Private companies grapple with many issues. In our experience, as companies expand and the founder brings on key people who are important to the long-term strategy (and especially the succession plan), there’s one major sticking point that inevitably comes up: how can these talented people be incentivised to grow the equity value of the business?
This topic goes far beyond what can be covered in a single article. In this piece, we will focus on one of the commonly used methods: phantom share schemes.
What are phantom shares?
You probably already know that a share is a unit of ownership in a company. Shareholders hope for the value of the shares to increase over time, while receiving dividends along the way. This can be lucrative, which is why astute executives expect to receive share-based remuneration of some sort as they play an increasingly important role in the strategy of the business.
A phantom is an immaterial illusion – one which has little use in business, other than to Andrew Lloyd Webber. But when it comes to phantom shares, which imitate a share without actual ownership of the company changing hands, we find a powerful tool for incentivisation of employees.
How does a phantom share scheme differ from profit or revenue share?
The ultimate goal of a share-based incentive scheme is to create a system in which all parties are aligned. The founder, senior executives and important managers must be pulling in the same direction. One of the ways to do this is a revenue or profit share, an approach worth spending time on before we unpack how a phantom share scheme differs from these methods.
Incentive structures linked to revenue or profits may be quite simple to understand, but in practice come with challenges. A revenue share incentivises only the total value of sales but not the actual profit generated. This may lead to sales being made at margins that are not sustainable.
A profit share may seem like the obvious answer, but even this has challenges. What happens if the CEO drives profits up in the short-term to maximise the profit share, potentially to the detriment of the company over the long-term due to underinvestment in the operations?
A phantom share scheme incentivises behaviour that maximises the equity value of the company over time. This is the best way to align senior executives with shareholders, as they are exposed to the same measurement of value over time. Importantly, it bakes in longer-term thinking rather than the “short-termism” risks of e.g. profit-based targets.
Importantly, a phantom share scheme isn’t for everyone. For examples, members of the sales team would be better off with a sales-linked structure, provided there are checks and balances in place around profitability on individual deals. Phantom share schemes are more suitable for executives who play a broader strategic role that creates equity value over time. Using more narrowly defined targets for such executives may create misaligned goals.
A shareholder, like a new puppy, isn’t just for Christmas.
The business world is rife with stories of private company shareholdings gone wrong. Assigning shares to key employees may well incentivise them, but just remember that you’re bringing in someone who will be around until their shares are bought or sold. There are plenty of precautions you can take in the forms of vesting periods and exit clauses, but it may be easier not to have to consider them at all, especially as minority shareholders in a private company have little or no say on the strategic direction anyway.
Remember, the expectation created when a share scheme is implemented is that there will be a flow of value. This implies both dividends and some kind of eventual exit. This may not be in the best interests of the company or the controlling shareholder, leading to the incentive structure having the exact opposite outcome to what was intended: sowing the seeds of discontent in the business rather than creating alignment.
How does a phantom share scheme work?
A phantom share scheme allows participation in the company without having legal ownership of any shares. This solves many problems, ranging from funding of share purchases through to difficult tax implications.
Instead of owning a share, the incentivised party is entitled to the value appreciation linked to the share based on a pre-determined formula. They may also be entitled to equivalent dividends from the profit generated. The agreement could offer one of these options, or a blend of the two, and potentially include additional vesting periods or performance metrics.
Naturally, real shareholders still own the actual equity, so these synthetic options will be an expense in the business which decreases profit and has a fundamental influence on the value of the shares. The intent is to create incentives linked to the value of the company without creating a significant burden on the company.
In a year with tight cash flows for example, but an uptick in the value of the equity, the company would be required to pay a portion of the value to incentivised parties without receiving any related cash flow for doing so.
What are the downsides?
As alluded to above, a phantom share scheme can be complex and its effect should be carefully financially modelled. The implementation may also be subject to certain laws in the relevant jurisdiction. Engaging experienced and qualified legal and accounting professionals is highly recommended.
This is also a complex incentive scheme for employees as well. It’s easy to explain and track a 1% revenue split over time but phantom share schemes must be clearly understood by all parties if they are to be of maximum benefit. Of critical importance to remember is that the value of the equity is impacted by many factors, including external issues like macroeconomics, so great company performance in a given period may not be rewarded by the equity value.
To achieve the intended benefits, the phantom share scheme needs to be a reasonable portion of the remuneration package, so it is better suited to more senior employees who aren’t as cash-strapped each month. If it is too small a part of the remuneration package, it may not be enough to drive the right behaviour anyway.
What are the shares of a company worth?
For publicly listed companies, this is an easy answer as we have sight of the day-to-day trading in the stock and can calculate the value as the latest share price multiplied by the number of issued shares. For private companies, this becomes much more complex.
The best phantom share agreements make mention of the share valuation methodology. There should preferably be an independent expert who values the company at the start date and each calculation date thereafter. A simple approach is to set a given multiple (e.g. 4x EBITDA), but then this ends up being no different to the profit incentivisation as this doesn’t take into account other valuations factors like long-term investment and risk mitigation.
Can bizval value the business for a phantom share scheme?
Once you’ve identified that this scheme is the right way forward to incentivise the behaviour that you want to see in the organisation, then bizval is perfectly placed to assist with not just the starting valuation for the scheme, but the ways in which the valuation should be conducted going forward.