Phantom Equity Plans: A Flexible Alternative to Retain and Motivate Key Employees
Findings from a recent Gallup Workforce Panel show that a little over half of U.S. employees are currently watching the job market or actively looking for a job. (http://www.gallup.com/ businessjournal/186602/job-hopping-employees-looking.aspx) For employers these findings could represent a major challenge in the near future because employee attrition or loss creates considerable expense, which is magnified when high level or “key employees” resign. Key employee attrition can have a significant impact on both the short and long term success of a company. As such, in order protect against key employee attrition, employers must find ways to retain and motivate these employees to perform.
Fortunately, employers have a variety of options available to achieve the goals of motivating and retaining key employees. For example, companies can issue stock options to employees, provide employees with company shares, or provide other variable compensation awards. However, the specifics of the plan or package selected by the employer can have significant implications for the company, such as diluting the equity of the current owners, complicating the corporate governance of the enterprise, or even creating onerous tax burdens for both the employer and employee. As a result, an increasingly popular option for companies, in this situation, is to design plans that provide employees with phantom equity.
At its core, a phantom equity plan simply involves a company promising to pay an employee a bonus, at a particular time or upon the employee achieving a specified goal. The payment by the company can be either a cash payment or through the conversion of the phantom equity “shares” into actual stock. Phantom equity plans are not subject to many of the restrictions or risks that are inherent to the actual transfer of a company’s shares. As such, phantom equity plans provide a flexible alternative to equity ownership plans for employers. For instance, phantom equity plans eliminate the possibility of disputes over control in a company between the existing ownership and the new equity holders, which can result under traditional equity ownership compensation plans because in phantom equity plans the employees are not actually given any company shares and do not have any voting or consent rights. Similarly, phantom equity plans mitigate potential concerns among existing ownership about immediate dilution of their equity. Further, the legal and accounting costs of phantom equity plans are less than those associated with traditional equity ownership compensation plans. Finally, by implementing a phantom equity plan, an employer can avoid the need for employees to invest cash or experience immediate taxable income as a result of shares being issued.
Accordingly, a phantom equity plan can be used to mimic the benefits of providing real equity to key employees by contractually guaranteeing the employee a payout, either in cash or in shares, based on certain benchmarks being met or a certain amount of time passing, while minimizing the risks and costs associated with transfers of actual equity. The value of the payment is determined based on what type of plan the employer designs. Two common types are the “appreciation only” plan, which only pays the employee based on the increase in the business’s equity value over a period of time, or the “full value” plan, which pays the employee based upon the total value of a business’s shares at the time of pay out. Due to the nature of the payout for phantom equity plans, these plans can provide employers with a powerful retention tool because prior to vesting or to the employee meeting a specified benchmark, the phantom “shares” have no actual value and the employee will get nothing if he or she leaves the employer. In addition, the plans can provide a significant source of motivation for key employees to invest time and energy in order to benefit monetarily from any gain in the company’s value.
As can be seen, phantom equity plans provide a way for employers to motivate and retain key employees without having to immediately hand over either equity or cash. When designed correctly, these plans can meet the employer’s needs and simultaneously provide the incentives necessary to keep key employees from switching jobs or not investing time and energy into improving the company. However, if these plans are not designed correctly an employer can unintentionally create liability for the company or cause the employees to suffer significant tax repercussions. For example, phantom equity plans are generally not covered by the requirements of Employee Retirement Income and Security Act of 1974 (“ERISA”), but if the plan is designed incorrectly, then it could subject the company to considerable liabilities under ERISA. Similarly, if a plan is not properly structured to ensure it is not subject to the rules of Section 409A of the Internal Revenue Code, then an employer’s non-compliance with Section 409A can impose significant tax penalties on the employee (e.g., an additional 20% tax).
Based on the potential benefits, employers should consider phantom equity plans as a potential flexible alternative to traditional equity plans or other variable compensation awards to retain and motivate key employees. It is important for any employer considering implementing a phantom equity plan to consult with an attorney to ensure that the plan is properly designed to meet the employer’s goals and objectives while avoiding potential pitfalls.
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