Compensation and Performance Management, Inc.www.cpmnet.com

© Compensation and Performance Management, Inc. All rights reserved.

Fred E. WhittleseyPrincipal

American Compensation Association 4 May 1999

Expanding thePhantom Stock Concept

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.

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.

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.

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.

Traditional Plan Design: Performance Measurement

Actual equity value Market valuePrivate transactions

Estimated equity value Formal appraisalFormula

Determinants of equity value Revenue growthProfitReturn

Drivers of equity value Unit volumeCustomer baseCycle time

Compensation and Performance Management, Inc.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Considering Phantom Stock through a Strategic Model

REWARDDESIGN

Strategy Finance

Behavior

Compensation and Performance Management, Inc.

Factors Driving Compensation Plan Design

Strategy

Corporate governance philosophy

Shareholder value realization strategy

Industry norms

Product/Operations/Customer Strategy

Diversity of Products/Services

Decision-Result Cycle

Performance Measures

Compensation and Performance Management, Inc.

Factors Driving Compensation Plan Design.

Finance

Shareholder value model

Risk-adjusted return

Performance measures

Capital structure

GAAP reporting

Corporate and individual tax

Cash flow

Investor communications

Compensation and Performance Management, Inc.

Factors Driving Compensation Plan Design.

Behavior

Joining, remaining, exiting

Individual, group, business unit

Short-term, long-term decisions

Volume

Quality

Time

Internal mobility

Compensation and Performance Management, Inc.

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”

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

Plan Design Ideas

Compensation and Performance Management, Inc.

Expanding …To New Industries (Where do we use it?)

Not-for profit organizations

Educational institutions

Government organizations

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

Plan Design Ideas

Compensation and Performance Management, Inc.

Expanding …To New Situations (Why do we use it?)

Joint ventures

Affiliate investments

Turnaround situations

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

Plan Design Ideas

Compensation and Performance Management, Inc.

Expanding …To New Levels (Who is included?)

Profit centers

Cost centers

Project teams

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 awardedProduct revenues, determining share value

Plan Design Ideas

Compensation and Performance Management, Inc.

Expanding …To New Award Schedules (When do we reward?)

Annual distributions

Quarterly dividends

Elective redemptions

Phantom stock grant at hire with a monthly dividend -- no cash compensation

Phantom stock accounts extending beyond retirement with elective redemptions

Plan Design Ideas

Compensation and Performance Management, Inc.

New Award Schedules

FinalDistribution

Elective Redemptions

Dividend Payments

Compensation and Performance Management, Inc.

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.

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.

Design Considerations: Regulatory

SEC Section 16

SEC Proxy Disclosure

ERISA

Blue Sky Laws

FASB

Compensation and Performance Management, Inc.

Design Considerations: Administrative

Employment termination

Change-in-control

Change in exit strategy

New plan may require “jump start”

Compensation and Performance Management, Inc.

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.

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

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