2 Compensation and Performance Management, Inc. About The SpeakerFred Whittlesey is the founding Principal of Compensation and Performance Management, Inc. (CPM), a management consulting firm based in Newport Beach. CPM helps organizations allocate financial capital to human capital. Fred specializes in improving organization performance through the evaluation, design, and implementation of compensation programs and the underlying performance management processes.His 15 years of management consulting experience include positions with Towers Perrin and William M. Mercer. Prior to founding CPM, he was director of the Western Region compensation consulting practice at KPMG Peat Marwick.Fred is an instructor for the American Compensation Association (ACA), UCLA Anderson Graduate School of Management, and UCLA Extension on financial aspects of managing people in organizations. His recent articles include "The Future of Human Resources Management" appearing in the ACA Journal and "Employee Ownership in Initial Public Offerings" published in The Stock Options Book by the National Center for Employee Ownership.Fred received his MBA from UCLA with concentrations in human resource management and marketing. He graduated Phi Beta Kappa and Magna Cum Laude from San Diego State University with a BA in industrial/organizational psychology.Compensation and Performance Management, Inc.
3 Compensation and Performance Management, Inc. Today’s DiscussionWhat is phantom stock?Why is it used as a form of compensation?Why consider phantom stock as a compensation tool?Viewing phantom stock through a strategic compensation modelNew opportunities for phantom stockCompensation and Performance Management, Inc.
4 Compensation and Performance Management, Inc. What is Phantom Stock?Performance-based compensation programContingent right to share increases in valueUnsecured promise to payMulti-year performance periodUsually settled in cashTypically reflects underlying actual stock valueCompensation and Performance Management, Inc.
5 How is Phantom Stock Different From Stock Plans? No investment by employeeNo stock certificates issuedNo legal equity ownershipNo voting rights existDividend equivalents rarely providedAccounting and tax treatment differ significantlyCompensation and Performance Management, Inc.
6 Typical Phantom Plan Operation Value formula determinedTarget compensation level establishedPhantom shares/units awarded at beginning of periodInitial value zero (appreciation plan) or estimated FMV (value plan)Payment at end of fixed performance periodCompensation and Performance Management, Inc.
7 Traditional Plan Design: Performance Measurement Actual equity value Market value Private transactionsEstimated equity value Formal appraisal FormulaDeterminants of equity value Revenue growth Profit ReturnDrivers of equity value Unit volume Customer base Cycle timeCompensation and Performance Management, Inc.
8 Traditional Plan Design: Performance Periods Typically 3 to 7 yearsMay be event-triggeredMay be tied to product cycleTypically multiple cyclesEnd-to-endOverlappingMay be multiple cycles based on differing criteriaCompensation and Performance Management, Inc.
9 Illustration of Phantom Stock Performance Cycles Single CycleSequential CyclesOverlapping CyclesYear 1Year 2Year 3Year 4Year 5Year 6Compensation and Performance Management, Inc.
10 Traditional Plan Design: Vesting and Exercisability Usually time-based vestingIncremental vestingCliff vestingMay be performance-acceleratedMay be event-triggeredPrimarily end-of-cycle payoutsLump-sumStream of paymentsCompensation and Performance Management, Inc.
11 Factors Driving the Rise of Phantom Stock Popularity More private companiesBull market pressuresCapital accumulation needsLimits on qualified plans creating reverse discriminationIncreased pressure to “align with shareholder value”Changes in securities regulationsMore complex equity structuresCompensation and Performance Management, Inc.
12 Phantom Stock Synonyms: Traditional Terminology Stock Appreciation Rights (SARs)Stock price as measure, paid in cashPerformance UnitsFinancial and operational measures, paid in cashPerformance SharesPerformance measures and stock price, paid in sharesCash LTIPs“Target” rather than “unit” focusCompensation and Performance Management, Inc.
13 Phantom Stock Synonyms: Emerging Practices “Class B” common sharesNon-votingNon-dividendTracking stock (“letter stock”)Tied to performance of business unitNo claim on assets of business unitOften no voting rightsUsually in non-dividend sectorsConvertible securitiesPreferred sharesDebenturesCompensation and Performance Management, Inc.
14 Why consider phantom stock as a design alternative? Common stock options are “too big”Line of sight and impact on resultsExternal factorsShort-term cash incentives are “too small”Short-term focusDecision-result cyclePhantom stock may be “just right”….Compensation and Performance Management, Inc.
15 Who would consider phantom stock as a design alternative? Equity use undesirable, complicated, illiquid, or illegalPrivate companySubsidiariesForeign corporationSEC insidersEquity doesn't exist in a securitized formMutual organizationsCooperativesNot-for-profit organizationsDivisionsCompensation and Performance Management, Inc.
16 Who would consider phantom stock as a design alternative? And Why? Entity equity not the best measure of valueComplex ownership structureDiversified lines of businessConsolidated financial statementsUndesirable requirements for equity useDisclosure of resultsRegistrationTax effectsCompensation and Performance Management, Inc.
17 Considering Phantom Stock through a Strategic Model StrategyFinanceREWARDDESIGNBehaviorCompensation and Performance Management, Inc.
18 Factors Driving Compensation Plan Design Corporate governance philosophyShareholder value realization strategyIndustry normsProduct/Operations/Customer StrategyDiversity of Products/ServicesDecision-Result CyclePerformance MeasuresStrategyCompensation and Performance Management, Inc.
19 Factors Driving Compensation Plan Design .Shareholder value modelRisk-adjusted returnPerformance measuresCapital structureGAAP reportingCorporate and individual taxCash flowInvestor communicationsFinanceCompensation and Performance Management, Inc.
20 Factors Driving Compensation Plan Design .Joining, remaining, exitingIndividual, group, business unitShort-term, long-term decisionsVolumeQualityTimeInternal mobilityBehaviorCompensation and Performance Management, Inc.
21 Expanding …To New Forms of Pay (What do we use it for?) Short-term (annual) incentive plan deferralStock option gain deferralSupplemental executive retirement plans (SERPs)Elective nonqualified deferred compensationStock-based compensation “gaps”Plan Design IdeasSERP accruals and payments based on valueDeferred amounts value determined by phantom stock formulaSix-month phantom plan to bridge proposed option repricing waiting periodCompensation and Performance Management, Inc.
22 Expanding …To New Industries (Where do we use it?) Not-for profit organizationsEducational institutionsGovernment organizationsPlan Design IdeasUniversity faculty members and support staff receiving phantom shares based on a composite of 15 indicators of the school’s performance including starting salary of MBA graduates University of Pittsburgh Katz School of BusinessNot-for-profit health care holding company with diversified business units provides long-term incentive compensation based on mission-related measuresCompensation and Performance Management, Inc.
23 Expanding …To New Situations (Why do we use it?) Joint venturesAffiliate investmentsTurnaround situationsPlan Design IdeasExecutive officers participate in cash or stock distributions from Company’s venture investments. Distributions paid only after company recovers cost basis. Adobe Systems, Inc. “Adobe Incentive Partners, LP”Senior officer plan pays out only if company is sold at or above a predetermined price. Private investment firm acquiring financial institutionsCompensation and Performance Management, Inc.
24 Expanding …To New Levels (Who is included?) Profit centersCost centersProject teamsPlan Design IdeasPhantom share value based on contribution margin of profit centerInitial phantom share value fluctuates with costs (reverse gain sharing)Project team phantom shares determined by Milestones, determining number of shares awarded Product revenues, determining share valueCompensation and Performance Management, Inc.
25 Expanding …To New Award Schedules (When do we reward?) Annual distributionsQuarterly dividendsElective redemptionsPlan Design IdeasPhantom stock grant at hire with a monthly dividend -- no cash compensationPhantom stock accounts extending beyond retirement with elective redemptionsCompensation and Performance Management, Inc.
26 Compensation and Performance Management, Inc. New Award SchedulesElective RedemptionsFinalDistributionDividend PaymentsCompensation and Performance Management, Inc.
27 The Next Wave: Phantom Stock Popularity Soars FASB continues to expand charges for stock plansInvestors disregard EPS, focus on cashMerger and acquisitions create complex organizationsExecutive mobility continuesStock market stagnatesAll-employee option plans disappointCompensation and Performance Management, Inc.
28 Design Considerations: Financial Impact on other compensation plans from expense accrualCash outflow of payments -- financial modeling is criticalExcess accumulated earnings taxDe facto ERISA plan without tax benefitsDeemed security due to reduction in other compensationCompensation and Performance Management, Inc.
29 Design Considerations: Regulatory SEC Section 16SEC Proxy DisclosureERISABlue Sky LawsFASBCompensation and Performance Management, Inc.
30 Design Considerations: Administrative Employment terminationChange-in-controlChange in exit strategyNew plan may require “jump start”Compensation and Performance Management, Inc.
31 In Closing: Advantages EmployerFlexibility in designNo ownership dilutionNo minority shareholdersRewards tied to value creationPossibly exempt from regulationRetention power of multi-year performance periodsSelf-funding based on economic value creationEmployeeNo cash outlay for employeeNo wait for a liquidity event for sharesHigh upside over short-term cash compensationCompensation and Performance Management, Inc.
32 In Closing: Disadvantages EmployerAccounting charges to earningsTax deduction deferred until paymentCash outflows may be burdensome or ill-timedNo downside in reward formulaEmployeeNo actual ownership unless paid in stockNo control over timing of compensation if payment timing is fixedLump sum awards may create significant tax liabilityCapital gains treatment will not apply to award paymentCompensation and Performance Management, Inc.
33 About CPMCompensation and Performance Management, Inc. (CPM) helps organizations allocate financial capital to their human capital. We resolve employee performance and reward management issues within a business-based framework emphasizing strategic, financial and behavioral issues over traditional human resources management concepts.Founded in 1991, CPM has served clients in a variety of industries ranging from small not-for-profit organizations to Fortune 500 companies. Our Firm specializes in working with organizations undergoing significant changes in ownership, size, and/or strategy -- and who are genuinely interested in improving organization performance.We assist clients with determining, designing, and implementing the elements of a total economic performance management system required for meeting business objectives.Compensation ManagementPerformance ManagementCompensation StrategyEmployee Ownership ProgramsExecutive CompensationDirector CompensationIncentive ProgramsEmployment ContractsSales CompensationSalary ManagementSeverance PoliciesCompensation CommunicationsObjective SettingPerformance MeasurementPerformance Evaluation SystemsManagement Training and CoachingHuman Resource Strategic PlanningHuman Resource Diagnostic ReviewsOrganization AnalysisStaffing StrategiesEmployee Opinion ResearchEmployee Business EducationCompensation and Performance Management, Inc.
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