Unlocking Employee Loyalty: The Power of Phantom Share Plan
One of the major challenges faced by privately held businesses revolves around devising effective strategies to incentivize their key employees and managers, ensuring their long-term commitment and sustained motivation to contribute to the company’s growth. Frequently, these key personnel lose their motivation in the company’s growth trajectory due to their lack of direct involvement in its progress, often leading them to explore external opportunities or even contemplate launching their own ventures.
Determining how to reward your key employees and managers stands as one of the pivotal strategic decisions a business can make. It can provide a significant competitive advantage, reinforce the organizational culture, and stimulate the desired behaviors necessary for scaling a company. Given that it frequently constitutes one of the largest expenditures within your business, if not the largest, the matter demands thorough consideration. Various compensation options may be available, such as salary increases and performance bonuses. However, these traditional methods often prove short-lived and may not consistently yield the desired outcomes.
One potential solution involves offering key employees and management shares in the company, essentially granting them an ownership stake. Although this method frequently succeeds in sparking motivation among key personnel and inspiring them to approach the company’s growth with an owner’s mindset, it does bring along notable disadvantages. The primary concerns include the dilution of your ownership, complexities in the ownership structure, and potential partnership issues that may arise down the road.
Fortunately, there exists a lesser-known option for business owners: Phantom Share Plans, also known as phantom stock or shadow stock. This form of compensation offers numerous advantages and merits consideration.
What is a Phantom Share Plan?
Phantom Shares stand as an effective form of value-sharing, providing an alternative to traditional equity compensation. Unlike stock options that grant actual equity, Phantom Shares link rewards to sustained company growth without the need for real stock exchanges. Essentially, they are a commitment to pay employees in cash based on specific conditions, such as time of employment or an increase in the company’s stock value.
Think of Phantom Shares as a ‘deferred bonus.’ Employees enjoy the economic benefits of owning company shares, including potential stock price appreciation and dividend payouts, without having any voting rights or ownership stake in the company.
These units’ worth is intricately tied to the company’s overall value. Instead of receiving tangible company shares, the employee is granted virtual shares. Although these are not actual shares, the phantom stock mimics the fluctuations in the real stock’s value and provides payouts based on the resulting profits.
Characteristics of a Phantom Share
Since phantom share plans are contractual agreements, the terms of the agreement can be drafted based on the needs of the specific business. Meaning that there’s no one fits all phantom share plan. However, there are distinct characteristics tied to a phantom share plan, which include:
- Value Tied to Actual Shares: Phantom shares are designed to mimic the value of the company’s real shares. As the company’s actual stock price fluctuates, the value of phantom shares follows suit. This alignment ensures that employees benefit from the company’s financial success.
- No Actual Ownership: Despite their name, phantom shares do not represent actual ownership in the company. Employees who hold phantom shares do not possess voting rights or ownership stakes in the traditional sense. Instead, they have a financial interest in the company’s performance.
- Not Regulated by Specific Legislation: Phantom Shares are not regulated by specific legislation and are essentially a contractual bonus scheme. Their terms and operation are governed by the contractual agreements between the employer and employees.
- Customizable Terms: Companies have the flexibility to customize the terms of phantom shares to suit their specific needs and objectives. This includes determining which employees are eligible, setting issuance and redemption conditions, and defining payout criteria.
- Issuance Price: Typically, phantom shares are granted to employees at an issuance price equal to the fair market value of the company’s actual shares at the time of the grant. Importantly, employees do not need to purchase these units; they are granted to them as part of their compensation package.
- Triggering Events: Phantom shares are subject to specific triggering events that dictate when they can be redeemed. Common triggering events include the sale of the business, an employee’s retirement, or their permanent disability. Upon the occurrence of these events, employees become eligible to receive the value of their phantom shares.
- Two Forms of Payment: Employees holding phantom shares are generally entitled to two types of payments:
- Distributions: Employees may receive periodic distributions, which are determined at the company’s discretion, similar to the issuance of dividends to shareholders.
- Redeeming of Units: Units are redeemed by the company upon the occurrence of triggering events as outlined in the PSP. Upon redemption, employees receive the difference between the value of the units when they were granted and the value of the company’s shares at the time of the triggering event
- Two Main Types of Phantom Stock Plans: There are two primary types of phantom stock plans:
- Appreciation-Only Plans: These plans do not include the value of the actual underlying shares themselves. They may only pay out the value of any increase in the company’s stock price over a specified period that begins on the date the plan is granted.
- Full Value Plans: Full value plans pay both the value of the underlying stock and any appreciation
Benefits of a Phantom Share Plan
Implementing a Phantom Share Plan can offer numerous advantages for both employers and employees. These benefits include:
1. Employee Motivation and Retention: Phantom Share Plans can be powerful tools for motivating and retaining key employees. By linking the value of phantom shares to the company’s performance, employees have a direct stake in the company’s success. This fosters a sense of ownership and commitment that traditional salary and bonus structures often can’t achieve.
2. No Transfer of Ownership: With a Phantom Share Plan, employees receive phantom shares or stock, not actual ownership in the company. This means they won’t have voting rights or a say in the company’s management decisions. It’s a way to reward and incentivize without diluting the ownership held by existing shareholders.
3. Customization and Simplicity: Phantom Share Plans are highly flexible and can be tailored to meet the company’s unique needs. Employers can specify which employees are eligible, how many phantom shares are issued, when they can be redeemed, and what happens to the shares if an employee leaves the company. This flexibility allows for straightforward implementation without the complexities associated with issuing real shares.
4. Minimal Upfront Costs: One of the appealing aspects of Phantom Share Plans is that they typically involve minimal upfront costs. The main expenses are associated with setting up and administering the plan. This can be particularly attractive for companies looking to motivate and retain employees without making large cash outlays.
5. Deferred Taxation: Payments made to employees as part of a Phantom Share Plan are typically considered employment income for tax purposes. The tax is only applied when the employee receives the payment, providing potential tax benefits compared to other forms of compensation. Properly designed plans can help employees defer taxation until a later date.
6. Alignment of Goals: Phantom shares help align the long-term goals of employees with those of the company. Since the value of the phantom shares is tied to the company’s performance and growth, employees are naturally incentivized to work towards the company’s success.
7. Employee Appreciation: Offering phantom shares demonstrates that the company values and appreciates its employees’ contributions. It can enhance employee morale and job satisfaction, contributing to a positive workplace culture.
Practical Scenario Depicting the Use of a Phantom Share Plan
Let’s say a manufacturing company decides to implement a Phantom Share Plan to reward its top-performing production manager, Sarah. As part of the plan, Sarah is granted 100 phantom shares in the company. The Phantom Share Agreement specifies that these shares will vest over a five-year period, incentivizing Sarah to make sustained contributions to the company’s long-term growth.
At the time of the grant, the company’s actual shares are valued at $10 each. Over the next five years, Sarah diligently works to improve production efficiency and reduce costs, contributing significantly to the company’s profitability. During this time, the company’s actual share value steadily increases, reaching $20 per share by the end of the vesting period.
However, before Sarah can redeem her phantom shares, the company is acquired by a larger competitor in an industry consolidation. The acquisition triggers the Phantom Share Agreement provisions, allowing Sarah to cash out her vested phantom shares. Since the grant value of her shares was $10 each, and the shares were valued at $20 each at the time of the triggering event, Sarah is entitled to receive the difference, which is $10 per phantom share.
In this real-life example with a five-year vesting period, the Phantom Share Plan not only motivated Sarah to contribute to the company’s success over an extended period but also rewarded her with a significant payout upon the sale of the company, aligning her interests with the company’s long-term growth and eventual exit strategy.
How to Issue Shares in a Private Company Canada
When preparing and implementing a Phantom Share Plan, consider the following steps:
Step 1 – Identify Key Personnel: The initial step in establishing a phantom share plan is gaining a comprehensive understanding of your business and recognizing the pivotal employees who contribute significantly to your company’s success.
Step 2– Define Phantom Share Program Attributes and Draft: Establish the terms and features of your phantom share plan, working closely with your lawyer to develop the contractual agreement.
Step 3– Assess Fair Market Value: Evaluate the fair market value of your business. Fair market value represents the price at which your company could be sold in an open market context, assuming that both the buyer and seller possess reasonable knowledge about the asset, act in their best interests, encounter no undue pressure, and have a reasonable timeframe to finalize the transaction. Often, this process involves collaborating with an accountant.
Step 4– Engage in Employee Discussions: After you’ve prepared the draft of the phantom share program, initiate conversations with your employees. This phase frequently involves providing them with information about the program, with assistance and legal guidance from your lawyer
Phantom Share Plan Lawyers in Toronto
If you are contemplating the implementation of a Phantom Share Plan or require guidance in structuring such a program, we encourage you to get in touch with us. Our experienced team of legal professionals is here to provide expert assistance in designing and implementing a tailored plan that aligns with your business objectives. To gain a deeper understanding of how we can assist you in optimizing your compensation strategy, please reach out to us or call (647) 724-5179 today.