Simulated Equity Plans

Goal-Driven Long Term Cash Incentives

Definition

Simulated equity plans are long-term cash incentive programs designed to reward participants for contributing to the organization’s future success.  Plans are designed to resemble stock option or grant programs in every way possible (without the use of real stock).

Awards are made to participants in paper unit “shares” with a given dollar value at the beginning of a performance period, usually two to three years.  Participants receive a vested right to the appreciation in “share value” over the performance period and defer personal taxation until such time that the appreciated value is received in cash.

How They Work

• Awards are made to participants in paper unit “shares” with a given dollar value at the beginning of a performance period (usually two to three years).

• Initial “share” price is determined by dividing the calculated “enterprise value” of the organization by the number of “shares” allocated to the Plan.

• Future “share” prices are calculated at least annually and may increase or decrease dependent upon the degree to which corporate success factors (goals) are achieved.

• Participants receive a vested right to the appreciation in “share” value over the performance period (or life of the plan) based upon the attainment of corporate performance goals.

• Personal taxation is deferred until such time that the appreciated value is received in cash.

• The corporation must accrue for contingent liabilities (cash payments) consistent with vesting schedule or life of the plan.

• Change of control features (buy/sale agreements) may be applied.

• Life of plans are usually seven to ten years

• Plans are usually administered by a committee appointed by the Chief Executive Officer.

Trends and Characteristics

Trends in plan design:

• Plans that are performance-driven and funded through incremental earnings.
• Plans that relate executives’ reward to actual company performance as opposed to stock price movements.
• Plans that provide stakeholders’ a predetermined return on their investment prior to rewarding internal management.
• Plans that directly integrate executive incentives with company’s strategic objectives.

Viable plans share the following characteristics:

• They encourage teamwork and cooperation among eligible participants.
• Awards are based on specific, not general or discretionary achievements.
• There are no guarantees of award payments.
• Awards are made only if warranted by the financial health of the organization.
• Group efforts and achievements are recognized.
• The award criterion is simple and easily understood by participants.
• Awards are sufficient to make the effort worthwhile.
• Targets are realistic and attainable.

Answers to Frequently Asked Questions

1. What are simulated equity plans?

   They are long-term incentive programs designed to reward participants for contributing to the organization’s future success.  They are often referred to as phantom stock or performance unit/share plans.

2. What does simulation mean within this context?

   Plans are designed to resemble actual stock option or grant programs in every way possible (without the use of real stock).  Plan design features usually include:  internally valued “stock” which may vary up or down in future prices based upon corporate performance; share grants;  performance cycles;  vesting schedules; grant agreements; etc. 

3. What types of organizations are most likely to be interested in such programs?

   Privately held organizations who want to retain their senior management team members without diluting equity;  new business units of publicly held companies;  and any organization who wishes to share future corporate value with its management in an internally measured fashion. 

4. How do these plans work?

   Awards are made to participants in paper unit “shares” with a given dollar value at the beginning of a performance period.  Participants receive a vested right to the appreciation in “share” unit value over the performance period and defer personal taxation until such time that such ‘share’ values are received in cash.

5. What types of stock programs are most often simulated?

   Restricted Stock, Stock Appreciation Rights and stock grant programs. 

6. How are “share” values calculated?

   The enterprise value of the organization is determined and divided by the number of “shares” required for the plan.

7. What determines the future value of “shares?”

   The achievement of predetermined corporate success factors (goals).  Future “share” values grow with the attainment of goals, or decline in value should objectives not be achieved.

8. Why are these plans growing in popularity, even among publicly held corporations?

   Changing accounting treatment for stock award programs.  The Financial and Accounting Standards Board (FASB) requires that performance based stock programs be treated as “cash plans” and charged to earnings.

9. How does an organization benefit from having a simulated equity plan?

   They focus the mutual interests of senior management and stakeholders through increased corporate performance.  Value is internally based and measured as opposed to public opinion of share value

10. What is the drawback to these plans?

    They represent a charge to earnings; however, they are self-funded through incremental earnings.  The goal setting process produces high earnings to costs leverage multiples.  Additionally, many organizations today are voluntarily expensing stock options in response to the regulatory environment.

11. Can phantom shares be converted to real corporate stock?

    Yes.  Some plan designs allow such conversions in the event of corporate “change of control” usually represented by mergers, initial public offerings, etc.