Legal Watch: Shadow Equity Plans

Jan. 16, 2013
Closely held security companies can use these structures to their advantage

Hiring and retaining quality employees for key positions is essential in delivering first-rate security services and crucial to the success of security providers. A “shadow equity” or “phantom stock” plan— an often-overlooked form of compensation for key executives—gives closely held security providers an effective way to attract, retain and motivate key employees while preserving capital that companies might otherwise use for employee compensation.

These plans provide key employees that the company designates as participants with significant monetary incentives while tying the participants’ right to compensation to specific events—the participant’s retirement or the sale of the company to a third party, for example. Key employees are more likely to remain with the company long-term since resignation or termination under the plan results the loss of their rights to compensation.

Creating the structure

A properly structured plan requires a written agreement outlining all of the plan’s provisions, including those designating which employees are eligible to participate in the plan, establishing vesting periods and triggering events, and setting the maximum number of plan “units” a participant can receive and how those units are valued. The agreement also establishes a committee to administer the plan, typically comprising the company’s owners, and often including designated management.

In these plans, units substitute for actual shares of the company stock. Plans often issue “phantom stock” units to participants, the value of which typically “shadow” the value of the company’s shares. This gives participants a sense of investment in the company’s ownership and long-term success, without forcing the company’s owners to share the company with participants. Plan units accumulate in the employees’ “memorandum accounts”— essentially bank accounts solely for the employees’ units that exist for a specific period, beginning when participants enroll in the plan and ending with the occurrence of one of a number of specific events, including the employee’s death, non-competitive resignation or retirement, or a specific liquidity event such as a sale of the company’s assets to a third-party acquirer.

Plans compensate participants only for any shareholder value created after the establishment of a plan, increases in the value of company stock, increased earnings or EBITDA, for example. Plans can also compensate employees based on a triggering event, such as the payment of dividends, or based on some other measurement. Because these plans can take takes many different forms, they offer companies a great deal of latitude in creating a plan to suit their specific needs.

One of the most important issues in establishing a plan is how the company will fund payments due to employees, especially if certain payment obligations are not tied to a liquidity event. For example, the company may be required to make a large cash payment following an unexpected event such as an employee’s death. The company should prepare projections of potential payments to determine the impact of various events on the company’s future cash flows.

Another important and challenging aspect of these plans is accurate valuation of plan units, a technical, financial and legal determination that requires advice and guidance from legal and accounting professionals. The company also may have to recognize the plan’s expense and liability for financial statement purposes prior to recognizing any tax deduction, which may significantly impact earnings.

Ultimately, despite a few challenges in properly structuring a plan, shadow equity plans can provide a real “win-win” situation for both the closely held security provider and its employees.