Issuing Stock to Employees: A Complete Guide to Direct Stock Plans
This guide will walk you through two common ways to issue stock to your employees: direct stock grants and direct stock purchase plans. We’ll explore...
6 min read
Let's talk equity compensation! Instead of issuing regular company stock, which can lead to loss of control, complex compliance, and dilution of ownership, consider phantom stock plans and stock appreciation rights (SARs). These equity-like compensation tools provide financial incentives based on company performance without issuing actual shares.
In this guide, we'll explore how phantom stock and SARs work, how to design a plan, and the key considerations when offering these types of compensation. We'll also cover the pros and cons of each, providing practical examples to help you decide which might be right for your company.
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What Are Phantom Stocks?
Phantom stocks are an equity-like compensation tool where the company promises a cash payout equivalent to the value of a specified number of shares, plus any increase in value, upon the occurrence of a specific event (e.g., vesting date, liquidity event). Phantom stock doesn’t involve issuing actual shares, which means no shareholder rights are granted.
Pros of Phantom Stocks
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Aligns Interests: Phantom stocks align the interests of employees and the company—as the company grows, employees' payouts increase.
Example: If your company grows from a valuation of $1 million to $5 million, an employee with phantom shares will see their potential payout increase in line with that growth, providing motivation to contribute to company success.
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Flexibility and Control: Phantom stocks allow you to maintain control over the company while incentivizing employees. You can set custom vesting schedules and choose which employees are eligible.
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No Dilution: Because no actual shares are issued, phantom stocks do not dilute ownership among existing shareholders.
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No Cash Outlay from Employees: Employees do not need to spend money to participate, unlike stock options where they must purchase shares at a fixed price.
Cons of Phantom Stocks
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Cash Flow Requirements: Since phantom stocks are paid in cash, they can create a financial burden at the time of payout.
Example: If your company grants $100,000 in phantom stock and achieves significant growth, you’ll need the cash to pay that out at vesting—this can strain your budget if not planned properly.
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Valuation Requirements: Phantom stock payouts are based on company valuation, which means you may need professional help to determine the fair market value at grant and payout dates, adding additional costs.
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Perception of Value: Employees may not perceive phantom stock as valuable as actual stock options because they don't receive shares and voting rights.
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Ordinary Income Tax: Phantom stock payouts are taxed as ordinary income rather than receiving favorable capital gains treatment.
What Are Stock Appreciation Rights (SARs)?
Stock Appreciation Rights (SARs) are similar to phantom stocks in that they reward employees based on the company's stock value appreciation. However, SARs only compensate employees for the increase in value from the grant date, not the full value of the shares.
How SARs Work
With SARs, employees receive a cash payment or equivalent in stock based on the difference between the stock price at grant and the stock price at vesting or exercise. Unlike stock options, employees don’t need to purchase shares—they simply receive the value of the "spread."
Example: If Jane is granted 100 SARs when the share value is $5, and the value increases to $15 after three years, she would receive $1,000 (the $10 increase in value per share, multiplied by 100 shares).
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Pros of SARs
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No Dilution: Like phantom stocks, SARs do not issue shares, avoiding dilution of company ownership.
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No Purchase Necessary: Employees don’t need to spend their own money to exercise SARs, making them easier to participate in compared to stock options.
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Lower Equity Dilution: Since SARs only pay out based on the increase in value (not the full share value), they have a smaller impact on the company’s equity compared to full-value equity awards.
Example: If you grant 100 SARs with a starting value of $5 per share, and the value grows to $30, the employee would receive $25 per share, totaling $2,500. In contrast, issuing stock options would cost the company $3,000 in equity per employee for the same appreciation.
Cons of SARs
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Volatile Payout: The payout for SARs depends entirely on stock value growth, making compensation unpredictable.
Example: If the stock price remains flat or declines, SARs will yield no payout, which could be demotivating for employees.
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Cash Flow Requirements: Like phantom stock, SARs are typically paid in cash, which requires careful planning to ensure funds are available.
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Taxation: SARs are taxed at ordinary income rates upon payout, similar to phantom stock, rather than benefiting from capital gains treatment.
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Phantom Stocks vs. SARs: Which Is Better?
The decision between phantom stocks and SARs will depend on your company's objectives and cash flow situation. Here are key factors to consider:
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Cost to Company: SARs generally cost the company less in terms of compensation due to the appreciation-only payout structure, whereas phantom stocks require the company to pay the entire value of the shares upon vesting.
Example: If you issue 1,000 phantom shares at $5 each, and they appreciate to $15, the payout is $15,000. If they were SARs, you’d only pay $10,000 (the appreciation).
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Retention Value: Phantom stocks may be more attractive for employee retention since they guarantee some value at payout, whereas SARs only provide value if the stock appreciates. Employees with SARs could feel less incentivized if stock performance is stagnant.
Key Considerations When Designing a Phantom Stock or SARs Plan
Before you offer phantom stock or SARs to employees, consider these key factors to create an effective plan:
1. Purpose of Offering
Define your primary goal—whether it's retaining key employees, incentivizing performance, or simply providing additional compensation. If your goal is to align long-term growth incentives, both phantom stocks and SARs work well, but they function differently in how they motivate employees.
2. Who Is Eligible?
Phantom stock plans are considered non-qualified deferred compensation programs under ERISA, meaning they are typically available only to a select group of highly compensated employees, such as senior management. To include a broader group, consider how you might adjust vesting schedules to comply with ERISA.
Example: You may limit participation to senior executives and managers, or provide shorter vesting schedules for broader employee participation.
3. Vesting and Conditions
Determine whether vesting will be based on time (e.g., three years) or performance (e.g., reaching sales targets). Vesting conditions create the "golden handcuffs" effect, encouraging employees to stay for a set period.
Example: You can implement a three-year vesting schedule for SARs, where employees receive compensation only if they remain with the company until vesting is complete.
4. Cash vs. Stock Settlement
Consider whether you’ll settle the awards with cash or actual shares. Cash is simpler, avoids shareholder issues, and prevents dilution, but if cash flow is limited, settling with shares might be a viable alternative.
Example: If cash flow is a concern, you might allow employees to choose whether to receive the payout in cash or convert the appreciation into stock, giving them more flexibility.
5. Compliance with Section 409A
Phantom stocks and SARs may be subject to Section 409A regulations, which govern deferred compensation plans and restrict accelerated distributions to prevent abuse. To be compliant, make sure your plan includes appropriate payout events and conditions.
Example: Include vesting, change of control, or separation from service as qualifying payout events to comply with Section 409A.
6. Taxation
Both phantom stocks and SARs are taxed as ordinary income when paid out. Make sure your employees understand the tax implications and how it affects their net compensation. Be transparent about withholding obligations like Social Security and Medicare.
Example: If an employee receives a $10,000 payout from SARs, they will owe ordinary income taxes on that amount, and you will be required to withhold employment taxes.
Drafting Your Plan Agreement
Once you’ve decided on the structure of your plan, it’s essential to draft a legally binding plan agreement that outlines the rights and obligations of both the company and the recipients. Enlist the help of legal professionals to ensure the agreement is thorough and compliant with applicable laws.
Key Elements of the Agreement
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Grant Date: Specify the date on which phantom stocks or SARs are granted.
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Offering Period: State the time frame from the grant date until payout.
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Vesting Conditions: Include time-based or performance-based vesting conditions.
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Valuation Method: Define how the company's value will be determined for payouts.
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Forfeiture Rules: Specify what happens in case of death, disability, retirement, or termination. For example, unvested shares may be forfeited upon termination for cause.
Example: If an employee retires before their SARs vest, you might include a clause that allows for pro-rata vesting to compensate for time already served.
Conclusion
Phantom stock and SARs offer a unique way to incentivize and reward employees without diluting company ownership or losing control over voting rights. The choice between phantom stocks and SARs depends on your company’s financial situation, employee demographics, and your goals for the compensation plan. Phantom stocks are ideal for providing guaranteed payouts, while SARs provide an appreciation-only approach that may save money while still aligning employee interests with company growth.
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