners are dedicated to guiding business owners in making well-informed decisions around plans that attract and retain great employees and strategically planning for their financial future. Over the past 25 years, we have refined our financial planning process, The Integrated Phantom Stock Advantage™, to provide personalized recommendations that empower you to navigate the complexities of phantom stock ownership with intention, both now and in the future.
