This article is part of a series on profit-sharing plans, an interesting alternative for companies wishing to improve employee retention within their ranks.
Over the past few months, our team of Canadian tax consultants has assisted a number of companies in the development and implementation of certain profit-sharing plans, and has decided to write articles on the subject in order to inform even more entrepreneurs keen to offer their employees the best possible working environment.
Find our other articles on profit-sharing schemes here.
In previous articles, you were able to understand how the bonusplan works, the freeze and new share issue strategies and thestock option. Here, we take a look at the phantom stock plan.
Concept overview
The purpose of a phantom share plan, also known as a phantom unit plan, is to issue units to certain employees, the value of which is modelled on the value of the actual shares held by the shareholders. Under this plan, key employees who participate in the plan do not actually hold shares, but only phantom shares on which they can benefit from any capital gains.
The broad outlines applicable to the operation of this type of plan
As this type of plan is flexible, it is possible to grant key employees the benefit of the total value of the phantom units received, or only the increase in value relative to these units over a period of time. The objectives and terms of the plan may be modified at management’s discretion, depending on the wording of the plan. In addition, the profit attributable to phantom units may be subject to a multitude of triggers such as, for example, retirement, a sale transaction, a number of years worked within the company or a major liquidity event such as a round of financing.
The main challenge with this type of plan is to be able to assess the value of the phantom shares and to properly define the financial parameters applicable to the granting and payment of the shares. When a public company implements such a plan, it is easy to track the value of the phantom shares, since this value is available on the various stock markets. However, this is an entirely different challenge when it comes to a private company whose shares are not listed on an external market.
For example, some private companies will coincide the payment to employees of profits attributable to fictitious units with a transaction involving the company’s shares. This solution provides an accurate assessment of the value of the company’s shares. However, this external validation of the value of the company’s shares is not always available. For example, if the payment is made when an employee retires, the valuation of the private company’s shares may be an issue. Although it is possible to provide a formula based on the company’s sales or adjusted EBITDA, this approach is always delicate and arbitrary.
The second important aspect of this type of plan is to clearly define the triggering events that will enable key employees to receive the value of the phantom shares or the increase in value under the terms of the plan. Clear and complete documentation of the plan is essential, since it will have an impact on the company’s liquidity and the motivation of key employees.
As a general rule, the amount received by the employee in respect of the value of the phantom units or the increase in value of the units will be treated as taxable remuneration (salary), which will also give rise to a deduction for the company. Under this type of plan, therefore, employees cannot benefit from capital gains treatment in respect of phantom shares.
Accounting and financial statement presentation
The Canadian Accounting Standards for Private Enterprises (CASPE) set out specific rules for compensation and similar payments. Thus, a company that sets up a phantom stock plan to compensate employees must generally recognize a compensation expense for the appreciation in value of the shares, as well as the related liability.
Depending on the terms and conditions of the contract, the valuation and method of recognizing compensation expense will vary from one plan to another, and can become complex in some cases. Finally, the issues involved in valuing shares for closely-held companies can be significant, generating a great deal of extra work and complicating the accounting of items.
Case studies and analysis
Recently, a well-established company with over 200 employees approached the Demers Beaulne team to set up a profit-sharing plan for some of its key managers and employees. Management’s objective was for the company to continue to grow, while targeting certain key operational elements to make it more competitive with its main competitors.
The managers are convinced that their company has great potential and that, with the contribution of its employees, it is destined for a promising future. Ultimately, they want to make the company attractive so that they can sell it at a high value within 10 years. They therefore want to implement a profit-sharing plan for the organization’s key employees, which will enable them to mobilize employees and pursue the strategic plan.
Management is initially targeting 3 experienced executives with this plan, as they will be the key allies in the changes they want to bring about within the company. However, they want the incentive plan to be flexible enough to allow new key employees to be added to the program over the next few years.
Management wishes to maximize the company’s available liquidity and therefore avoid short-term cash outflows. Management also wishes to link the plan to a liquidity event or potential transaction over a medium-to-long-term horizon, i.e. 7 to 10 years. In view of management’s objectives, the introduction of an annual bonus plan based on employee and company performance was not retained, as it would not preserve the company’s liquidity.
Management also considered setting up a stock option plan. However, after analyzing the implications of implementing such a plan, this solution was discarded. Indeed, the implementation of a stock option plan would have given the selected employees rights attributable to those of minority shareholders, and management did not feel comfortable having employees as co-shareholders in the company. As shareholders, key employees would have had access to a wealth of financial, administrative and operational information, which current shareholders do not want.
A phantom share plan was eventually set up to grant the 3 selected key employees the possibility of receiving up to 5% each of the company’s capital gain from the date the phantom shares were granted. In drafting the plan, it was determined that the profit attributable to the appreciation in value of the phantom shares would be remitted to the employees on the earlier of the date of sale of the company’s shares to a third party and the employee’s retirement after a certain number of years with the company. At the time the phantom shares were granted, the value of the shares was determined by an external valuation report. Subsequently, for all future internal transactions, it was agreed that the value of the shares would be determined using a specific formula, based on a multiple of adjusted EBITDA. Furthermore, in the event of an external sale transaction, it was agreed that the value of the shares at the time of the transaction would prevail for the purposes of the incentive plan.
Although drafting the agreement for this plan was no mean feat, both management and employees were keen to see the plan implemented.
Do you have questions about this type of plan, or how to implement it in your company? Contact a member of our team to discuss it further.
