Looking to Benchmark Pay?
Compensation Anchored to Stock Performance
In some circumstances it is impossible or undesirable to grant managers equity compensation. This perspective is common when the organization is closely held or does not want ownership dilution. Some plans are designed where the underlying value of the compensation is based on stock performance, yet the company is not giving managers any company stock. Companies rely on these compensation plans that "act like equity plans," and are the basis of long-term incentive plans. Privately owned companies may offer these types of plans and document/communicate the valuation methodology to the plan participants. Examples are:
- phantom stock plans
- stock appreciation rights (SARs)
- performance unit plans
Phantom stock plans. In these cases, "mirror" plans can be created, hence the "Phantom" stock plan. Under a phantom stock plan, an employee receives units that represent shares of stock with a specified vesting period. Once the units vest, the employee is paid the then-current cash value of the stock or the difference between the original value and current value like full-value awards or appreciation awards covered earlier.
Taxation: The income received from the phantom stock options is taxed as ordinary income. This income is treated the same as a cash incentive.
Valuation: Determining the current value of the stock is complex. Stocks not widely traded may have no readily ascertainable market value. Sometimes, a number of other financial measures are used as surrogates of the stock value, and their movement directly impacts the phantom stock valuation. Other times, organizations will have an appraiser make annual valuations. Federal income tax rules for deferred compensation exist in the U.S. and should the employee enjoy "constructive receipt," the employer may be required to withhold income taxes. Two important points: 1) many companies using these types of plans perform an appraisal on a Quarterly basis and 2) this is a complex and changing area of tax law.
SARs. Top management is paid cash incentives (or sometimes in stock which is outside the scope of this course) based upon the appreciation of the corporate stock. A SAR grants managers the right to receive a cash payment equal to the appreciation of company stock over a period of time. Managers benefit from an increase in stock price, as they would with stock options. However, they are not required to pay the exercise price; they receive the proceeds without purchasing anything.
How SARs work:
For example, assume a manager is given 100 SARs when the grant date fair market value of the stock is $12 and, over the next three years, the stock price increases $50 per share. As a result, the manager gets $3,800.
Performance Unit Plans
In these types of plans, the final reward is not related to the value of the stock at the end of the time period. Instead, a value is often fixed for the performance unit when the grant is made. Actual payouts may be in cash or stock. If a grant is for 100 units at $100 with a vesting period of five years, then the employee may receive cash or stock valued at $10,000 in five years provided the performance goals were met.
Summary
Alternative, equity-based compensation plans allow for capital accumulation without the necessity of actually involving the use of shares of stock. Much like regular stock options, however, there are considerations to review regarding:
- accounting treatment enforced by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board
- IRS income tax, including deferred compensation rules
- the potential need for appraisals
Memory Jogger
Phantom stock plans