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Fred E. Whittlesey Principal American Compensation Association 4 May 1999 Compensation and Performance Management, Inc. www.cpmnet.com © Compensation and.

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Presentation on theme: "Fred E. Whittlesey Principal American Compensation Association 4 May 1999 Compensation and Performance Management, Inc. www.cpmnet.com © Compensation and."— Presentation transcript:

1 Fred E. Whittlesey Principal American Compensation Association 4 May 1999 Compensation and Performance Management, Inc. © Compensation and Performance Management, Inc. All rights reserved. Expanding the Phantom Stock Concept

2 Compensation and Performance Management, Inc. About The Speaker Fred 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.

3 Compensation and Performance Management, Inc. Today’s Discussion ©What 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 model ©New opportunities for phantom stock

4 Compensation and Performance Management, Inc. What is Phantom Stock? ©Performance-based compensation program ©Contingent right to share increases in value ©Unsecured promise to pay ©Multi-year performance period ©Usually settled in cash ©Typically reflects underlying actual stock value

5 Compensation and Performance Management, Inc. How is Phantom Stock Different From Stock Plans? ©No investment by employee ©No stock certificates issued ©No legal equity ownership ©No voting rights exist ©Dividend equivalents rarely provided ©Accounting and tax treatment differ significantly

6 Compensation and Performance Management, Inc. Typical Phantom Plan Operation ©Value formula determined ©Target compensation level established ©Phantom shares/units awarded at beginning of period ©Initial value zero (appreciation plan) or estimated FMV (value plan) ©Payment at end of fixed performance period

7 Compensation and Performance Management, Inc. Traditional Plan Design: Performance Measurement ©Actual equity valueMarket value Private transactions ©Estimated equity valueFormal appraisal Formula ©Determinants of equity valueRevenue growth Profit Return ©Drivers of equity valueUnit volume Customer base Cycle time

8 Compensation and Performance Management, Inc. Traditional Plan Design: Performance Periods ©Typically 3 to 7 years ãMay be event-triggered ãMay be tied to product cycle ©Typically multiple cycles ãEnd-to-end ãOverlapping ãMay be multiple cycles based on differing criteria

9 Compensation and Performance Management, Inc. Illustration of Phantom Stock Performance Cycles Single Cycle Sequential Cycles Overlapping Cycles Year 1Year 2Year 3Year 4Year 5Year 6

10 Compensation and Performance Management, Inc. Traditional Plan Design: Vesting and Exercisability ©Usually time-based vesting ãIncremental vesting ãCliff vesting ãMay be performance-accelerated ãMay be event-triggered ©Primarily end-of-cycle payouts ãLump-sum ãStream of payments

11 Compensation and Performance Management, Inc. Factors Driving the Rise of Phantom Stock Popularity ©More private companies ©Bull market pressures ©Capital accumulation needs ©Limits on qualified plans creating reverse discrimination ©Increased pressure to “align with shareholder value” ©Changes in securities regulations ©More complex equity structures

12 Compensation and Performance Management, Inc. Phantom Stock Synonyms: Traditional Terminology ©Stock Appreciation Rights (SARs) ãStock price as measure, paid in cash ©Performance Units ãFinancial and operational measures, paid in cash ©Performance Shares ãPerformance measures and stock price, paid in shares ©Cash LTIPs ã“Target” rather than “unit” focus

13 Compensation and Performance Management, Inc. Phantom Stock Synonyms: Emerging Practices ©“Class B” common shares ãNon-voting ãNon-dividend ©Tracking stock (“letter stock”) ãTied to performance of business unit ãNo claim on assets of business unit ãOften no voting rights ãUsually in non-dividend sectors ©Convertible securities ãPreferred shares ãDebentures

14 Compensation and Performance Management, Inc. Why consider phantom stock as a design alternative? ©Common stock options are “too big” ãLine of sight and impact on results ãExternal factors ©Short-term cash incentives are “too small” ãShort-term focus ãDecision-result cycle ©Phantom stock may be “just right”….

15 Compensation and Performance Management, Inc. Who would consider phantom stock as a design alternative? ©Equity use undesirable, complicated, illiquid, or illegal ãPrivate company ãSubsidiaries ãForeign corporation ãSEC insiders ©Equity doesn't exist in a securitized form ãMutual organizations ãCooperatives ãNot-for-profit organizations ãDivisions

16 Compensation and Performance Management, Inc. Who would consider phantom stock as a design alternative? And Why? ©Entity equity not the best measure of value ãComplex ownership structure ãDiversified lines of business ãConsolidated financial statements ©Undesirable requirements for equity use ãDisclosure of results ãRegistration ãTax effects

17 Compensation and Performance Management, Inc. Considering Phantom Stock through a Strategic Model REWARD DESIGN StrategyFinance Behavior

18 Compensation and Performance Management, Inc. Factors Driving Compensation Plan Design Strategy © Corporate governance philosophy © Shareholder value realization strategy © Industry norms © Product/Operations/Customer Strategy © Diversity of Products/Services © Decision-Result Cycle © Performance Measures

19 Compensation and Performance Management, Inc. Factors Driving Compensation Plan Design. Finance © Shareholder value model © Risk-adjusted return © Performance measures © Capital structure © GAAP reporting © Corporate and individual tax © Cash flow © Investor communications

20 Compensation and Performance Management, Inc. Factors Driving Compensation Plan Design. Behavior © Joining, remaining, exiting © Individual, group, business unit © Short-term, long-term decisions © Volume © Quality © Time © Internal mobility

21 Compensation and Performance Management, Inc. Expanding …To New Forms of Pay (What do we use it for?) ©Short-term (annual) incentive plan deferral ©Stock option gain deferral ©Supplemental executive retirement plans (SERPs) ©Elective nonqualified deferred compensation ©Stock-based compensation “gaps” ©SERP accruals and payments based on value ©Deferred amounts value determined by phantom stock formula ©Six-month phantom plan to bridge proposed option repricing waiting period Plan Design Ideas

22 Compensation and Performance Management, Inc. Expanding …To New Industries (Where do we use it?) ©Not-for profit organizations ©Educational institutions ©Government organizations ©University 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 Business ©Not-for-profit health care holding company with diversified business units provides long-term incentive compensation based on mission-related measures Plan Design Ideas

23 Compensation and Performance Management, Inc. Expanding …To New Situations (Why do we use it?) ©Joint ventures ©Affiliate investments ©Turnaround situations ©Executive 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 institutions Plan Design Ideas

24 Compensation and Performance Management, Inc. Expanding …To New Levels (Who is included?) ©Profit centers ©Cost centers ©Project teams ©Phantom share value based on contribution margin of profit center ©Initial 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 value Plan Design Ideas

25 Compensation and Performance Management, Inc. Expanding …To New Award Schedules (When do we reward?) ©Annual distributions ©Quarterly dividends ©Elective redemptions ©Phantom stock grant at hire with a monthly dividend -- no cash compensation ©Phantom stock accounts extending beyond retirement with elective redemptions Plan Design Ideas

26 Compensation and Performance Management, Inc. New Award Schedules Final Distribution Elective Redemptions Dividend Payments

27 Compensation and Performance Management, Inc. The Next Wave: Phantom Stock Popularity Soars ©FASB continues to expand charges for stock plans ©Investors disregard EPS, focus on cash ©Merger and acquisitions create complex organizations ©Executive mobility continues ©Stock market stagnates ©All-employee option plans disappoint

28 Compensation and Performance Management, Inc. Design Considerations: Financial ©Impact on other compensation plans from expense accrual ©Cash outflow of payments -- financial modeling is critical ©Excess accumulated earnings tax ©De facto ERISA plan without tax benefits ©Deemed security due to reduction in other compensation

29 Compensation and Performance Management, Inc. Design Considerations: Regulatory ©SEC Section 16 ©SEC Proxy Disclosure ©ERISA ©Blue Sky Laws ©FASB

30 Compensation and Performance Management, Inc. Design Considerations: Administrative ©Employment termination ©Change-in-control ©Change in exit strategy ©New plan may require “jump start”

31 Compensation and Performance Management, Inc. In Closing: Advantages Employer ©Flexibility in design ©No ownership dilution ©No minority shareholders ©Rewards tied to value creation ©Possibly exempt from regulation ©Retention power of multi-year performance periods ©Self-funding based on economic value creation Employee ©No cash outlay for employee ©No wait for a liquidity event for shares ©High upside over short-term cash compensation

32 Compensation and Performance Management, Inc. In Closing: Disadvantages Employer ©Accounting charges to earnings ©Tax deduction deferred until payment ©Cash outflows may be burdensome or ill-timed ©No downside in reward formula Employee ©No actual ownership unless paid in stock ©No control over timing of compensation if payment timing is fixed ©Lump sum awards may create significant tax liability ©Capital gains treatment will not apply to award payment

33 Compensation and Performance Management, Inc. Compensation 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. About CPM © Compensation Strategy © Employee Ownership Programs © Executive Compensation © Director Compensation © Incentive Programs © Employment Contracts © Sales Compensation © Salary Management © Severance Policies © Compensation Communications © Objective Setting © Performance Measurement © Performance Evaluation Systems © Management Training and Coaching © Human Resource Strategic Planning © Human Resource Diagnostic Reviews © Organization Analysis © Staffing Strategies © Employee Opinion Research © Employee Business Education Compensation Management Performance Management

34 Return to CPM home page See upcoming presentations


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