Phantom stock is sometimes more “phantom” than valuation and accounting professionals would like. Small business owners may make phantom stock agreements with key employees, but fail to mention these agreements to their financial advisors, particularly, but not exclusively, when the agreements are verbal. While there is clearly an economic impact on a company’s value due to the existence of a phantom stock agreement, there are also accounting requirements that phantom stock be expensed as it is awarded (for tax purposes, it is expensed when exercised). Despite an impact on value and the reporting requirements, the agreement is frequently overlooked until exercised.

What is Phantom Stock?

Phantom stock is deferred or incentive compensation which involves a promise to pay an amount to an employee at some future date. The future date may be defined in terms of a certain number of years, or by a triggering event, such as the employee’s retirement, a change in controlling ownership of the company, or the employee’s attainment of a certain age. The amount to be paid at the defined future date is tied to the value of the company’s stock, sometimes, but not necessarily, reflecting dividends.

A phantom stock plan is typically not a tax-qualified plan because it is normally designed to cover a very limited number of key employees. However, it should be noted that should a phantom stock plan attempt to include a broad spectrum of employees and defer some or all of the phantom stock payments until after retirement (or other termination), the plan could potentially be considered an ERISA plan.

Reasons for Phantom Stock

There are a variety of reasons a company may choose to create a phantom stock arrangement. One of the most obvious reasons is the ownership restriction for certain types of entities, such as a sole proprietorship, a partnership, a limited liability corporation, or the S corporation 75-owner rule. If a company has no ownership restrictions but the owner wants to retain ownership, phantom stock provides incentives based on the value of the company while allowing the owner(s) to maintain the ownership interest.

Some companies have an equity ownership plan in place but desire to provide equity-type incentives to a restricted group of individuals. This could be a group of managers or one division of a company. The equity price is sometimes based on a value for a group or division within a larger company.

Management, particularly in a smaller company, may find conventional ownership plans too restrictive or cost of implementation too high. Additionally, there are on-going administrative costs that may be prohibitive. A phantom plan typically provides a less expensive alternative that is not subject to the same restrictions as most equity ownership plans.

Valuation Considerations

A key valuation consideration is that the phantom share liability not dilute the value of the company’s equity shares, rather, remain equal in value to the equity shares. Therefore, a circular, or iterative calculation is necessary to make the phantom and equity share price equal.

While there is a phantom share “price” equal to equity shares, phantom shares typically have an element of risk that common shares do not have, in that they are frequently tied to a period of time, or a triggering event. There may also be an “option price” whereby the phantom shareholder only receives the amount above a certain level, similar to stock options. Therefore, the expected life of the “option” and volatility of the stock must be estimated, so that a present value calculation can be performed. If dividends are a factor, a dividend yield should be estimated. The considerations above amount to an analysis that is similar to that used in the valuation of stock options.

Conclusion

There are a variety of factors to consider when a company has phantom stock agreements; not the least of which is whether an agreement is in place that is not reflected on the company’s financial statements. While these plans do provide some flexibility to the company, they can create some complications in the determination of value.