Phantom Stock and Stock Appreciation Rights: Incentives Without Dilution

September 14, 2020 Aunalisa Arellano

Phantom Stock and Stock Appreciation Rights

Employee stock options and other stock-settled awards are well-accepted vehicles to attract top talent, enhance productivity and reward your staff for a job well done. But not every private company is in a position to dilute the stock of primary shareholders by issuing options. Is there still a way to link compensation to company performance?

Yes, there is. Enter phantom stock and cash-settled stock appreciation rights (CSARs).

A closer look at phantom stock

Considered restricted stock units (RSUs), phantom stock units are tied to the value of your company’s stock and generally vest over a set period. Instead of giving unitholders the right to acquire company shares, however, phantom stock gives them a cash payout on settlement.

Depending on how the award is structured, phantom stock can vest after employees have served a set period of time (e.g., if they’ve been with the company for over one year) or when the company reaches a performance milestone, such as hitting a revenue target. Either way, vesting is a company-initiated controlled event – which allows you to pay out multiple employees at the same time.

Once phantom stock vests, the cash payout is equal to the full aggregate value of a stock unit in your company. So, if an employee is issued phantom stock when your stock is valued at $10 and the award vests when your stock is valued at $50, the cash payout will be $50 per unit. In the same vein, if your stock’s value declines in the interim – to, say, $5 at vesting – the cash payout would be $5 per unit.

The basics of stock appreciation rights

As their name implies, cash-settled stock appreciation (CSAR aka SAR/C) rights pay employees any increase in value your stock realizes between the date they’re issued and the date they vest. There are stock-settled stock appreciation rights (SSAR aka SAR/S), though this article will focus on CSARs. On or after the vesting of CSARs, employees can choose to exercise their options to get their appreciation before the expiration period which is typically 10 years. With CSARs, if your stock goes from $10 at issue to $50 at exercise, a CSAR would provide employees with a cash payout of $40 per unit. On the flip side, CSARs don’t provide employees with any payout if your stock value declines, and the awards go underwater.

Not surprisingly, this can make CSARs less attractive to employees who risk losing out on your company’s growth if their awards vest when values are weak. For this reason, CSARs come with an option-like benefit: after the grant date, employees generally have a five- to ten-year window during which they can cash out giving them more time to choose when to exercise. While this is an advantage to employees who get to decide when to pull the trigger on their awards, it could notionally require a company to process new transactions every day – making CSARs more administratively complex than phantom stock units.

The pros and cons

If employee retention is one of the goals of your compensation plan, stock-based awards deliver the longest-term benefits. That’s because awards settled in stock allow your employees to participate in the future growth of the company, long after their awards have vested. However, if dilution is a concern, cash-based compensation is a great alternative.

Companies can use the standard cash bonus, which is a one-time payment. The downside to this option is there is no long-term incentive for employee retention and no value for growth. These bonuses, if awarded annually, are also often tied to the company’s fiscal performance and the employee’s performance, so amounts can be inconsistent.

Then, there are deferred cash awards. These awards are more likely to encourage employees to stick around because there are vesting periods for the cash to be earned and paid out. But like standard cash bonuses, there is no potential for growth.

Finally, there are the aforementioned cash-based plans like CSARs or phantom stock. These options both provide incentive because employees have to wait for vesting whether that be time-based or performance-based and they provide the potential for growth in value.

Keep in mind that you’ll need to have sufficient cash on hand to pay these awards when they vest. This can be a serious downside for cash-strapped companies. Additionally, the accounting treatment for cash-settled awards such as CSARs and phantom stock is considered by many to be more complex than stock-settled awards (e.g., stock options, RSUs).  Generally, stock-settled awards are considered a fixed expense so their value can be forecasted into the future. Cash-settled awards, however, are not fixed – requiring companies to account for them as a liability through a mark-to-market valuation process up until settlement.  While this is not a deal-breaker, you should consider this complexity upfront.

Help at hand

If your company is considering issuing phantom stock or CSARs, you don’t have to go it alone. Shareworks can help your company with administration, participant communication, taxation and most importantly the financial reporting requirements for these awards types.

Want to learn more? Get in touch!

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