Transcript Expanding the Phantom Stock Concept
Expanding the Phantom Stock Concept
American Compensation Association 4 May 1999 Fred E. Whittlesey Principal
Compensation and Performance Management, Inc.
www.cpmnet.com
© Compensation and Performance Management, Inc. All rights reserved.
Today’s Discussion
What is phantom stock?
Why is it used as a form of compensation?
Why consider phantom stock as a compensation tool?
Viewing phantom stock through a strategic compensation model New opportunities for phantom stock
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What is Phantom Stock?
Performance-based compensation program Contingent right to share increases in value Unsecured promise to pay Multi-year performance period Usually settled in cash Typically reflects underlying actual stock value
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How is Phantom Stock Different From Stock Plans?
No investment by employee No stock certificates issued No legal equity ownership No voting rights exist Dividend equivalents rarely provided Accounting and tax treatment differ significantly
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Typical Phantom Plan Operation
Value formula determined Target compensation level established Phantom shares/units awarded at beginning of period Initial value zero (appreciation plan) or estimated FMV (value plan) Payment at end of fixed performance period
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Traditional Plan Design: Performance Measurement
Actual equity value Market value Private transactions Estimated equity value Formal appraisal Formula Determinants of equity value Revenue growth Profit Return Drivers of equity value Unit volume Customer base Cycle time
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Traditional Plan Design: Performance Periods
Typically 3 to 7 years May be event-triggered May be tied to product cycle Typically multiple cycles End-to-end Overlapping May be multiple cycles based on differing criteria
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Illustration of Phantom Stock Performance Cycles
Single Cycle Sequential Cycles Overlapping Cycles
Year 1 Year 2 Year 3 Year 4 Year 5
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Year 6
Traditional Plan Design: Vesting and Exercisability
Usually time-based vesting Incremental vesting Cliff vesting May be performance-accelerated May be event-triggered Primarily end-of-cycle payouts Lump-sum Stream of payments
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Factors Driving the Rise of Phantom Stock Popularity
More private companies Bull market pressures Capital accumulation needs Limits on qualified plans creating reverse discrimination Increased pressure to “align with shareholder value” Changes in securities regulations More complex equity structures
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Phantom Stock Synonyms: Traditional Terminology
Stock Appreciation Rights (SARs) Stock price as measure, paid in cash Performance Units Financial and operational measures, paid in cash Performance Shares Performance measures and stock price, paid in shares Cash LTIPs “Target” rather than “unit” focus
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Phantom Stock Synonyms: Emerging Practices
“Class B” common shares Non-voting Non-dividend Tracking stock (“letter stock”) Tied to performance of business unit No claim on assets of business unit Often no voting rights Usually in non-dividend sectors Convertible securities Preferred shares Debentures
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Why consider phantom stock as a design alternative?
Common stock options are “too big” Line of sight and impact on results External factors Short-term cash incentives are “too small” Short-term focus Decision-result cycle Phantom stock may be “just right”….
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Who would consider phantom stock as a design alternative?
Equity use
undesirable, complicated, illiquid, or illegal
Private company Subsidiaries Foreign corporation SEC insiders Equity
doesn't exist
in a securitized form Mutual organizations Cooperatives Not-for-profit organizations Divisions
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Who would consider phantom stock as a design alternative?
And Why?
Entity equity
not the best measure of value
Complex ownership structure Diversified lines of business Consolidated financial statements
Undesirable requirements
for equity use Disclosure of results Registration Tax effects
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Considering Phantom Stock through a Strategic Model
Strategy REWARD DESIGN Behavior
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Finance
Factors Driving Compensation Plan Design
Strategy
Corporate governance philosophy
Shareholder value realization strategy
Industry norms
Product/Operations/Customer Strategy
Diversity of Products/Services
Decision-Result Cycle
Performance Measures
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Factors Driving Compensation Plan Design
.
Shareholder value model
Risk-adjusted return
Performance measures
Capital structure
GAAP reporting
Corporate and individual tax
Cash flow
Investor communications Finance
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Factors Driving Compensation Plan Design
.
Joining, remaining, exiting
Individual, group, business unit
Short-term, long-term decisions
Volume
Quality
Time
Internal mobility Behavior
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Expanding …To New Forms of Pay (What do we use it for?)
Short-term (annual) incentive plan deferral Stock option gain deferral Supplemental executive retirement plans (SERPs) Elective nonqualified deferred compensation Stock-based compensation “gaps”
Plan Design Ideas
SERP accruals and payments based on value Deferred amounts value determined by phantom stock formula Six-month phantom plan to bridge proposed option repricing waiting period
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Expanding …To New Industries (Where do we use it?)
Not-for profit organizations Educational institutions Government organizations
Plan Design Ideas
University faculty members and support staff receiving phantom shares based on a composite of 15 indicators of the school’s performance including starting salary of MBA graduates University of Pittsburgh Katz School of Business Not-for-profit health care holding company with diversified business units provides long-term incentive compensation based on mission-related measures
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Expanding …To New Situations (Why do we use it?)
Joint ventures Affiliate investments Turnaround situations
Plan Design Ideas
Executive officers participate in cash or stock distributions from Company’s venture investments. Distributions paid only after company recovers cost basis.
Adobe Systems, Inc. “Adobe Incentive Partners, LP” Senior officer plan pays out only if company is sold at or above a predetermined price.
Private investment firm acquiring financial institutions
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Expanding …To New Levels (Who is included?)
Profit centers Cost centers Project teams
Plan Design Ideas
Phantom share value based on contribution margin of profit center Initial phantom share value fluctuates with costs (reverse gain sharing) Project team phantom shares determined by Milestones, determining number of shares awarded Product revenues, determining share value
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Expanding …To New Award Schedules (When do we reward?)
Annual distributions Quarterly dividends Elective redemptions
Plan Design Ideas
Phantom stock grant at hire with a monthly dividend -- no cash compensation Phantom stock accounts extending beyond retirement with elective redemptions
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New Award Schedules
Elective Redemptions Dividend Payments
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Final Distribution
The Next Wave: Phantom Stock Popularity Soars
FASB continues to expand charges for stock plans Investors disregard EPS, focus on cash Merger and acquisitions create complex organizations Executive mobility continues Stock market stagnates All-employee option plans disappoint
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Design Considerations: Financial
Impact on other compensation plans from expense accrual Cash outflow of payments -- financial modeling is critical Excess accumulated earnings tax De facto ERISA plan without tax benefits Deemed security due to reduction in other compensation
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Design Considerations: Regulatory
SEC Section 16 SEC Proxy Disclosure ERISA Blue Sky Laws FASB
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Design Considerations: Administrative
Employment termination Change-in-control Change in exit strategy New plan may require “jump start”
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In Closing: Advantages
Employer
Flexibility in design No ownership dilution No minority shareholders Rewards tied to value creation Possibly exempt from regulation Retention power of multi-year performance periods Self-funding based on economic value creation
Employee
No cash outlay for employee No wait for a liquidity event for shares High upside over short-term cash compensation
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In Closing: Disadvantages
Employer
Accounting charges to earnings Tax deduction deferred until payment Cash outflows may be burdensome or ill-timed No downside in reward formula
Employee
No actual ownership unless paid in stock No control over timing of compensation if payment timing is fixed Lump sum awards may create significant tax liability Capital gains treatment will not apply to award payment
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