What Works: Dishing It Out

The benefits of phantom stock

In the mid-1980s, Beck Building was a scrappy $10 million construction business in Avon, Colo. The construction industry is fiercely competitive, and CEO Andy Beck knew he needed to do something more than pay good salaries to hang on to his top managers. So he created a phantom stock program, an incentive plan that distributes shares to selected employees without actually granting them equity. Beck gave five managers phantom shares that together totaled 5% of the company. "It encourages my employees to stay engaged and start thinking like owners," says Beck. The shares are now worth about 35% of the 50-employee, $50 million business.

Phantom stock programs are particularly good for startups short on cash and entrepreneurs who don't want to cede control. The shares confer no voting rights and cost a company nothing until the employees cash them. Employers take a payroll tax deduction when the shares are converted to cash, and employees owe income tax on the payout. The plans can be structured in a variety of ways to suit the goals of the company, with, for example, employees receiving compensation based on a vesting schedule, when they retire, or when the company is sold.

Setting up a program takes some effort. Your first move is to determine who should receive the stock, says John Brown, president and founder of Business Enterprise Institute, an exit-planning organization for small businesses in Golden, Colo. He suggests giving shares to no more than 10% of employees, and keep in mind that the IRS stipulates that the employees must have sufficient sophistication to understand how the plan works.

You'll need to get a professional valuation of your company, which in turn will determine the price of each share. "Small business owners tend to have an inflated value of their company in their minds," says David Wasserstrum, partner and head of the executive compensation and employee benefits practice at Weiser LLP in New York. The IRS considers phantom stock programs nonqualified deferred compensation plans, and there is a 20% penalty plus any taxes due if the price of the stock is lower than the fair market value at the time it was issued.

Finally, you'll have to decide whether you want shares to vest at once or over time. A typical schedule would be to have 10% of shares vest each year of a 10-year period, says Brown. Andy Beck set up a five-year vesting schedule. One of his managers cashed out at retirement; another did so when he left the company. The remaining three managers with phantom shares are planning to convert them into real shares to purchase the company from Beck when he retires.

Mike Erinakes is pleased with the plan he set up in 2005. The CEO of U.S. Underwater Services awarded phantom shares to 15 of his 40 employees. When he sold his Burleson (Tex.) company to a public firm last summer, the value of the phantom stock doubled to about $1.3 million, about 10% of the value of his company. The employees' shares were converted to real stock in the new company. And all 15 employees are still with the company. Says Erinakes: "This tool does not cost you anything, but keeps your employees motivated and allows you to hold on to them longer."

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