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Private business owners are often looking for ways to reward key employees without giving them actual equity in their company.  One of the most popular of these ideas is a phantom stock plan.

Phantom stock allows an owner to reward key employees when those employees help grow the value of the company.  Phantom stock can help you avoid problems that come from giving or selling parts of your company to your employees.

It’s important to note that Phantom stock is not real stock in a company.  It is a form of deferred compensation that tracks the value of the company but doesn’t give the employee any actual ownership or ownership rights in the company.  This is one of the reasons that many owners adopt this plan with key employees.

A phantom stock plan is a bonus program that is known as 409(a) plan by the IRS.  As with many IRS regulated plans there are some do’s and don’ts that are important to know about a phantom stock plan.

The plan can only be offered to a small group of your employees.  Deferred compensation is sometimes referred to as a top hat plan.  This means the plan can only be offered to the top 5% of your employees by compensation.

The plan should be funded.  Deferred compensation and deferred incentive programs can either be funded or not funded.  Your employees will not believe the program is real unless it’s funded.

The plan should have clear metrics before phantom stock awards are made.  Managers who participate in the phantom stock plan need to have clear metrics that are achieved before stock grants are made.  You should clearly set out the rules of getting phantom stock grants before starting the program.

You need to get good legal advice before setting up the plan.  You will need to have an attorney who specializes in 409(a) plans put the plan document together.  Because of the poor behavior by Enron you will be saddled with the same rules that large public corporations use.  It’s very important that you use an attorney who understands how these plans work and what the rules are.  Not following the rules properly can result in very large penalties.

Have a vesting schedule that helps keep your key employees at your company.  One of the reasons to use a phantom stock plan is to help retain employees that are important to the success of your company.  I like to use what is called a rolling vesting schedule.  With this type of plan every phantom stock grant you have won’t have any value until a triggering event or period of time has passed.

You must have an easily communicated method for valuing the company.  Phantom stock values go up and down with the value of your company.  It’s important that those who participate in the plan understand how their stock is valued and believe the valuation method is fair.  Transparency is often important in the success of a phantom stock plan.

Be prepared to share your financial statements with your key people.  Your employees who participate in your phantom stock plan will have to understand your company’s performance.  I believe the more information you share with this key group of employees the better the plan will run.

A phantom stock plan can be a real positive for helping you reward key people for making your company better.  For the plan to work you should remember the more organized you are the better your result is likely to be.

Josh Patrick

A major part of a successful phantom stock program is understanding and using key metrics as a trigger for the plan.  I’ve written a special report on using key metrics in your business.  Click on the button below to get your report.


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Topics: for business owners, value creation, deferred compensation

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