A Piece of the Action: Phantom Stock

By Russell S. Holdstein     Add your comments

Is there another way to encourage and compensate employees besides giving up a piece of the company? Here’s what our “growth guru” Russ has to say.

In the Internet world it’s a given. You work hard, you work for lower wages and you expect to get rich when your company goes public. It seems like everybody’s got stock options these days.

Fact is, most businesses are not going public. If you’re not a dot.com how can you compete to attract and retain good people? How can you get your people to work harder and commit to the company’s future especially if you don’t feel comfortable giving up your 100% ownership?

There are clear drawbacks to giving employees equity (or options) in your company. Having minority owners means you are obligated to provide them an accounting of your finances. Having minority owners also means they might exercise their legal rights in ways that could become a real headache for you. But if you don’t give your employees a piece of the action, you lose one of the most powerful motivational tools you have. There is nothing that energizes and involves your people more than the opportunity to make a pile of money.

The good news it that you can have the best of both worlds. You can cut your people in and still keep them out of your private affairs. It’s a technique called phantom stock and it works. I used it at the company I owned and I’ve helped others set up similar programs in their companies.

Phantom stock plans can be basic and straightforward or they can be as complex as you wish. The basic plans look a lot like the stock options the dot.coms are giving out. They reward employees for the increase in the value of the company from the day the plan begins until the day the company is sold. These plans reward employees for the increase in company value that they helped to create.

The plans work something like this. A value is placed on the business as of today. Participating employees are awarded participation shares that represent a fractional portion of this total value. Several years later, when the business is sold, the employees receive the difference between what the participation shares were worth when the program began and what they are worth when the business is sold.

For example, say you determine (by formula or by appraisal) that your company is worth $1 million today. You award your vice presidents phantom “shares” of 1% each. That establishes the base valuation at 1% x $1,000,000 or $10,000. Five years later you sell the business for $5 million. Their participation shares valuation is now $50,000 (5% x $5,000,000). Each participant receives $40,000, the increase in the value of the shares over the five year period ($50,000 – $10,000 = $40,000).

These “shares” do not confer any of the rights of ownership that come with options or actual stock ownership. If you prefer, you can structure them so that they vest over a period of years. You can set them up so that when an employee leaves the company, they forfeit their participation shares. Or you can structure them so you can pay off a departing employee for the value of their shares over several years.

The key in establishing a phantom stock plan that works is educating the participating employees. Unless they clearly understand the value of the plan, you’ll be giving up something with high potential for nothing in return. You need to show your people how they will benefit from the plan, and you have to keep reminding them about it regularly. Be sure to set up initial training meetings, then follow up regularly. Graphing the value of their shares as they grow is a great way for people to see just how much they’re making.

Check with your lawyer before you make any commitments. Quiz your lawyer to be sure he is familiar with phantom stock plans. If not, find an attorney who has the direct, personal experience to give you the advice you need to do this right.

You can compete with the dot.coms, you can engage your people in the success of your business and you can retain full ownership of your company. Construct your phantom stock plan carefully, educate and excite your employees about the plan and you’ll find a new level of commitment and excitement in your business.

© 2008 Russell S. Holdstein All rights reserved.

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