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Phantom Stock Gives Sense of Ownership

Hemal Jhaveri, Chairman and CEO, SofTec Solutions, Inc.

Finding creative ways to motivate and compensate good salespeople is an ongoing challenge for most business owners. When sales associates perform well and contribute to the company’s success, they, too, want to reap the financial rewards. While owners want to provide fair and appropriate incentives, they are also reluctant to risk too much. At SofTec Solutions, an IT outsourcing and consulting firm, we’ve designed a plan that allows our sales associates to feel like they have a piece of the pie, and at the same time protects my interests as the company’s owner.

For senior-level sales associates – vice president of sales and up – we offer a sense of ownership in the company, particularly for those who are committed for the long haul and who consistently reach their goals and do well. The key to our plan is the use of phantom stock.

The real beauty of this plan, however, is that phantom stock doesn’t require any actual relinquishing of ownership; 100 percent remains with me as the owner of the company. Rather, phantom stock is based on some future (it is assumed, appreciated) value relative to the company’s net income. The stock, or what we refer to as “units,” is in addition to a standard base or base-plus-commission structure and may be calculated on time, performance, or a combination of the two. Junior-level sales associates can benefit, too, where phantom stock may serve as more of a bonus for meeting quota in addition to a base salary and commission.

However, there are no time-based units in such instance. For the purposes of example, we’ll focus on the way phantom stock works for senior-level associates and use a combination performance- and time-based model.

Assume your company’s annual net profits are $10 million today. Suppose you then create a pool of phantom stock that is 1 million units for the entire company. That means each unit would equal $10 as of today, the day you are issuing the phantom stock. Next, you would need to decide what amount you would keep in the employee pool based on how much you want to share with them and how much you think you can part with. Let’s assume you decide to give away 10 percent of the 1 million units (your entire company), which means you will keep aside 100,000 units to give to different employees over a given period of time.

Then, basing the plan on both performance and time as indicated above, we might assign 70 percent of eligible units to performance and 30 percent of them to time. If after completing one year an employee has met their performance goals, they would get 70 percent + 30 percent or 100 percent of the eligible units. The eligible units equal whatever you want to part with, say 500 units annually. Next, you must determine what a unit is worth after one year, which is very important because the payout amount is based on the appreciated value of the units.

After one year, look at your net profits again. Let’s say they are now $14 million (up from $10 million the year before). So $14 million minus $10 million equals a gain of $4 million. That means the current appreciated value of a unit is $40 less $10, or $30 – the actual unit appreciation. Therefore, the 500 units eligible for payout would be equal in value to 500 x $30 or $15,000.

Of course it isn’t necessary to pay out the full amount. You may want to consider creating a vesting schedule for employees in an effort to enhance retention and protect cash flow. For example, after year one, you may want to make only 20 percent available to employees for cashing out; in year two, 40 percent, and so on. As such, following year one, they might have $15,000 but could only cash out $3,000, with the remainder staying with the company until they are completely vested.

If you want to consider a similar phantom stock plan for your company, first plan up front as best as possible how you’re going to grow and how many people you’ll likely bring on, etc. These are important considerations when structuring a plan that is attractive and meaningful for sales associates but also practical for you and your company. Remember, when new people come on, they are eligible only for appreciation from the then current unit value to whatever the defined maximum may be. So if they enter during year three of the plan, the unit value may be $5 rather than $1, and they would be eligible for appreciation from $5 to up to a $10 maximum, or a total appreciation of $5.

A company’s overall performance from year to year means that the value of a person’s vested units actually fluctuates over time, going up or down accordingly. And while it is possible to legally change your original allocations and/or dilute the plan if necessary, remember the real goal is to be taking care of your performers.

For instance, while you have the option to change the pool size (although likely this would not happen every year and, along with the annual profitability, would affect the value of the unit), typically, the number of units designated for the employee pool, the number of units determined for annual distribution, and the percentages allocated for time and performance would not change. Ideally, the company is doing well and the net income is growing every year. Therefore, the unit value of the phantom stock is increasing every year as well. In SofTec’s case, because we plan to sell the company in five to six years, we look for these vested amounts to continue to grow over time and provide a lucrative “parachute” for dedicated employees who have worked hard to help the company meet its necessary goals.

© 2006 Ewing Marion Kauffman Foundation. All rights reserved.

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