This article was first published in the May 2013 International edition of Accounting and Business magazine.
Startups may not be able to pay €150,000 for an experienced CFO and, therefore, the war for talent is nothing new. In order to attract talent, startups usually grant key employees compensation packages which, apart from the basic salary, may include equity. However, instead of actual shares a number of companies grant virtual equities, ie, phantom shares.
These plans yield the same payoffs to an employee as actual equity, but the company may benefit from lower administration and legal costs. This article illustrates the framework of phantom shares and highlights what you need to know as an entrepreneur and employee before granting or receiving phantom shares.
What is a phantom share?
Generally, a phantom share plan is a contract between an employee and a company. The contract defines the number and the value of phantom shares granted by the company to the employee, as well as the conditions that trigger a payout. Furthermore, it defines the applicable share valuation method.
Some phantom share plans may include stock option rights or frequent dividend payments. However, these won’t be discussed in this article for simplicity reasons.
Equity shares v phantom shares
Employees who are granted phantom shares do not become a shareholder in the company and are not granted additional voting rights. Therefore, existing shareholders will not dilute their ownership percentages and will stay in control of 100% of the stock of the company. A trading of phantom shares cannot physically happen and there is no public or second market for phantom shares. Furthermore, the founders can maintain a greater financial privacy, ie, no obligation to open the books or to follow regulatory requirements.
Phantom shares are rather a powerful compensation arrangement and incentive plan and not an ownership agreement. It is, however, the company’s responsibility to implement and contractually define as many rights to the employee as necessary to make it feel like a real equity ownership.
Please note that the examples below focus on share appreciation rights only.
How many shares to grant?
One of the main aspects of how many phantom shares to grant is the growth expectation of the company. The higher the grow expectations of earnings before interest, taxes, depreciation, and amortisation (EBITDA), the higher the potential appreciation of the phantom shares. Management can calculate the expected phantom share appreciation under different growth scenarios and use the calculation as a reference in salary negotiations with employees. The bottom line amount of the incentive must represent an above average market value salary in order to reflect the high business risk of a startup (risk to achieve the growth) and the time value of money (delayed compensation receipt). Please refer to the simple phantom shares calculation below as a reference calculation.
The phantom share plan (PSP)
What to define in the PSP
The phantom share plan must contain the number of shares granted to the employee, the total shares in issue, the share valuation at grant date and any special conditions attached.
A frequent valuation (at least once a year) is necessary to determine the value of the company, the value of the phantom shares, the share appreciation for the employees and their bonus, respectively. A professional valuation done by valuation specialists can be very pricey, up to more than the annual audit and tax costs combined, and very time and resource consuming. A company may define in its phantom share plan a simpler valuation mechanism.
Simple phantom shares valuation
The following example is the simplest valuation of a company: an EBITDA multiple of comparables. The first task is to define the number of phantom shares available (say 100,000) and the EBITDA multiple, which is considered an appropriate valuation:
Date: 31/12/2012 (FY12)
EBITDA valuation multiple: 5x
company value = €15.0m
Number of phantom shares in issue = 100,000
Calculated phantom share value = €150 per share (calculated as company value divided by number of phantom shares in issue)
The above calculation can be included in the annual management reports and, therefore, be made available to all phantom shareholders. Furthermore, the phantom share plan will be included in the annual report notes.
Phantom shares are usually granted rather than sold to employees. Therefore, a right to virtually sell the shares to the company or other employees is not viable. Instead, the employee benefit is focused on the phantom share appreciation over a certain time period.
Therefore, appreciation rights must clearly define the start value of the shares granted and the vesting period, ie, the period in which the employee may trigger a payout. Some plans contain annual targets, which the employee must meet in order to be eligible to receive the share appreciation. These can be defined according to the company goals agreed with each employee.
The example calculation will continue the valuation example from earlier. We will assume that a certain employee has been awarded 3,000 phantom shares (3% of total phantom shares), eligible for share appreciation rights, ie, share increase, only.
If we assume an EBITDA increase from €3m in FY12 to €4.5m in FY13, the employee would be entitled to the share of the phantom share apperception:
The €225 value per share was calculated as €4.5m EBITDA in FY13 *multiple of five/by number of phantom shares in issue.
The employee earned €225,000 through the phantom share appreciation (€675,000 – €450,000). Some PSPs may have vesting conditions, for example a minimum time duration of five years. Consequently, the employee may be eligible for a payout in FY17 (FY12 plus five years), hence the FY12 to FY17 EBITDA increase serves as the basis of calculation for the share value increase. Vesting conditions may also contain certain company goals, but are usually focused on time in order to keep key employees aboard.
PSPs are treated in a similar fashion to deferred staff compensation, ie, capitalised as a liability over the PSP duration and generally recognised as a compensation expense through profit and loss. The deferred element is necessary as a portion of an employee’s remuneration is distributed after it is earned. The liability is adjusted at year-end to reflect the value changes and obligations arising from the rise or decline of the phantom share price. The corresponding charge is generally recognised in the profit and loss as personnel expenses.
Accounting treatment of phantom shares under complex vesting structures (ie, special performance targets) is excluded from this article for simplicity reasons.
Phantom shares value at:
Day of grant 31/12/2012: 3,000 shares *€150 value per share = €450,000
Day of vesting 31/12/2013: 3,000 shares *€225 value per share = €675,000
Ivan Lukanov ACCA is a manager at KPMG Germany.
The views and opinions expressed here do not necessarily represent the views and opinions of KPMG International or KPMG member firms