Running a family business frequently takes more than just family. It is not uncommon for executives with outside experience or home-grown talent to come from outside the family lineage. As a result, family business owners are often faced with a decision as to how to compensate these key executives.
The owners that I work with always seem to want to reward the big contributors to the business in ways other than salary and bonus. By doing so, they are able to attract and retain the top talent that helps keep them competitive. Hard equity can seem like a natural path to explore. However, in my experience I’ve found that it is easy to give away but much harder to get back, particularly if things are not working out. Plus, owners don’t necessarily want to dilute their ownership in the process.
This is where the use of a phantom stock plan may be of some assistance.
What is phantom stock and how does it work?
At a very high level, phantom stock is a form of deferred compensation that fits into the category of a non-qualified, long-term incentive. Since – unlike a 401(k) plan – phantom stock is non-qualified, the owners have discretion over who participates.
The company calculates a cash benefit to be paid at a future point in time to participants. The benefit is tracked against the overall performance of the business using a predetermined formula or metric. The owners then have discretion as to how much of the increase – or even decrease – in value they wish to assign to the participants. The plan also dictates how and when benefits are paid to participants, which often occurs upon a triggering event such as death, disability, or retirement.
What are the advantages?
A significant advantage – particularly for a family business – is that no stock or equity is actually given up. Therefore, the family can remain in control of the business. Another advantage is that when a plan is set up properly, the tax implications are deferred until the benefits are actually paid. Plus, the non-qualified nature of phantom stock allows for a fair amount of flexibility in the overall design of the plan. Provisions such as vesting on benefits can further increase the long-term incentive aspects of the plan.
What are the disadvantages?
One of the biggest disadvantages is that a liability needs to be recorded on the company’s books for financial reporting purposes. This liability can grow over time to be significant, which could impact financial covenants. When setting up a plan, it is important to take some time to model out what that liability could look like based upon growth and allocation assumptions.
With some thoughtful planning and monitoring, issuing phantom stock may be a good alternative to actual stock in your family business, while still creating an incentive and rewarding your key employees.
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