A Phantom Option Stock Incentive Program (POSIP) is actually a specific kind of IRS non qualified deferred compensation program (NQDCP). These programs are used to meet several objectives in privately held corporations that include senior executive retention and long term capital accumulation for key executives. These programs are frequently used as a means to incentivize key executives to remain with a corporation during an ownership transition.

Since the IRS does not qualify these programs, owners of corporations have complete discretion and freedom to structure anything that meets their best interests. There are no externally imposed rules. The bad news is that operating expenses needed to fund these programs do not qualify as a current expense deduction for income tax purposes with the IRS. The company does not get a tax deduction at the time of contribution, only when the program beneficiary is in constructive receipt of the funds in a pay out situation. The proceeds from these programs have no tax consequence to the individual until they receive a disbursement based on plan design. This is not a situation of tax avoidance for either party, rather a deferral based on program structure. It is carried on the company books as a common creditor liability. It can be terminated at any time by the employer under employer-defined terms in the plan.

Employers generally provide these agreements to senior executives within limits described below. These represent common practice and in no way limit employer options. Indian River has even seen NQDCP's that required senior executives to lose weight and quit smoking.

• A contribution is made yearly, based on some formula, to a money management account, named for the individual. The account is owned by the company and carried as an asset to offset the liability.
• Each annual contribution usually vests over a multiple year period, e.g. 5 years in 20% increments. Any voluntary termination of the executive forfeits unvested portions. This component is often referred to as the "Golden Handcuffs."
• The executive provides a clear non-compete agreement as partial offset for this benefit.
• Unvested portions generally will vest 100% if the company is sold, the executive is disabled, or the executive retires in conformance to owner expectations.
• Employers tailor the economic value of these programs to the relative contribution of each senior executive. Consistency, at least in specifics, is rare.

The most common kind of NQDCP in distribution today is an annual contribution from 0% to 10% of a senior executives total cash compensation based on return on asset performance at the operating level. While it is hard to draw hard rules, contributions would generally be zero if ROA was under 5%. These programs also typically have a 20%/year contribution vesting schedule.

While simple and easily understood, this structure meets most of the design objectives of an owner trying to retain and provide for a small group of loyal key contributors. These programs are offered by the major financial institutions (Shearson, Merrill Lynch, etc.) and each executive has the ability to make investment decisions on the monies in his or her designated accounts. The executive, not the employer, also has the responsibility to manage a company asset until it becomes theirs in some transition event.

Phantoms: A Special Kind of NQDCP

The Phantom Share program is a special subset of NQDCPs where growth in accumulated capital is linked to a value of a notional equity in the business that employs the executive. This increases the uncertainty for the owner since the common liability will grow or shrink with the success of the business enterprise. A POSIP provides senior executives with the benefits of ownership, without the complexities of partners in closely held corporations. POSIPs act like true equity programs in many cases and are generally highly effective at creating an "owner's entrepreneurial perspective"

Owners should think carefully about the amount of "equity" that they are willing to share. In a pure start up the general maximum that would be given away or sold would be 30% for all executives combined. If the business is viable and the POSIP is being added, the general maximum would be 10% for all managers combined. Don't forget that many distributors need to also hold some "shares" in reserve for future acquisitions. It would be unusual to grant or sell all 10% during year one. Part of the value of these programs is to hold some in reserve so additional contributions can be made in subsequent years, or for outstanding contributions. Frequently the owner will divide a 10% equity based "share" into 10,000 or so notional performance shares and make grants or sales of these shares based on tenure, performance, or exceptional contribution.

Employee Stock Ownership Programs (ESOPs) are used to include all employees in an ownership culture. POSIPs are rarely used outside of a small group of individuals critical to the enterprise.

A typical vice president of sales being recruited into an ongoing viable distribution business would typically be able to earn from 1% to 3% of the equity on a Phantom Share basis over time with outstanding performance.

The key design element of a POSIP is that it is a kind of NQDCP that has uncertain value based on company performance. It is essentially a promise to pay a senior manager a sum of money, under a specific set of circumstances that is linked to value of the company. Annual cash contributions are made to some form of cash management account to offset the liability that increases with time. Once this mechanism is in place the program works essentially like an actual Stock Incentive Program in a public company.

The freedom in design is considerable and owners can decide if the stock "shares" are granted or sold. If they are sold, owners can determine if they are priced based on current book value or current market value. Many owners have limited funds authorized to purchase shares as a fixed percent (e.g. 0 –50%) of earned bonus awards. Owners can decide if the share value can be used as loan collateral. Owners can also decide what restrictions exist on vesting, use, and repurchase terms and conditions.

Owners who wish to consider either NQDCPs or POSIPS need to consult their own legal counsel to draw up their specific plan in conformance to applicable laws. These programs are quite common so the legal costs tend to be very reasonable. The real task is to think through what the real objectives of such a program include and who would be affected. The best Indian River advice is to start off small and add to the program over a multiple year history.

A sample employment agreement follows and it is offered as a guide to ideas and alternatives. Each owner must gain his or her own direct legal advice. This example involves recruiting a POSIP actually turns into equity. It is a disguised real situation.

START OF EXAMPLE...

EMPLOYMENT AGREEMENT
Between
NEVER IN CONTROL CORPORATION
And
CASEY JONES

1. OVERVIEW

This is an agreement that describes the hiring and appointment of an operating company President who will own 4 percent of the company when the agreement is fully executed over a three-year period. The two parties to this agreement are the NEVER IN CONTROL Corporation, whose Chairman is Roger Gabriel, based in Florida, henceforth known as Nevcon, and Casey Jones, henceforth known as Manager. The Manager will start employment on January 1, 2001, as a sales representative. The manager will be appointed to Sales Manager on or before January 1, 2004. The manager will be appointed to the position of President on or before January 1, 2006. This agreement describes the terms and conditions of work and the process by which equity is granted and earned.

2. TERMS AND CONDITIONS

The manager will have a starting salary of $65,000/year, which will be paid under normal company policy. The manager will also have the normal benefits and company car program provided by company policy. The start date of this agreement is January 1, 2001, however the actual start date may be later in January to reflect relocation constraints.

The manager will be reimbursed for packing and moving expenses associated with a permanent relocation to Orlando. It is expected that the manager will exercise care to minimize these expenses and keep Nevcon informed of progress in this effort.

The manager will be appointed to the position of Sales Manager on or before January 1, 2004. On this date the base salary will be increased to $75,000/year. The salary change date is fixed and it is probable that the manager will assume sales management responsibilities in advance of the salary increase date.The manager's salary will increase to 80% of the Chairman's base salary or $85,000/year, whichever is less, on January 1, 1996.The appointment to President will occur on or before January 1, 2005. Salary adjustments will be based on mutual discussion and agreement from January 2002 onwards. The ongoing intent would be to index the President's salary to 80% of the Chairman's salary so they can both rise in a normal fashion with scale. The manager will also receive income from equity based profit distributions as described later in this agreement.

3. NON COMPETE AGREEMENT

The manager, recognizing the benefits associated with this agreement, agrees to avoid competing with Nevcon under the terms described below. Not competing is defined as avoiding employment, involvement, or ownership of a competing company, within a 30-mile radius of Orlando, Florida. This agreement will last for periods included in the table below.

Time With NEVCON and length Of Non Compete Agreement

1/01 thru- 1/02 12 months after separation

1/02 thru- 1/03 24 months after separation

1/03 onwards 36 months after separation

4. OWNERSHIP ACQUISITION

The manager will "earn" 4% of the equity ownership in the company under the conditions described below. All grants and purchases will be based on the value of the corporation determined by audited financials as of December 31, 2000. Book equity value will be used to determine what the company is worth. This basis is chosen so the manager does not have to pay more for the 4% equity position because the manager's efforts have increased the book value of Nevcon.

Hoyman & Dobson, the firm’s current CPA firm, will prepare these audited financials. A copy of the audited 1999 financials is included for reference as Attachment One.

On January 1, 2001, Nevcon will grant the manager a phantom stock option for one third of the 4% equity position. This will represent 1.3333% of the agreed book value. This grant will vest on December 31, 2003.The manager will receive 1.3333% of the company's actual 2001 profits. This payment will be made as soon as the audited financials for 2001 are made available. The manager has the choice of taking the disbursement as income or using the moneys to purchase additional equity as defined below.

On January 1, 2002, Nevcon will provide the manager with a phantom stock option to purchase a second third of the 4% equity position. This represents an additional 1.3333% percent of the corporation’s equity. This option can be exercised on or after December 31, 2004. It is important to understand that the first third was a grant provided by Nevcon to the manager, but the second third is an option that the manager will purchase from the corporation. The actual purchase price will be 1.3333% of the December 31, 2002 agreed book value. In exercising this second option the manager will receive 2.6666% of the company's 2002 operating profits. It is expected that this option purchase will be made out of the profit disbursement. Nevcon and the manager may choose to execute a promissory note from the manager to Nevcon if cash flow constraints preclude execution on December 31, 2004.

On January 1, 2003, Nevcon will provide the manager with a phantom stock option to purchase the final third of the 4% equity position. This option will vest on December 31, 2004 under the same conditions as the second option. The manager will receive 4% of the company's 2003 operating profits. The purchase of this final third is expected to be made out of the profit disbursement.

Properly executing this agreement will constitute all the necessary paperwork necessary to action this grant and options. Terms and conditions of buy/sell rules are outlined later in this agreement. The fundamental intent of both Parties are to smoothly and fairly provide a track where the manager ends up as the Nevcon president with a 4% equity position in the corporation.

On January 1, 2004, Nevcon will convert this 4% phantom equity position to common stock ownership by properly executing a document that conforms to Florida corporate law. Both parties will seek CPA advice so that this entire process minimizes personal income tax liability of the parties involved.

Nevcon and the manager can mutually decide to accelerate the President appointment. In this case, the equity process would be accelerated such that the conversion to common stock would be coincident with the presidential appointment. A promissory note would be used to execute any outstanding required stock purchases.
 

5. FINANCIAL MEASUREMENT

The manager will have complete and ongoing access to all company financial records from the first day of employment. This will include financial statements; check books, bank records and all related materials.

The operating statements will continue to be prepared according to current company practices. There will be some notional adjustments to these statements for purposes of determining the profit for purposes of equity distribution.

The corporation rents it's facilities from a separate company that is owned by the owners of Nevcon. This is a common arrangement in the industry and rent expenses generally follow local market rates. To preclude any potential Conflicts between Nevcon and the manager regarding "fair” rents, the rent costs will be determined by a different basis.

The industry trade associations compile and provide financial information on common practices and expense levels. The manager and Nevcon will use the industry median rent costs as a percent of sales to determine the notional rent costs for purposes of profit disbursement. The actual profit from the operating statements will be adjusted up or down to reflect the difference between actual charges and the notional cost level. This revised level will be used for actual profit disbursement. This method provides a means of eliminating any potential conflicts on the "fair" profit level.

The manager and the Chairman will review and discuss details of the officers compensation packages on an ongoing basis. Particular emphasis will be on any forms of non cash compensation. It is expected that these normal practices will continue. The intent is to discuss any activity that may artificially reduce the true operating profit for purposes of distribution. If the manager and Nevcon Officers agree that any of these practices are material the notional profit will be increased to offset the associated expenses. An actual adjustment will probably not be required but the discussion on the subject is still critical. If it is examined on an ongoing basis then any conflicts will be avoided.

The intent is to continue these discussions until the presidential appointment is made. From that point on, the stated intention is that the President, as an officer of the corporation, would have "parity with respect to any non cash forms of compensation". This parity would describe economic balance, not necessarily the exact same configurations.

6. PERFORMANCE APPRAISAL AND MANAGEMENT

The manager will be expected to perform effectively in roles of increasing responsibility. It is in the best interests of both parties that this three-year appointment process be successful. To help and support this success, both parties agree to support the performance measurement process described in this section.

The principal objectives of this effort are twofold. First, it is critical that both parties mutually agree any quantifiable objectives so there is ownership. This helps manage the inevitable plan shortfalls that occasionally exist when both parties develop stretching goals. The second objective is to have frequent discussions so differences can be managed while they are small and correctable. This prevents any difference or problem from becoming large enough to be a "deal breaker."

The manager and the Chairman will agree a set of mutually agreed goals by the end of March 2001. This allows the manager time to get up to speed in terms of having meaningful input. The two parties will maintain an annual business plan from that point thereafter. Each month at a mutually agreed and consistent time (i.e. third Tuesdays) both parties will conduct a formal performance review. This meeting will not involve outsiders and will deal with: a review of numerical performance against targets, corrective planning, and actions against plan shortfalls, a Chairman's assessment of the managers performance in terms of strengths and weaknesses, a manager's assessment of the Chairman in terms of supportive and destructive behaviors, and finally both parties feelings as to the development of the relationship.

These five subject areas will be documented in a one page- meeting summary each month. It is critical that this process be documented, even in a handwritten format. This process guarantees that a decision to terminate the agreement would surprise neither party. The intent, as discussed above, is to correct the inevitable differences as they arise, rather than letting them "fester".

These meetings will also form the basis of both parties deciding to move the timetable up in terms of assuming responsibilities.

7. TERMINATION OF THIS AGREEMENT

Although both parties are entering into this agreement as "persons of good will" there are still circumstances where things don't work out for either party. This section outlines a series of ground rules for termination of this agreement by either party. Any such notice would be in writing and conform to the conditions outlined below.

If the company is sold to another party the phantom options will be converted to actual common stock and granted, but unvested amounts would immediately vest. Payments that the managers would owe to Nevcon would be deducted from the Manager's share of the sales proceeds.

If the company is dissolved or adjudged bankrupt, the manager would be considered in exactly the same basis as a sale to another party. Aside from the circumstances above, either party can terminate this agreement at their individual choice. The key conditions of this termination are largely determined by who initiates the termination. Where unanticipated differences between the parties exist, the Indian River Consulting Group who will act in the capacity of a binding arbitrator will evaluate the monthly meeting results.

The Chairman can terminate this agreement under the conditions outlined below:

• If the agreement is terminated before December 31, 2001 the entire initial grant (1.3333% of the 12/31/00 book value will vest immediately. Nevcon will "buy this equity back within a period of 12 months. Interest will accrue to the manager at current prime rates. The manager will also receive 3 months written notice of this termination at full pay.
• If the agreement is terminated between January 1, 2002 and December 31, 2002 the initial grant described above and any additional paid in capital will be bought back from the manager within 12 months. Interest will accrue to the manager as prime as described above. The manager will receive 6 months written notice at full pay during this period.
• If the agreement is terminated between January 1, 2003 up until the time of conversion to common stock, then Nevcon will buy back all vested equity and any additional paid in capital within 24 months. Interest would accrue as described above. In this period the manager would receive 9 months written notice at full pay.
• If the agreement is terminated after the phantom stock is converted to common stock, the normal Florida corporate shareholder laws apply. In any case, the manager would receive 9 months written notice at full pay.
• The manager can terminate this agreement under the conditions described below. Under any of the listed circumstances the non-compete restrictions described in section 3 will continue to apply.
• If this agreement is terminated before December 31, 2001 then the manager receives no equity related buy backs, and is liable to repay Nevcon the full costs associated with relocation. The manager agrees to provide a minimum written notice period of 3 months.
• If this agreement is terminated after January 1, 2002 and before December 31, 2002 the company will buy back the vested equity and any additional paid in capital within 24 months with normal prime interest accruing as appropriate. The manager agrees to provide a minimum written notice period of 6 months. The manager also agrees to reimburse Nevcon for 2/3 of the original relocation expenses.
• If this agreement is terminated between January 1,200 and the period when the phantom stock becomes common stock, Nevcon will buy back all vested equity and any additional paid in capital within a 36 month period with normal prime interest accruing as above. The manager agrees to provide a minimum written notice period of 6 months. The manager also agrees to reimburse Nevcon for 1/3 of the original relocation expenses.
• If the agreement is terminated after the phantom stock is converted to common stock the normal Florida corporate shareholder laws apply. In any case the Manager would provide 6 months written notice.

8. RESOLUTION OF MAJOR ISSUES

In any privately held corporation there is a potential conflict between the needs of the owners and the needs of the business. This is especially true when the equity owners are also employed by the business.

The corporation currently has two equity owners, Mr. and Mrs. Gabriel. This agreement will result in a third major stockholder. All three individuals will also serve as employees of Nevcon. Mrs. Gabriel will report to and work for the manager, who in turn will work for and report to the Chairman.

Until the company chooses to create an outside board of advisors this agreement provides a mechanism of mediation for any major issues by using the Indian River Consulting Group (IRCG). It is important to make clear that IRCG has a legal binding arbitration role ONLY in termination of this agreement, IRCG has only a mediation role (provision of non-binding advice) in any other area.

The intention is to provide a means of any party to raise an issue to a third party as an alternative to actually terminating this agreement. This would be a forum of last resort prior to voting legal equity positions. Any vested equity holder has the right to submit an issue to IRCG to gain a third party perspective. IRCG will bill Nevcon for services provided.

9. EXECUTION OF THIS AGREEMENT

This agreement is binding on all parties when properly executed by the Manager and all Nevcon shareholders and it is notarized with the corporate seal attached.

The undersigned parties all agree to the terms and conditions outlined in this agreement. All parties further agree that any changes to this agreement will be made in writing and signed by all parties.


_________________________ ____________
MANAGER DATE


_________________________ ____________
SHAREHOLDER DATE


_________________________ ____________
SHAREHOLDER DATE


_________________________ ____________
NOTARY DATE

...END OF EXAMPLE.

Indian River Consulting Group is an experienced based firm specializing in Distribution. Started in 1987 by Michael Marks, a current DREF Research Fellow, IRCG has specialists who consult with distributors and suppliers to make the changes necessary to maintain competitive advantage. You can contact them by calling 321-956-8617, or visit www.ircg.com for more information.

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