A common challenge faced by owners of family-run businesses is how best to reward and retain key executives while maintaining control of the company until such time as the owner’s children are ready to take the helm. One solution: the life insurance-funded phantom stock plan, which ties the executive’s compensation to the employer’s performance without diluting the owner’s controlling interest in the company.
In a perfect world, the children of business owners would be ready to take over the reins of the family-owned company just as their parents were ready to let go. But in the real world, this often is not the case because the children are not yet mature or experienced enough to assume control.
When their children need more time, it’s important that business owners take steps to retain their key non-family managers to link them to the business until the family’s next generation is ready. Employers have increasingly looked to incentive-based compensation to reward and retain key employees.
Employers often believe an employee’s economic success should be tied to the economic success of the business. By linking an employee’s remuneration to the employer’s performance, an employee is rewarded much like an owner and, thus, has an increased interest in the long-term performance of the business.
Equity-based incentives, which often serve as “golden handcuffs,” are effective tools for accomplishing this. They motivate and lock in valued employees by linking their fortunes to the performance of the business. The key employee is rewarded much like an owner and therefore has an interest in the company’s long-term success.
Family business owners, however, often reject equity-based incentives, seeing only a potential threat to future family ownership. This is where you, as a financial services professional, can step in to show business owners how to largely eliminate the threat.
You can do this by pointing out that there are several ways to provide equity-like incentives to non-family members without risking loss of family control. The incentives include stock options (both qualified and non-qualified) with a buy-back agreement, phantom stock plans, non-qualified deferred compensation and cash bonuses. The right incentive depends on the circumstances of the case.
Consider this scenario: A client, Jim Smith, is the owner of Smith Electrical Supplies, a $10 million wholesale electrical business. Jim is approaching retirement and, although he wants ownership to remain in the family, he recognizes that his son and daughter, both active in the business, lack the experience to run the highly competitive company. However, Jim’s general manager, Kevin Keyperson, has the expertise to guide the company in the interim. To bridge the time gap until his children are ready, Jim has to retain the services of this talented manager.
The solution: A phantom stock plan
We discussed this situation in great detail with both Jim and Kevin to arrive at a solution that would be agreeable to both. Non-qualified stock options and incentive stock options were ruled out because of possible difficulties in valuation of the shares and the complexities involved. Annual cash bonuses did not create the long-term golden handcuffs that were needed. We determined that a phantom stock plan best addressed the client’s need.
A phantom stock plan offers Kevin the ability to benefit from the success of the business without diluting Jim’s current ownership. Under this incentive plan, no stock is transferred. Instead, Kevin is granted hypothetical units of the business. These units may rise or fall in value based on a specified formula or the value of Smith Electrical Supplies.