Phantom stock: Use shadow equity plans to motivate, retain employees

Guest Commentary
Sunday, October 1, 2006

Good help is hard to find. Yet every successful security provider must hire and retain quality employees to deliver first-rate service. Access to business capital is another important ingredient in the overall success of a security provider, particularly given the upfront investment necessary to create recurring monthly revenue. Good help often costs employers real dollars in real time. No wonder closely held security providers can feel so pinched.
Here's a suggestion: A "shadow equity" or "phantom stock" plan can offer a closely held security provider an effective way to attract, retain and motivate key employees while preserving capital that might otherwise be used for employee compensation. In my experience, these plans can offer some real economic advantages and often aren't given sufficient consideration. The phantom stock is not actual equity but is tied to the value of your company's stock.
A plan is a form of deferred compensation. Properly structured, a plan provides key employees chosen to participate in the plan (participants) with significant monetary incentives while tying the participant's right to compensation to retirement or a liquidity event such as the sale of the company to a third party. (Shadow equity plans are non-qualified plans, which means the company can legally discriminate in favor of key employees.)
Participants are more likely to be tied to the company long-term by "golden handcuffs" since resignation or termination under the plan results in a complete forfeiture of any right to compensation.
Typically the plan works like this: A company establishes the plan by written agreement that outline all of the plan's necessary details. This includes determining which employees are eligible to participate in the plan and under what circumstances, setting vesting periods and the maximum number of units a participant can receive. The agreement also sets forth other details, such as how to value units and when participants receive compensation under the plan.
The agreement also establishes a committee to administer the plan. The committee is typically comprised of the company's owners and possibly designated management members. Thus, the committee, armed with a well-drafted agreement, should provide the company ample control over the plan.
A plan usually substitutes units for stock shares. These units are accumulated in an employee's memorandum account, which acts as a bank account for the employee's units.
The account is set up for a specific period, which may be tied to any number of events such as the employee's death, non-competitive resignation or retirement or may be linked to some liquidity event such as a sale of the company's assets to a third-party acquirer.
The value of the units in a plan typically shadow the value of the company's stock shares.
They also often issue phantom stock units to participants. As a result, participants often enjoy a sense of participation in the company's ownership based on ownership of the phantom stock units and because the value of issued units often corresponds to an increased value of the company's stock. Indeed, a good plan provides employees a positive sense of participation in the company's long-term success without forcing the company's owners to share the company with participants.
From the company's perspective, a plan should compensate participants for shareholder value created after the establishment of a plan.
For example, a plan may compensate participants for increases in the value of company stock or be tied to the payment of dividends.
Plans can also compensate participants for increased earnings, increased EBITDA or some other measurement. Ultimately, however, plans permit a great deal of latitude in creating a plan to suit a company's needs.
Perhaps most important issue is how the company will fund payments due under the plan, especially if a possible future payment obligation is not tied to a liquidity event. For example, the company may be required to make a large cash payment following an unexpected event such as an employee's death.
The company should prepare projections of potential awards to determine the impact of certain events on the company's future cash flows. For example, the impact upon the company of substantial payments can be mitigated through installment payments.
Accurate valuation of units is a technical, financial and legal issue that will require advice and guidance from your company's legal and accounting professionals.
Shadow equity plans can provide a real "win-win" situation for the security provider and its employees. Consider one for your company.