Construction is a competitive industry! In today’s business world, contractors aren’t just competing for projects; they’re also competing for a dwindling supply of new management talent and other skilled workers. Salary, bonuses, incentives, and other fringe benefits options may get individuals in the door, but the problem remains: How to retain your talented employees as they move up the ranks?
To combat this problem, consider incentives that can help you attract, retain, and motivate quality employees. Another option is through equity-based compensation. Two examples of equity-based compensation are phantom stock and stock appreciation rights.
One of the most powerful tools for engaging employees and aligning their interests with those of your business is equity-based compensation. Skin in the game so to speak! Sharing ownership by granting stock options or restricted stock awards, for example — is a time-tested strategy for maintaining long-term relationships with employees.
However, for closely-held construction companies, doing so may not be a viable option. Owners may be unwilling to dilute their ownership and control of the business. Many privately-held companies have buy-sell agreements and other restrictions on their ability to transfer shares or issue new stock. Family-owned construction companies may also restrict ownership by nonfamily members.
Fortunately, there are ways to leverage the economic benefits and motivational power of equity without transferring shares to employees.
Phantom stock (or equity)
Phantom stock is an equity-like grant of shares that is tied to the company’s stock value. It is important to realize that these shares are not actual units of equity in the company, but they are counted as if they are actual units for purposes of certain payments or events of the company.
The phantom equity holder (i.e. the employees) receives cash bonuses (although stock can be used) based on the value of a specified number of shares at a specified point in time or upon a specified event, such as termination of employment or sale of the business. Some plans even permit employees to receive dividends or other benefits of ownership.
Stock appreciation rights
Stock appreciation rights (SARs), similar to stock options and phantom equity, are a grant of shares that is tied to the company’s stock value. However, employees need not put up the cash to purchase these shares of stock as is the case in a stock option plan. Again it is important to realize that these shares are not equity in the company and employees hold no equity in the company.
Unlike phantom equity, the SAR holder receives cash bonuses (or, in some cases, stock) based on the appreciation in value of the set number of shares at a specified point in time or upon a specified event. Similar to phantom equity, payments are usually made at a specific time or a specified event.
Flexible planning tools
Both phantom stock and SARs offer a great deal of flexibility in designing incentive compensation plans to meet a construction company’s needs. Although the term “stock” is used, they aren’t just for corporations. Partnerships and LLCs can take advantage of these tools based on their ownership “units”. Unlike other fringe benefit plans (for example, profit-sharing, 401(k), and employee stock ownership plans), phantom stock and SAR plans can limit participation to key employees.
You can design both of these plans with individual features to tie employees to the company long term and motivate them to improve business performance. For example, you can:
- establish vesting schedules
- tie payouts to performance goals, such as reaching certain revenue or earnings targets
These plans do not need to be the same for all employees. You can vary vesting schedules and performance targets on an employee-by-employee basis.
As with any incentive plan, phantom stock and SARs aren’t without downsides. Some of the downsides are—
- These awards are usually paid in cash, which can have a negative effect on cash flow.
- Employees do not buy into these plans so the company receives no infusion of cash.
- These awards are usually taxed at ordinary-income tax rates via bonuses (i.e. no favorable capital gain treatment for employees).
- These plans may require a business valuation either at payout (phantom stock) or at the onset (SAR).
Equity-based compensation plans can be complex and will require specific employee agreements to be put into place. We encourage you to contact the construction accounting team here at LGT below and discuss this with your legal advisors to ensure you are maximizing the benefits and risks for both company and employee.