1. Expanding the Phantom Stock Concept
Compensation and Performance Management, Inc.
© Compensation and Performance Management, Inc. All rights reserved.

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.
Compensation and Performance Management, Inc.

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
Compensation and Performance Management, Inc.

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
Compensation and Performance Management, Inc.

5. 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
Compensation and Performance Management, Inc.

6. 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
Compensation and Performance Management, Inc.

7. Traditional Plan Design: Performance Measurement
Actual equity value Market value Private transactions
Estimated equity value Formal appraisal Formula
Determinants of equity value Revenue growth Profit Return
Drivers of equity value Unit volume Customer base Cycle time
Compensation and Performance Management, Inc.

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

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

10. Traditional Plan Design: Vesting and Exercisability
Usually time-based vesting
Incremental vesting
Cliff vesting
May be performance-accelerated
May be event-triggered
Primarily end-of-cycle payouts
Lump-sum
Stream of payments
Compensation and Performance Management, Inc.

11. 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
Compensation and Performance Management, Inc.

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

13. Phantom Stock Synonyms: Emerging Practices
“Class B” common shares
Non-voting
Non-dividend
Tracking stock (“letter stock”)
Tied to performance of business unit
No claim on assets of business unit
Often no voting rights
Usually in non-dividend sectors
Convertible securities
Preferred shares
Debentures
Compensation 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 results
External factors
Short-term cash incentives are “too small”
Short-term focus
Decision-result cycle
Phantom 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 illegal
Private company
Subsidiaries
Foreign corporation
SEC insiders
Equity doesn't exist in a securitized form
Mutual organizations
Cooperatives
Not-for-profit organizations
Divisions
Compensation and Performance Management, Inc.

16. Who would consider phantom stock as a design alternative? And Why?
Entity equity not the best measure of value
Complex ownership structure
Diversified lines of business
Consolidated financial statements
Undesirable requirements for equity use
Disclosure of results
Registration
Tax effects
Compensation and Performance Management, Inc.

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

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

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

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

21. 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”
Plan Design Ideas
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
Compensation and Performance Management, Inc.

22. Expanding …To New Industries (Where do we use it?)
Not-for profit organizations
Educational institutions
Government organizations
Plan Design Ideas
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
Compensation and Performance Management, Inc.

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

24. Expanding …To New Levels (Who is included?)
Profit centers
Cost centers
Project teams
Plan Design Ideas
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
Compensation and Performance Management, Inc.

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

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

27. 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
Compensation and Performance Management, Inc.

28. 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
Compensation and Performance Management, Inc.

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

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

31. 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
Compensation and Performance Management, Inc.

32. 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
Compensation and Performance Management, Inc.

33. About CPM
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.
Compensation Management
Performance Management
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 and Performance Management, Inc.

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