Page 520 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

506 The Complete Guide to Executive Compensation

The formula for these plans is not tied to company stock in any way. Instead, it specifies
the amount of cash that will be paid with the achievement of defined objectives (note that
performance-unit plans, paying in cash, not stock, would meet this description). The award
can be paid immediately or deferred over a period of time. The company has a deduction at
the time of payment equal to the amount the executive has earned in the way of income. The
earnings statement is charged with accrued expense over the performance period.
However, the strength of these plans is their weakness. With cash payments, there
are no opportunities for long-term capital gains tax treatment. Also, although they are not
likely to go “underwater” or remain flat for prolonged periods like market-based stock
plans, so too they are not capable of rising dramatically in times of a bullish stock market.
These characteristics make such plans almost a form of guaranteed-payout profit sharing.
Of course, establishing a minimum growth target before payment thwarts this problem.
Nonmarket-based plans are sometimes called employer stock plans because they have no
market value stock component. Sometimes, publicly traded companies use them instead of
stock. They are also called phantom stock or shadow stock plans. When prices are languishing
on the stock market, an internal valuation might be more beneficial because of languishing
stock price. Publicly traded companies also use them for strategic business units (SBUs)
that do not have their own stock. However, they are most common with privately held
companies, where they are an attractive alternative to diluting ownership.

Measurements Used. Lacking a market measurement, nonmarket-based plans rely on
internal financial measurements. Probably the most common is book value, or shareholder
equity (i.e., assets minus liabilities) divided by shares outstanding. Another form of phantom
stock is the earlier-described tracking stock. In a private company, it could be at any level—
company-wide or by division. In a public company, it typically would be found in an SBU.
The measurement could be a financial one that would relate to that unit (e.g., gross margin
or EBITDA). The phantom stock issued could be full-value units or appreciation. Other pos-
sibilities include those described in Chapter 2 (“Performance Measurements and Standards”).
These include budget attainment, cash flow, earnings, earnings per share, economic profit,
equity growth, market share, net-worth growth, return on assets, return on equity, return on
invested capital, return on net assets, return on sales, revenue, and total shareholder return.
Variable accounting rules are in effect to determine charge to earnings, and the company will
have a tax deduction when the individual receives the income.
Dividend Equivalents. A privately held company may also use phantom stock to pay
dividends of some form of interest. This is advantageous in closely held organizations where
the owners do not wish to dilute ownership. Alternatively, the dividends could be paid on
stock actually awarded.
Appreciation Rights. An appreciation right on the phantom stock of privately held
companies or SBUs would use some measuring device other than market value. Many plans
are constructed around book value. Unlike company stock, which can bounce up and
down under the influence of macroeconomics issues rather than company performance,
book value usually has a nice steady progress. (However, it is affected by acquisitions and
divestitures.) Book value plans have been used primarily by privately held companies,
although publicly held companies may also adopt them when stock performance is lackluster.
Simply stated, such a plan allows executives an opportunity to benefit from appreciation in
book rather than market value.