PHANTOM STOCK AND SARs

Company management and key employees are incentivized by having a stake in the firm's success. However, actual shares of common stock must be issued for cash, property or past services. When exchanged for past services, the receiver must recognize taxable income. Thus, stock options are a popular form of equity compensation and key element of incentives in high-tech companies. In order to exercise a stock option or convert to actual shares, a cash payment must occur. The most obvious forms of exit or liquidation of these converted shares are an IPO (initial public offering) or a sale of majority ownership to a third party.

Phantom stock is a form of compensation from a corporation (C or S) that confers the right to receive cash at a future point, often based upon a valuation formula. The primary benefits of phantom stock are that there is no tax to the recipient at the time the stock is granted; and, this form of stock/compensation avoids the many potential landmines of minority ownership of actual stock. The phantom stock (PS), also known as synthetic stock, usually mimics the value of real stock, since the cash distribution is concomitant with the stock value increase after the PS grant date.

Advantages

The benefits of phantom stock (a cousin to Stock Appreciation Rights or SARs), versus awarding options or actual shares, are the following:

1. The terms of the PS agreement can be very flexible, e.g. vesting, voting rights, dividends, performance metrics, profit participation, etc.
2. Typically, since these "pseudo shares" are not actual shares before an exit event, there is no tax to the recipient. At the time of an exit, he would normally receive an amount equal to the cash he would get if he held the actual stock.
3. Some plans provide that the payout is not in cash, but the issuance of common or other types of equity.
4. The reward is usually contingent upon the recipient remaining with the firm until the triggering event.
5. Designed and administered properly, plans limited to key employees are not subject to the burdens of ERISA oversight or IRS regulation (such as deferred compensation under Section 409A).
6. Share ownership for the employer is not diluted.
7. The implementation and operation of these plans is relatively simple and inexpensive.
8. Owners of the firm avoid the many pitfalls of dealing with minority shareholders.

• Governance issues, including minority shareholder rights to dissent against mergers and other significant corporate transactions.
• Minority shareholders of private companies may have unrealistic expectations regarding their role in corporate decision making.
• Minority shareholders may have voting rights (if common shares with voting privileges are used).
• Minority shareholders owning enough stock individually or collectively may create obstacles to corporate action and have the right to petition a court for the involuntary dissolution of the corporation. For example, in California the holders of 30% of the shares can petition the court for the involuntary dissolution of the company.
• During times of great opportunity or immense hardship, minority shareholders can cause trouble.
• Minority shareholders may exercise inspection rights and force privately-owned businesses to produce their accounting records.
• It may be difficult to terminate the employment of a minority shareholder.
• Minority shareholders may make claims of excessive compensation of majority owners or question expense reimbursements.

Types of Plans

Essentially, there are two types of plans:

• Appreciation Only – pays only for the growth in value of share price (e.g. starting at the grant date).
• Full Value – includes underlying value of stock at the grant date, so that the payout is considerably more per recipient.

Stock Appreciation Rights (SARs)

SARs another form of equity compensation that is simpler than a conventional stock option plan. While SARs do not provide for the full value of the underlying stock, they reward the profit improvement which drives a price increase in the shares between the grant and exercise dates. Usually, a SAR is awarded as stock or units when vesting has occurred. And, the employee can exercise his rights at any time after vesting. In other words, phantom stock benefits are reaped when the company completes some significant action; SARs are available at the employee's discretion.

SARs Advantages

1. Employee exercises after vesting at his discretion.
2. Most often cash is paid, since there is no transaction to receive SARs shares.
3. Employer only grants the appreciation in share value for a specific number of shares over a specified period of time, not the entire underlying stock value per share. Employees receive the equivalent cash benefit in shares equal to this amount, minus withholding taxes.
4. Shares held for a year or more are subject to long term capital gains, not ordinary income.
5. The issuance of shares is reduced, versus a non-qualified stock option plan, so there is less share dilution.
6. Employers benefit from the vesting schedules tied to performance or specific goals.
7. These plans are extremely flexible in how the terms are devised, but do require considerable thought as to how the provisions (e.g. voting, dividends, restrictions on selling or collateralizing, etc.) will be proscribed for the long term benefit of the company.
8. Employers classify these expenses as fixed, not variable.

Valuation

The hypothetical PS units rise and fall in unison with the company's actual share price. It is critical to most phantom holders that they know the annual (or more frequent) share price, as a motivation to gauge their efforts in improving the company value since their grant date.

Similarly, SARs value is created over a set time period and in harmony with company share value (increase or decrease).

The initial business valuation considers numerous quantitative and qualitative factors. These considerations are many and varied, and must be reasonably aligned in the discounted cash flow and sales comparison (multiples) approaches. The phantom stock and SARs plans present some challenges (beyond a normal business valuation) to the business valuator, as follows:

1. Per share value upon exit must account for the possible redemption of PS and SARs.
2. Interim valuations/analyses (after the initial valuation and before any significant event) should anticipate profit and/or dividend payouts to vested holders of PS and SARs (when part of the plan), which dilutes the expected cash flows to the firm.
3. Distributions for retirement, separation of service, or other trigger events must be considered as part of the future net cash flows. If significant in terms of potential redemptions (out flows), the profitability will be adjusted.
4. The cash flow modeling should allow for ease of updating, to more efficiently recalculate interim period valuations.
5. The infusion of capital and revisions to the capitalization table, as well as any current interest on debt-like instruments, should be considered for their impact on PS and SARs awards.

The chart which follows encapsulates the comparisons of real and phantom equity.