Stock Option Plans, Restricted Stock, Phantom Stock and Other Incentive Plans for Closely Held Businesses
Article #6 – Cash Plans, Phantom Stock Plans and Stock Appreciation Rights
This series of articles explains how restricted stock, stock options, cash plans and phantom stock work for closely held companies, and what their value is for the company and the employee.
The articles in the series are:
2. Equity Plans – Stock Options and Restricted Stock
3. Stock Option Plans
4. Restricted Stock Plans
5. Company Buy-Back and Repurchase of Stock Options and Restricted Stock
6. Cash Plans, Phantom Stock Plans and Stock Appreciation Rights ◄You are here
7. Summary and Plan of Action
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 Stock.
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 appreciation rights.
When Would You Use a Cash Plan?
Cash plans are useful when:
*** Cash provides more incentive than stock. Your employees might not be interested in a small ownership interest; some folks just take cash, thank you.
*** 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.
*** You 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 stock.
How to Structure the Cash Plan
Most home-made 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 stock.
Phantom Stock Plans and Stock Appreciation Rights
Stock appreciation 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 care.
You should 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.