Stock Option Plans, Restricted Stock, Phantom Stock and
Other Incentive Plans
for Closely Held Businesses
Article #6 – Cash Plans, Phantom Stock Plans and Stock
This series of
articles explains how restricted stock, stock options, cash
plans and phantom stock really work for closely held
companies, and what their real value is for the company and
articles in the series are:
Where You Are in the Series
In this article
#6, I explain how you use cash plans, phantom stock plans
and stock appreciation rights.
To review, there
are two types of incentive plans: equity plans and cash
plans. I discussed equity plans in prior articles #2-5.
With an equity plan, you give employees stock options or
restricted stock. Equity means ownership, so with an equity
plan you give ownership in the company to the employees.
With cash plans,
you give money to the employee, not ownership. With a cash
plan you can give the employee similar economic benefits as
stock, but you don’t actually give stock. There is good and
bad in this – you avoid the hassles of employee /
shareholders, but you miss out on the psychological benefits
of employee / part-owners. For more on this topic, see
Article #2 - Equity Plans – Stock Options and Restricted
You can base the
amount of cash given on the company’s performance. You also
can give cash in a way that tracks the performance of the
company’s stock as with a phantom stock plan or stock
When Would You Use a Cash Plan?
Cash plans are
provides more incentive than stock. Your employees might
not be interested in a small ownership interest; some folks
just take cash, thank you.
want to give economic benefits that are not tied to stock
value, for example performance based bonuses for a division
or even an individual.
don’t want to dilute existing shareholders, for example, you
envision a big payoff when you sell the company and you
don’t want to share.
In cash plans, you
give cash almost like a bonus. You base the payment on some
performance milestone such as company earnings or increases
in the value of the company's stock. Most cash plans also
provide for lump sum payments at the sale of the company.
Hence you can give the employee (1) ongoing payouts based on
how the company is doing (like stock dividends and
distributions); and (2) a final payout at the sale of the
company (which is the ultimate payoff for shareholders).
These payments mimic very closely the economic benefits of
How to Structure the Cash Plan
cash plans run into problems here: Do you give a percentage
of actual net profits on the financial statements, or a
special pool of net profits set aside for employees?
Be very careful
when giving employees a direct percentage of the company’s
earnings or profit (say 1% of net profit as it appears on
the company’s financial statements). A percentage of
earnings or profits can never be diluted, which means you
are stuck with the grant so long as the employee stays
around. For example, the company may grow by 100 employees
and earnings might increase 20 times, and the original
employee will still be taking his 1% cut of earnings just
like before. But the pie has gotten a whole lot bigger,
which means he gets more than his fair share and he squeezes
other people out of their share.
The best way to
take growth into account is to set up the cash plan like a
stock option plan. It’s a little complex to explain, which
means a downside is that it will be hard to explain to your
employees. The basic idea is that the employee doesn’t get
a straight percentage of profits. Instead he gets something
called a “unit.” The unit applies to something I like to
call the “employee pool.” The employee pool gets the direct
percentage of net profits, say 25%. So the employee might
have 100 units in the pool, which would give him a share of
the 25%. Now, as you bring in more employees, you issue
more units. The effect is that you dilute the original
employee’s share in the 25%. This works like equity plans
where the employee / shareholder is diluted by new grants of
Phantom Stock Plans and Stock Appreciation Rights
rights and phantom stock are frequently used
interchangeably. I’ll call these types of plans “phantom
stock plans” for short. Phantom stock plans grant "units,"
which are treated like shares of company stock. The units
track the company’s stock, and increase or decrease in value
along with the stock (plus any dividends that your company
might pay). The units vest like stock options, and the
employee can convert vested units into cash. The units
usually vest after completion of a set number of years of
employment, upon a sale of the company or upon a public
offering of company stock. The employee forfeits the units
at termination of employment.
For small to
mid-size companies and startups, the real value of a phantom
stock plan will come at the sale of the company. At this
point, phantom stock plans act very similar to stock options
and restricted stock, because the employees receive a
payment from the sale of the business.
The downside to
phantom stock plans, however, is that your employees might
not be familiar with them. You have to explain the value of
the plan to your employees, and they might not understand or
hire a competent attorney to help with your cash plan,
phantom stock plan or stock appreciation rights. Plaintiff lawyers
who represent employees love to see an unclear compensation
package. Remember that bitter employees love to sue, and
their lawyers will take full advantage of any confusion that
may exist as to what you owe the employee. If you want
to read more try my page,
Business Lawyer. From there you can link to other
pages and articles of interest.
Call me to schedule a legal consultation: