Using Phantom Stock to Compensate Executives in Privately Held Businesses

by Harvey Wigder

The difficult challenge of recruiting top talent for privately held companies is getting tougher. Lately stock options are getting to be a more essential part of the compensation package. Everyone knows someone who has benefited from stock options and everyone wants a piece of the company from day one. Clearly, this is an adverse development for entrepreneurs who do not want to give up control.

"Phantom stock" is one possible solution, at least for recruiting and rewarding executives. Phantom stock is an agreement between the owner and the employee which rewards the employee based on growth of the company. With phantom stock, the entrepreneur can address all of the three types of compensation that would be available to the executive if he joined a public company: base salary, annual incentive compensation, and long-term incentive compensation.

  1. Base salary is essentially the going rate for a person with the skills and experiences that fit the position description.
  2. Annual incentive compensation encourages a person to focus on the achievement of business plan goals, gives rewards for meeting goals, and allows the person to share in profits in good years.
  3. Long-term compensation plans provide a way to reward an executive for contributions toward growing the business and (because of vesting) give the person a reason to stay.

In a public company, long-term compensation is addressed through stock options, determined by the market value of the stock. In a private company, phantom stock is a proxy, the value of which is determined by an evaluation method that the individual company chooses.

Some companies hire expert evaluation firms to provide both a method for evaluation of the company, and a valuation value. When this option is chosen, the method the expert chooses becomes the standard for comparison, and is repeated in future years to track growth in value. More often, the company goes to its own balance sheet and uses a measure like book value to track growth.

Other necessary elements of a phantom stock plan are: (1) determining the number of shares (or stock options); (2) determining a starting value for each share of phantom stock; (3) setting a vesting schedule; and (4) designing the rules and timing for the withdrawal of earnings under the plan.

Phantom stock allows the owner of a privately held company to provide long term incentives to selected executives who have a key role in building the company. It counters the absence of stock options but doesn’t force the entrepreneur to give up control. Armed with this tool, private companies regain recruiting clout based on their inherent advantages, which include stability, flexibility, and lack of bureaucracy.