Optimizing Business Value: Incentivize Your Employees!
Human capital is one of the most valuable intangible assets of your business. Potential investors and buyers place a higher value on businesses that have experienced leadership teams and skilled employees, making them important drivers of business value for your company.
In a competitive labor market, a generous compensation plan can attract the highest caliber of talent to your company, motivate them to achieve stellar performance, and help you retain them. Let’s take a look at two effective, deferred compensation strategies that are based on company stock: Stock Appreciation Rights and Phantom Stock.
Stock Appreciation Rights
A stock appreciation right (SAR) is an award that enables the employee to profit from the appreciation in value of a set number of shares of company stock over a set period of time. Valuation of the SAR operates like a stock option—the employee benefits from any increases in stock price above the price set in the award. However, unlike a stock option, the employee is not required to pay an exercise price to exercise the SARs.
How SARs Work
Stock appreciation rights are granted at a set price and generally have a vesting period and an expiration date. Once a SAR vests, the employee can exercise it at any time prior to its expiration. Depending on the compensation plan rules, the employee receives the proceeds (the net amount of the increase in the stock price) in cash, in stock shares, or a combination of both. If the employee receives the proceeds in shares, the shares can be treated as any other shares of stock in a brokerage account.
Types of SARs
There are two types of stock appreciation rights:
· Standalone SARs are granted as independent instruments and are not issued in conjunction with any stock options.
· Tandem SARs are granted in conjunction with a non-qualified stock option or an incentive stock option, which entitles the employee to exercise it as an option or as a SAR. Once the employee selects an election type, the tandem SAR cannot be exercised as another election type.
Advantages of SARs
Stock appreciation rights benefit both employees and business owners. Since no money is required to exercise the SARs for cash, the employee automatically receives the proceeds from an exercise without having to pay for the cost of the shares.
And with a standalone SAR plan, the business owner benefits because equity, voting rights and direct ownership are not granted, unlike incentive stock options which dilute ownership and affect control of the business.
Phantom Stock
Phantom stock gives select employees—usually executives or key staff—financial rewards that are tied to the value of company shares without granting them ownership of the shares. The employee receives mock or virtual shares whose value tracks the company’s real stock price.
Phantom stock typically pays out after a vesting period, upon retirement, or at another specified event. The employee receives a cash payment equal to the market value of a set number of company shares or the increase in their value over time, depending on the compensation plan’s structure.
Phantom stock compensation plans are flexible; business owners can customize the plan to suit company goals such as providing incentives to key staff and rewarding employees when they meet performance milestones. Phantom stock is common at private companies, startups, and organizations that want to offer equity-like incentives without restructuring their capitalization table or issuing actual shares.
Types of Phantom Stock
There are two main types of phantom stock:
· Appreciation-Only Plans: The employee benefits only when the share value increases since the grant date.
· Full-Value Plans: The employee receives the equivalent cash value of the company’s stock at payout. The cash value includes the original value plus any appreciation.
Advantages of Phantom Stock
Phantom stock plans are attractive to both employees and business owners. Employees receive cash payouts when the company grows, and they are not required to invest personal capital.
Business owners benefit because phantom stock plans align employee interests with company performance, encourage employees to remain with the company, and reward growth without diluting ownership for existing shareholders. Employees do not receive voting rights or dividends, and payouts are typically taxed as ordinary income rather than capital gains. In the United States, phantom stock is considered deferred compensation and is subject to specific tax regulations, such as IRS Code 409A.
Comparing SARs and Phantom Stock Plans
Here’s a brief comparison of the two deferred compensation plans.
| Stock Appreciation Rights | Phantom Stock |
Share Value | Pays the appreciation in share value over a set period | Pays the full value of the company shares or the appreciation in value over time, depending on the plan |
Dividends and Voting Rights | Does not provide dividends, voting rights, or any form of ownership | Can be structured to mimic shareholder benefits such as dividends or voting rights (rarely), though not typical |
Exercise | · Employee can choose when to exercise a vested SAR · Payout is made at exercise, not at a preset date | No exercise required |
Settlement | Some plans allow for share settlement | Usually paid out at a predetermined date, a specific company milestone, or sale |
Payout | Usually paid in cash | Typically paid as a cash bonus; however, shares can be issued |
Ownership | No ownership of stock | No true equity or shareholder status; only a contractual right to payment |
Reap the Business Benefits of Rewarding Your Employees
Whether your eventual exit from your business is distant or getting closer to reality, it’s good practice to assess the drivers that can increase the value of your business for future investors or buyers. Human capital assets—your employees—are a key driver of business value.
Savvy owners understand the importance of hiring and retaining the best talent to help them operate their business, achieve strategic goals, and build business
value. Offering deferred compensation benefits, such as stock appreciation rights and phantom stock, is an effective way you can attract and keep the caliber of people who will help you propel your business to success and demonstrate superior business value to prospective investors and buyers. It’s a win for your employees and a win for you, too!.
