Business Law Articles
Houser Henry & Syron LLP
Savvy business owners go to great effort to hire the right staff. The inevitable scenario can then arise as to how to retain and motivate those exceptional employees who rise to the top.
Key employees can lose focus and ultimately leave because they have no ‘skin in the game’. At a certain point, a star employee(s) may see more opportunity elsewhere or think that ownership is crucial to being a part of the company’s long-term future. Further bonuses or salary increases may not make sense for the company and/or fail to properly motivate the employee.
From an owner’s perspective, relinquishing control of the company comes with its own set of problems. Adding shareholders can: (i) add complexity to the ownership structure; (ii) make the company less attractive to prospective purchasers; (iii) make it more difficult to run the company; and iv) expose the financial details of the company, which may be sensitive.
Fortunately, there is an alternate option: A Phantom Share Plan (a “PSP”) allows an employee to share in the company’s future growth without the principals giving up ownership in the company.
What is a PSP?
A PSP is a contractual arrangement between an employer and an employee, whereby the employee is granted so-called units (also known as phantom shares), the value of which are closely linked to the value of the company. The employer has the ability to draft the terms in the PSP to suit its own commercial needs and goals.
PSP’s are not regulated by specific legislation and are basically a contractual bonus scheme. However, unlike stock options, it pays cash instead of shares.
Generally, PSPs have the following characteristics:
- Units are issued to an employee that mirror the value of the share equity of the company;
- Units have only the rights provided in the PSP;
- Typically, units have an issuance price that is equal to the fair market value (“FMV”) of the company’s shares at the time they are granted to the employee. The employee does not pay for units received;
- The company redeems units from the employee upon the occurrence of certain triggering events. Triggering events typically include the sale of the business or the death or permanent disability of the employee; and
- Employees who have units are generally entitled to two forms of payment:
o Distributions: Employees may receive distributions set at the sole discretion of the company, similar in concept to issuing a dividend; and
o Redeeming of units: Units are redeemed by the company on the occurrence of triggering events as specifically agreed in the PSP. Upon redemption the employee will be entitled to receive the difference between the units’ value on the date that they were granted to the employee and the value of the company’s shares on the date of the triggering event.
For example, assume a company implements a PSP and grants an employee ten (10) units. The PSP states that units must be redeemed by the company if the company is sold. On the date the units are issued, the company’s shares have a FMV of $5.00 each. Three years later, the company is sold to an unrelated buyer for $12.00 a share. This is a so-called “triggering event”, and the employee would be entitled to receive $7.00 per unit; the difference between the phantom shares’ grant value and the value of the share at the date of the triggering event.
Why implement a PSP?
Employees who receive units under a PSP participate in the future growth of the company. Their goals can now be aligned with the company’s long-term goals in a manner that normal salary and bonuses cannot achieve.
Benefits for the employer include:
- No transfer of ownership – A unit is not a share of the company’s stock. Units carry no voting rights and do not dilute ownership of the company;
- Customized and simple to implement – PSPs are a contractual agreement. An owner has flexibility to incorporate terms such as: which employees participate, how many units to issue, when the units are redeemed and what happens to the units if the employee is no longer employed by the company.
a. PSPs avoid a lot of the additional paperwork and complexity associated with issuing actual shares and do not require a shareholders agreement;
- Employee motivation and retention – Employees with units will directly benefit from the success of the company.
- Minimal Upfront Costs – The only initial cash outlay is the administrative costs to implement the plan; and
- Deferred taxation – Payments made by the company in relation to the units are treated as employment income for tax purposes, and are only taxed when the employee receives payment. Also, if the PSP is properly designed and implemented, an employee will not be taxed for receiving units.
Indicators that a PSP is right for your Company
PSPs can be a powerful source of employee motivation and retention. However, not every company is ideally suited to implement a PSP. Consider these factors to determine whether a PSP is right for your company:
- The company has a small number of shareholders.
- There are a small number of key employees. For a PSP to be effective, the employee who receives units should be integral to the future value of the company. Companies typically only reward management and senior employees who are key to the company’s success and growth;
- The company is increasing its employees’ responsibilities and does not want to increase salaries directly; and
- The company is in fairly good financial position and is likely to continue to grow. A motivational tool is only effective if benefits are likely to be realized.
How to implement a PSP
When designing and implementing a PSP, consider the following:
- Discuss with your shareholders which employees you would like to target and the parameters of your plan (i.e. number of units, triggering events and payout schedules). We recommend including your accountant and lawyer in these discussions to determine the plan’s feasibility and compliance with the law;
- Discuss the plan with your key employee(s), keeping your parameters in mind. A PSPs power as a tool for motivation and retention ultimately depends on its appeal to the employee(s) to whom it will be offered;
- Set up a timeline with the employee(s) and your lawyer to complete a draft of the plan and a date to have the plan signed; and
- Determine the FMV of the company’s shares. This figure will be used to set the initial value of the units. This is usually done by an independent valuator.
A PSP represents a win-win opportunity for both employers and employees. It is a cost-effective method to motivate and retain great employees and can be customized to suit an employer’s specific requirements.
A properly constructed plan will help you achieve your business goals and ensure compliance with the Income Tax Act (Canada). Please speak with a lawyer at our Firm if you are interested in learning more or plan to implement a share plan for your company.
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