WP90X Recap — Phantom Stock Plans: Designing Effective Incentive Strategies for Private Companies

Our latest WP90X session featured WealthPoint’s own Ryan Barradas and Michael Kenneth along with David Whaley from Thompson Hine. Together, we outlined how private companies can use synthetic equity to design compensation plans that drive leadership performance, align behaviors with value creation and maintain flexibility in ownership. Plus, we reviewed a case study that highlights the real-world impact of synthetic equity and answered key questions from advisors.

Want to learn more? Download the presentation slides or read on as we cover the highlights.

What Is Phantom Equity?

Phantom equity, sometimes called synthetic equity, is a form of long-term incentive compensation. Unlike traditional equity, phantom equity does not involve actual ownership or voting rights. Instead, it offers participants the economic equivalent of equity without changing the cap table.

The appeal is clear: It mimics the financial upside of ownership, but avoids the downsides of dilution, governance complexity and loss of control. And because it’s not real equity, it allows companies to tightly manage participation, vesting and payout terms.

Private companies often prefer phantom equity because it provides a clear path to reward executives for helping grow enterprise value, without triggering the challenges that come with issuing real shares. It also gives companies the ability to engineer outcomes around succession, exit planning and cultural alignment.

SARs vs. Full-Value Units: Two Varieties of Phantom Equity

The most common types of phantom equity are Stock Appreciation Rights (SARs) and Full Value Units (FVUs).

SARs provide upside only. If the company grows from $100 million to $200 million in value over five years, the SAR holder shares in that $100 million increase, but not the underlying $100 million base.

FVUs represent a more complete economic proxy for equity. They entitle the participant to the total enterprise value (subject to vesting and plan terms), not just the appreciation. Because they are more valuable, FVUs are typically reserved for top executives.

Designing Synthetic Equity: Start With the End in Mind

Incentive strategy should follow business strategy. At WealthPoint, we start by understanding where a company is going and what kinds of leadership behaviors will be required to get there, then we reverse engineer the right plan. We ask questions like:

• What are you trying to achieve with this plan?
• Who are you trying to retain or incentivize?
• What kind of behaviors or results do you want to reward?
• What does success look like five or ten years from now?

Too often, companies or their advisors begin with the tool (“We need a stock option plan”) rather than the desired result (“We need to retain and align our next-generation leaders through a liquidity event”).

Once you define the future state you’re working toward—whether that’s a sale, a generational transition or long-term sustainable growth—you can build a phantom equity strategy that aligns incentives with that outcome.

Plans can also be designed to ensure participants only receive value if enterprise value increases. That performance linkage makes phantom equity both a motivator and a filter, rewarding the leaders who actually drive growth.

Building the Plan: Structure, Flexibility and Strategy

When it comes to phantom equity, there is no one-size-fits-all model. Companies should consider their size, maturity, cash flow, leadership bench and exit horizon when designing a plan. Here’s a look at the nuts and bolts of plan construction.

Performance Periods and Payout Timing

A typical phantom plan includes a defined performance period (often three to seven years) during which value is created, and a payout period (sometimes matching the performance window, sometimes staggered). For instance, a five-year performance window followed by a five-year payout schedule can smooth cash flow and aid retention.

Plans can be structured with cliff vesting, graded vesting or milestone-based vesting. Vesting provisions are often tied to continued service, specific KPIs or a change-of-control event. Payment timing can be structured as a lump sum or spread over time.

Grant Methodologies and Allocation Models

How you allocate units across your team has significant implications for fairness, impact and cost. Some companies use rolling grants, distributing new awards annually. Others use a fixed pool of units tied to a single valuation event.

Plans can be discretionary—where the board determines awards based on performance or leadership potential—or formulaic, linked to compensation or contribution.

Advanced plans sometimes include phantom dividends or interest features that mimic the compounding benefit of real equity without diluting actual shareholders. The exact approach you take depends on your specific goals and context. Get in touch with our team and we’ll listen to your story and objectives then help you reverse engineer a plan that makes sense for your company and its goals.

Managing the Liability: Valuation, Funding and Payouts

Unlike equity, phantom stock creates a cash liability. The company must eventually pay the participant in cash, so it’s critical to model and manage that obligation.

Valuation Discipline

Phantom equity plans must be structured in compliance with IRC Section 409A, which governs nonqualified deferred compensation. This includes using qualified valuation methodologies, updating valuations periodically and documenting plan terms.

Failing to follow 409A rules can result in tax penalties for participants. Moreover, inconsistencies between phantom plan valuations and estate planning valuations can create problems during audits, transactions or generational transfers.

Funding Strategies: From Operating Cash to Life Insurance

Some companies fund phantom obligations through ongoing operating cash. Others create a sinking fund, setting aside capital as phantom liabilities accrue.

In succession scenarios, companies may use corporate-owned life insurance (COLI) to match future benefit liabilities with policy payouts. This is especially useful when benefits are tied to retirement or death, creating tax-efficient liquidity for the business.

The important point is this: Phantom plans should not be designed in isolation. They must fit into the company’s capital strategy and long-term financial modeling.

How Does Change of Control or Termination Impact Phantom Equity?

Though phantom equity isn’t real ownership, it becomes very real during a transaction. A well-drafted plan should anticipate what happens if the company is sold, recapitalized or merged.

Plans may provide for acceleration of vesting, payout at closing or conversion into buyer equity. The specifics depend on the company’s objectives and the expectations of key employees.

Other scenarios that need clear treatment include voluntary resignation, involuntary termination (with or without cause), disability and death. Drafting matters—vague definitions of “good reason,” “cause” or “disability” can create conflict when tensions are high.

Some plans include clawback provisions that allow the company to reclaim payouts under specific conditions (e.g., fraud, early departure or missed KPIs). Others use stay bonuses to incentivize executives to remain through closing.

The key is clarity. Executives should understand how and when they get paid. Owners should understand the cost. And both sides should be protected if things don’t go as planned.

Tax, Legal, and Compliance Nuances

Phantom plans fall under a complex set of tax and legal rules. IRC Section 409A imposes strict timing rules around deferral elections and payout schedules. Plans must be documented with precision, including vesting schedules, valuation processes and distribution mechanics.

Plans for senior executives typically qualify as “top-hat” plans, exempting them from many ERISA requirements but still requiring a Department of Labor filing.

From an accounting standpoint, phantom stock is a liability, and must be booked accordingly. Companies should work with their CFO or external accounting team to ensure liabilities are recognized and reported over time.

It’s easy to get this wrong. That’s why WealthPoint partners with expert legal counsel like the team at Thompson Hine and plan administrators to build plans that are both strategic and compliant.

Case Study: Using Phantom Equity to Align Leadership and Ownership at a Major Construction Company

During our session, we discussed a real-world example of a construction company with more than $600 million in revenue. The company faced a common challenge: how to reward and retain key executives as they grew without issuing actual equity or giving up control.

WealthPoint worked closely with this client to design a custom phantom equity strategy. The plan focused on performance alignment, payout discipline and structural flexibility, all while preserving the ownership group’s long-term intentions.

Our Client’s Core Objectives

• Reward and retain high-performing executives
• Create alignment with measurable growth goals
• Avoid dilution and maintain equity control
• Prepare the company for long-term value creation and potential transition events

Designing the Plan

The construction company’s plan combined both SARs and FVUs across different leadership roles. Here’s what was included:

• Award structures tied to company-specific KPIs, ensuring leaders were rewarded for measurable outcomes without being over-enriched (which undermines motivation)
• Use of phantom dividends to simulate ownership economics while managing real-time cash exposure
• A plan structure that considered future transitions, with vesting and payout features aligned to long-term company strategy
• Legal drafting that accounted for change-of-control and leadership exit scenarios to reduce ambiguity

The design and implementation of this plan underscored a key theme of our WP90X session: Phantom equity works best when it’s designed with precision, tied to strategic goals and supported by thoughtful legal and financial planning.

Closing Thoughts: Making Phantom Equity Work for You

Phantom equity is a powerful tool, but only when it’s carefully designed to reflect your company’s goals, team and future vision. When done well, it can bridge the gap between ownership and leadership, helping companies retain top talent while preserving control.

But it’s not plug-and-play. Great phantom equity plans are the product of thoughtful planning, expert drafting and ongoing modeling—services that a leading firm like WealthPoint is equipped to provide.

Interested in exploring if phantom equity fits your business and objectives? Get in touch with WealthPoint to begin a conversation tailored to your company’s goals.

Thank you for joining us!

Full Webinar Recording and Transcript

Ryan Barradas (00:00)
Thank you all for joining us on behalf of WealthPoint and our team. Thank you for joining our quarterly education forum, WP90X, which is 90 minutes of extraordinary education. It’s our CE webinar series that we do each quarter (obviously, if it’s quarterly). Hopefully we will not disappoint in terms of the extraordinary category, but — I myself am Ryan Barradas. I’m the Managing Partner of WealthPoint. Michael Kenneth is my partner and is the President of WealthPoint and the head of our solutions team. And then we also have Mr. David Whaley, Partner with Thompson Hine.

In terms of the presentation today, we’ve got a few housekeeping items that we need to get through. We will offer CE and/or CPE credit for today’s program. It’s going to be one hour of CPE credit. Be sure to make sure that you look for and answer all of the required polling questions in order for us to be able to offer CE. We get audited, so we need to have you answer the polling questions, they don’t have to be the correct answer, but there will be three polling questions that will be popping up on your screen and please answer those to make sure that we get you eligible for your CE credit.

In terms of the presentation itself, we want this to be as interactive as possible. So please use the Q&A function of which we will be monitoring, and we’re happy to address questions on the fly. And we’ll pause in the most appropriate moment. And I will be, if it’s a specific question for Mr. Whaley from a legal perspective or Michael from a financial modeling perspective or myself, we will answer those questions. So please, again, do not use the chat function. Please use the Q&A function.

And if you have any technical questions, please don’t hesitate to email Kristin Teaff on our team at kristin@wealthpoint.net. At the conclusion of the event today, we will be sending out a survey. And so if you’re interested in receiving CE or CPE credit for attending the webinar, which we do offer this also for CFPs, please look for and complete that survey because that is part of our requirement in offering CE. And those certificates will be emailed to you within 30 days of doing the webinar itself.

So without further ado, and if I might just before we go through the learning objectives, David, would you mind just giving a brief background on yourself and your experience and background in dealing with executive benefits and compensation plans?

David Whaley (03:20)
Yeah, Ryan, thanks so much. My name is David Whaley. I’m a partner at Thompson Hine in Cincinnati. We’re a regional law firm with a national reach, but as a part of that, what we really are is a compliance firm. So I sit inside of the employee benefits group at Thompson Hine. As a part of that, I deal with qualified, non-qualified, deferred compensation, executive compensation, health and welfare, fringe benefits for large clients across the country.

So that’s half my practice. The other half of my practice actually deals with employee equity. And that can span the gamut from stock options to synthetic slash phantom programs to employee stock ownership programs. And so really dealing with privately held companies largely in that space with respect to trying to figure out how to award and incentivize their employees with equity or equity-like tools to make sure that those employees are driving forward with the same means and character that the owners need and desire

So, happy to be here. Thanks so much and happy to be able to assist with respect to this conversation today.

Ryan Barradas (04:24)
And Michael, we’ve worked with David on a number of opportunities, both on the buy side and the sell side. on semi opposing sides of the transaction for ESOP planning, maybe you can speak to your experience.

Michael Kenneth (04:40)
Yeah, happy to. Absolutely. We met David, gosh, David, probably three years ago now, I would say three, three and a half. David was advising the board of a privately held company who made the decision to move forward with an ESOP transaction. And they had asked for some introductions to ESOP implementation firms. We were lucky enough for David to make that introduction and have been working with him and his firm for several years now.

Like you said, Ryan, on the on the same side or on opposing sides. He’s much friendlier on the same side than he is on the opposing side. But I will add just a couple of comments. We work with a lot of highly qualified professionals. David is up there with some of the best professionals that we’ve had an opportunity to work with, both from his expertise and experience, as well as just the firm’s approach to implementation on these types of plans or on ESOPs as well.

You know, it’s not for David, it’s not necessarily about all of the planning and the details, but it’s actually getting the employees the equity and helping them realize those benefits, right? A great plan is one thing, but a plan that’s implemented and actually acted upon is a totally different thing.

David Whaley (05:53)
Yeah, and we, and we talk about this a lot. This is a part of a presentation that we’ve done a lot here. And it’s really, I always refer to the “I want to stock option plan” because a lot of times I’ll get calls from clients that say, “Hey, I want to stock option plan.” And you start with your partnership. You don’t have stock. And what we’re actually hearing from the client is not, “I want a stock option plan.” It’s “I want an equity incentive program of some kind, a bonus program of some kind, that accomplishes some goal.”

So we’re gonna talk today about what these programs look at, where do we get to? The biggest factor I think that we have to get to in any time we have those conversations is really starting with the end. Hey, what’s your goal? And when we figure out your goal, we can then work through what the tools are, often some form of equity based bonus or compensation to be able to align the interests of the executives with the interests of the shareholders.

Ryan Barradas (06:47)
And it’s not just the goal, it’s also what are the facts. So doing deep discovery and understanding the landscape of the business, the consistency of cash flows, the pool of people that they’re looking to communicate with and what both sides are trying to get out of it, not just one side or the other, but what are both sides.

And once we get that full depth and breadth of information, it really allows us to get into some very unique, sophisticated, and sometimes sophisticated, simplistic designs. Because the best design is one of the blessings of 409A, which is what governs the plans that we talk about today, is that you can do just about anything. But that also happens to be the curse because you can create so much complexity around these plans.

And we want to really stress it’s not only the best-designed plan that accomplishes what the goals and objectives of all stakeholders in the process are trying to achieve, but it’s also the one that can be understood and embraced and is going to truly incent that behavior and benefit that is trying to be communicated or conveyed to the employee base. So today we’re going to go through and understand phantom stock and stock appreciation rights in particular. We’re going to define the differences between various synthetic equity plans. And there are a lot. And we’re really going to focus today on two different types of phantom stock, the full value unit, which simulates actual equity, but it’s notional or synthetic equity. And then also stock appreciation rights, which is really just a growth over base. So where are at today? Where is the company growing to over a defined period of time and being able to compensate people for that growth over base?

We’ll also provide an overview of the plan document and the individual award agreement and what that should look like. A lot of times, even the best professionals like David can draft a document and you kind of get into, you start with a form document, but it really needs to be customized to really contemplate the real world scenarios that may come up down the road. And go through the tax impact to the company and the plan participant, and then identify funding strategies because we don’t like to do these plans where it’s a naked liability or a naked promise that’s out there because if the company grows, grows, grows, and now they have this large liability and then all of a sudden economic conditions change or there may be some sort of regulatory impact to the business. And now all of a sudden things dip down.

We want to make sure that we’ve got a sinking fund or a mechanism or essentially creating a market for the stock that already exists in the future when it’s needed most. And what we don’t want is to have cash flows plummeting and then there’s no cash to fund these future benefits that are essentially promises that the corporation and the board and the ownership group have made to those key employees. Michael.

Michael Kenneth (10:12)
Perfect. Yeah. So let’s just kind of jump right into just a real high level overview of really what is phantom stock or phantom equity. Ryan and David already hit on this a little bit, but effectively phantom stock and phantom equity are compensation arrangements. They’re providing employees with benefits that are similar to owning real equity in a business. As Ryan said, full value units, it’s just as if you owned real equity. Stock appreciation rights is as if you owned real equity, but you have a starting point, right? Whatever the value is today and growth over that.

So the advantage of it from a company standpoint is they don’t own real equity, right? It is not creating where they’re buying stock or they’re being granted real equity. They’re not holding actual stock certificates. They’re simply being treated as if they’re equity owners without being real equity owners.

You know, most phantom plans are designed to be based on the equity value of the company and the idea of keeping equity owners and non-equity owners aligned to growing enterprise value, right? We want to grow shareholder worth. We want to grow the value of the company and we’re incentivizing employees to be able to do that.

David Whaley (11:22)
We end up seeing, I think it’s really important. We end up seeing a lot of our privately held clients want to lean into the phantom equity position because there’s a desire that the actual equity continue to be retained by the sellers, by the operating company. And the real question is why?

It’s because we don’t want to give away the legal rights and requirements that are associated with stock, right? So the ability to have the stock ends up having the ability of somebody to actually start questioning, hey, you’ve done this in a way, no rights other than to ask the question. You’ve done this in a way that I don’t like. I want to see the financials. I want to see the board actions. Instead in a synthetic world, we can provide the financial information, the business information to the executives to the extent we desire to be able to show them what the growth is, but not have them participate in those conversations. Now it’s really important — we talk about this some later — that we provide enough financial information to those in executives, such that they know and pull forward with us.

They may know that it’s already a part of their job. They may not, depending on how broad-based we go. And so we wanna make sure we have enough that they pull with us, but we wanna make sure that it’s no more than that. You can get caught watching the paint dry a little bit if you give too much information and get lost from actually the job of running the business.

Michael Kenneth (12:39)
Good point.

Ryan Barradas (12:41)
But it’s also the cap table. When you start to dilute or expand the cap table, like David alluded to, when you have minority shareholders, can be, pardon the expression, but pain in the ass. And so by not having an impact on the cap table, but then having people participate in these long-term incentive plans that are based on growth, again, compensation motivates behavior. So we need to have something that’s going to motivate the behaviors that’s desired. And again, I’ll steal this last bullet. Sorry, Michael. But when you have a properly designed plan, the plan should really just pay for itself because all that future growth is going to be funding those benefits that we desire down the road.

Michael Kenneth (13:33)
Yeah, one other comment that I’ll make before we go to the next slide. David, you were hitting on it about real equity. The other aspect is real equity is very expensive to acquire, right? In other words, buying into a business costs capital. Most employees, even key employees or leadership team members don’t necessarily have a large capital source to be able to buy in. You know, say it’s a $50 million company and they want to buy 5%. That’s a two and a half million dollar check.

And most key employees don’t have that kind of wherewithal to be able to do that, or even just the capital sources to be able to do that, right, leveraging their own balance sheet or something like that. Or if you grant them equity, that’s typically taxed as compensatory. And so now we have to deal with the tax problem of a two and a half million dollar quote unquote bonus, right, or phantom income, in my example.

And so I think the other aspect from a privately held standpoint is I want to give people equity, but I’m trying to give them equity to people that don’t have necessarily a financial wherewithal to acquire that equity or to pay for it, at least upfront. So just from some advantages of phantom stock, and I think the biggest aspect here is that there’s really alignment between company benefits and employee benefits, right? So from a company standpoint, you’re creating this plan, Ryan hit on it, you’re designing the incentive plan to

grow the value of the company and would design properly the plan pays for itself, right? And so that compensation really drives behavior. And another advantage of it is the long-term retention, right? You’re laying out a plan. We’ll get into it in just a second when we look at a case study, but these phantom type plans are five, 10, 15, 20 year long time horizons, right? Depending on the executive and the design of the plan.

So, you’re really defining a compensation plan for somebody. And when you factor in things like other deferred comp type vehicles or rolling phantom equity forward, which we’ll talk about at the end of the presentation, these are long-term vehicles. And so from an employee perspective, I’m locked in because I see what my future path is really gonna look like. There also are some tax benefits. There’s no taxation when these phantom awards are being made or issued or granted, but there is tax consequences, ordinary income taxes for the employees, tax deductibility for the corporation when the benefits are actually being paid out.

From an employee perspective, it’s the exact same benefits, right? I know what I’m going to be getting paid. I know what my growth initiatives are. I know how to make more money or generate more wealth for my family. And it’s providing me with an incentive to stay.

The other aspect that I would just mentioned real quick is we’ve seen, I would say an increase, I don’t know, David, if you’ve seen this in your practice, but an increase in phantom type equity plans, really since COVID, because I think individuals are looking more so of what’s in it for me, right? It’s not, in other words, the power has shifted from the employer more so to the employee in terms of I need a compensation plan that fits what I’m looking for, because I could very easily go and work for a competitor if I’m at that top tier of leadership management, executive level.

David Whaley (16:37)
Well, and I don’t even think it’s, not only the great resignation of individuals going to work for competitors. We actually have seen since COVID some of the largest increases in new business startups in the history of the company. We’re seeing people go off and work on their own. And so the phantom program is designed to align the incentives of a W-2 employee such that they believe, feel, look like an owner and sort of satiate or appease that requirement or that thought that maybe that I want to go off and actually compete inside my own space.

Michael Kenneth (17:09)
So from a structure and payout perspective, and we’ll get into a real case study here in just a second, but most phantom plans are based on making an award of phantom equity or phantom stock. That award has a specific performance period and a subsequent payout period. What I mean by that is as an example, we’re allocating 1% of the company, we’re allocating 100 phantom shares. That could be a quarter of a percent, a half a percent, a full percent.

It, you know, is totally up to the company from that aspect. You’re making that award to them. That award then has a performance period. So in other words, we’re showing what the value is of the company today. We’re making that award. We’re waiting that performance period. I would say usually it’s three, five, seven years, something like that. It’s kind of a longer term incentive plan. And then at the end of that performance period, we see how much the value of the company is at the end of that.

In other words, 2025 valuation is 100 million, 2030 valuation is 150. We have $50 million of enterprise growth. Then at that point, the company buys back that award and pays for that over a three, five, seven year period. We usually see that the payout period matches the performance period. So if we have a five year performance period, we have a five year payout period, but it doesn’t have to be like that, right? We want to make sure that we’re obviously being mindful of the company’s cash flows when they’re redeeming those awards.

But again, we have total ability to customize that however the company really wants to make that decision. The other thing is that when we make that phantom grant, phantom award or grant, we buy that back, we’ve effectively bought that back into another pool of shares that we can then reissue, right? So if we’re allocating a hundred shares, we wait five years, we buy back a hundred shares, I now have a hundred shares as a company to reissue and I could reissue them to that same executive.

I could reissue them to a totally different executive or a combination of executives. And that really ties into that third bullet there of that most companies don’t allocate the phantom award all at one time. In other words, if I want to allocate 3%, 5%, 10% of my growth of the value of the company to, you know, key employees in phantom shares, I’m not wanting to do that at one point in time, you know, making a 10% award in 2025. What we like to do is, oh, go ahead, Ryan.

Ryan Barradas (19:32)
And the most common, though, is about 10%. Most folks will want to allocate 10% of the future growth or participation in the future growth over the foreseeable future. We don’t, like to Michael’s example, we don’t allocate it 100% in the first year. We’ll allocate 2% a year over a five-year period.

So that’s the total of that, two times five is 10. We’ve got 2% a year over a five-year period. That first 2% grows over five years. At the end of five years, we revalue the award and then we buy it back, but we do it on a soft buyback like Michael had alluded to. So we’ll buy back the value of that award for the principal plus interest, usually an interest in our example we’re gonna show is 5%. But now I can re-award that 2% to a new group.

More importantly, you can award to a pool. The award pool can go to a certain group of people in a certain amount of allocable shares of the 100% of that year’s award. And then next year can be a different group of people or in different percentages based on performance. Our client that we had the pleasure of rolling out a plan just this last Tuesday, they want to use their KPIs and their other incentive plans to really dictate if they do based on their own individual behavior as an employees, the next year they’ve made it very evident to those employees that their next year’s award is going to be based on their performance as an individual inside of the organization. Go ahead, Michael, I’m sorry.

Michael Kenneth (21:20)
No, perfect. So we want to roll into our first polling question. I know that Kristin and our team will pose that. Good luck. It’s a true-false. So we’ll post all the results at the end of the presentation to see who got this one right. But while you guys are answering that for the CE credit, I just want to run through a real quick kind of example of how these plans would work.

Now, we’re going to focus primarily on a SAR plan or stock appreciation rights just for illustrating how these plans work just at this part of the presentation. So again, first step is that that company is going to be making an award. The company is allocating these SAR units to a plan participant or multiple participants if they choose to. Again, no tax is owed when the award is granted and we’re stating a value, right? We will define that valuation formula within the plan document. Usually it’s some sort of a multiple book value or multiple of EBITDA.

And it’s also usually a very conservative valuation. And the reason for that is because we’ll hit on it in a few slides here, but we do have a change of control aspect associated with these types of plans. And we obviously want to, if the company ever wished to sell to a third party, we’d like to have a lift of the company value or the deal value relative to the plan value. So we typically, as an example, the plan that we’re working on right now.

We’re doing a 5X, even a multiple less of 40% discount for lack of marketability, minority interest, et cetera. So it’s really a 3X multiple. A company like this that we’ll hit on would probably be trading at seven to eight X or something like that. So yeah, Ryan, did you want to add from there?

Ryan Barradas (23:01)
The other aspect of the plan value is that a lot of times these folks are going through estate planning or other types of planning that is really valuation dependent. And what we don’t want is the plan value to fly in the face of potentially a discounted value that we’re using for estate planning purposes. So if you have too high a plan value, and let’s say I was to get a 6X multiple on EBITDA for simplistic terms and minus a 40% discount, you don’t want your plan value to be greater than that because it could cause problems in terms of the inconsistency in values itself.

Michael Kenneth (23:45)
And then the second bullet there is just that the company, the executive team, you know, CEO, president or the board itself will determine the allocation, the amount of the awards each year. So as Ryan mentioned, if we’re giving out 2% of SAR units each year for five years, that 2% could be all to one person. It could be to a group of people. The next year happens. It could be to the same exact employees, or it could be to a totally different group of employees.

The company and the board has total flexibility when making those awards and the amount. It might be 2% this year, it might be 3% next year, it might be half a percent the following year. They have total flexibility when it comes to the actual allocation of those awards.

Ryan Barradas (24:27)
In general, though, the participants need to meet one of three different categories. They need to be managerial, supervisory, or highly compensated. And that could be highly compensated as defined by the IRS or ERISA rules, which is about 125,000 or it could be some sort of benchmarking test for the individual company and maybe be the top 20% earners within a company itself. And then managerial and supervisory can be one and the same. They can also be two different things. That’s why a lot of people think, aren’t they one and the same? They’re not, they’re not. I could be managerial, but not supervisory or vice versa.

Michael Kenneth (25:13)
Obviously, this next step is we wait. We have the performance period, three years, five years, seven years, however long that’s defined in the plan document. Obviously, the goal being that the company grows in value. And obviously, would be growing in value because of the contributions that those SAR participants are making, hitting on Ryan’s point earlier, managerial, supervisory, or executive level, if you will.

David Whaley (25:38)
Yeah. And we see this timeline because Michael mentioned three years, five years, seven years, even longer. It really gets down to that first question that Ryan was talking to and I were talking about is, what’s your goal? And what’s your company look like with respect to that goal? What are your financials? What are you driving at? Because the timeline of growth and the timeline of payout with respect to this is going to be designed to incentivize a crowd of employees to accomplish and achieve something.

Right. And so you want to make sure that something is tied to what your personal goals are in the company’s operations and work as. And so I think that it’s important. And I say this a lot. You don’t provide compensation to employees, especially executive or equity compensation, because you’re nice. You don’t do it because you’re altruistic. You do it because it’s necessary to attract and retain quality employees. Right. And so with that goal of attracting and retaining quality employees, that’s going to need to mesh with the timeline over which this is built and the timeline in which it’s paid.

Michael Kenneth (26:36)
Great point. And then at the last step, we have the redemption of those units. So again, at the end of the performance period, we’re buying back those units, those units are effectively going into like treasury stock. Again, it’s not real equity. So it’s not going into real treasury stock, but we’re being retained. And then we have the ability to reallocate those units in the future or not, as David said, right, as you just mentioned, maybe the goal has shifted. And we don’t need to be allocating those synthetic units, you know, at the end of that performance period or something like that.

And then again, we have a payout period associated with it. We generally like to match the performance period with the payout period. So I just want to hit on that point real quick before we jump into the case study and Ryan can explain the fact pattern for the client. But if you think about it in an example of, five years. So we have a five year performance period, a five year payout period or redemption period. It’s really a 10 year cycle then for that executive to receive all of their money.

And so I think that’s important when we talk about long-term retention is that is the length of that cycle. And so, you know, that’s where it starts to make them really question, do I want to leave at any point? Because I know I have this defined period of cash flows that’s coming to me over a period of time.

Ryan Barradas (27:50)
I think it’s important to note too that this should be over and above current cash compensation. And we see some companies where they’ll try to take something away that might be current and people are relying upon that salary and bonus to live on and to buy vacation homes, go on vacation, do the things that they want to do. This should be over and above those compensation mechanisms that are currently in place. David, it looks like you’re trying to say something.

David Whaley (28:20)
Yeah, right. No, and I think that that’s exactly, I always talk about this in the sense that when you have a family owned company, an owner run company, right? They get comped in two spaces and I’m not talking legally. I’m talking that they actually get comped with respect. There’s a part of their compensation that’s with respect to their services for the entity, right? They’re literally because it’s almost their W2 side and they get comped with respect to a return of investment in capital, the ownership position.

What we’re really doing whenever we’re trying to align the interest of these employees to the equity growth of the company is giving up a portion, a position of that from the equity space, trying to get them into this spot of being and feeling like an owner. That means that really the company’s giving up a piece of that equity side. Now to Ryan’s point, they should pay for themselves, right? But the piece of that equity side of the ownership position, which means it’s extra.

It’s more than what you did in the day to get them there. Now, why do you have to do it again? You have to do it because it’s necessary to attract and retain quality employees. Your competitors may give actual or phantom equity as well. They’re going to give up a piece of their functional balance sheet to this employee because they need to align interests. Or that individual, as we talked before, may want to go off and start their own company to be their own capital creator. That’s what we’re trying to appease and accomplish with respect to that. But it does, to Ryan’s point, have to be extra compared to what the compensation was historically.

Michael Kenneth (29:46)
Perfect. We’ll switch into the case study. Ryan, do you want to give a quick overview of this?

Ryan Barradas (29:52)
Yeah, this client had, they were a large construction company, they were very diverse. They had essentially five different, they were doing, or they are doing over about 600 million in total revenue. Again, just to kind of back up, we’ve done this for as little as one person, one employee, and usually it’s one to five, but generally three to five key executives.

And then we have some plans that are as many as 40 key executives. So if there’s anything in between, obviously, the benefit needs to be meaningful enough that it’s going to move the needle for those key employees. But in this case, we had owners that were really looking to benefit their key employee base. They wanted to give away, initially, they said they wanted to give away 15% of the future growth. So growth over base where they’re at now to this pool of selected key executives. And they wanted to have the flexibility to add new people because they have been able to attract and retain and grow their talent base and they wanted to have the flexibility to add.

We’ll talk about this maybe a little later, but I’ll hit on it now. When we did it based on 15% because we modeled it based on 15% initially, and this is a very rapidly growing company, it was too rich for the current group of people that they wanted to allocate it to. And we’ve all heard stories about companies that have granted stock options or other mechanisms, and the employees have become so wealthy, they don’t need to work anymore.

And so we want to make sure that we don’t over-enrich those key employees, but we want it to be moving the needle. And in general, that’s somewhere between 20 and 25%, 30% in additional compensation above their current total gross pay. They also had an individual who was a former entrepreneur that had been convinced to come work for them.

And he was running two of their largest divisions that represented about 40% of the total revenue. And they were in discussions with him about granting him some equity. And we’re choosing this case study because it really is a really cool combination of both stock appreciation rights and also full value units or actual notional or synthetic equity.

And this individual, they had had a lot of conversations and they wanted to get him somewhere between five and 7% of the equity of the company. This company was doing, you know, $63 to $65 million in current EBITDA and 5% of the value of that company is enormous. And so they were looking at how do we grant him that equity? And so they were going to grant, they were talking about granting him equity over a five to seven year period, which then would be compensatory as Michael talked about. And then now he has this quote unquote phantom income tax liability because he’s received value in the actual equity ownership in the business and he has no cash to pay the tax.

So then they were saying, we’ll double bonus you the amount to pay the tax liability. So if I have a tax liability, say of $100,000, now I have to bonus the employee $150,000, the net amount of 100 to pay the tax on the benefit. And it’s almost like this circular reference or circular loop that you can get to a solution, but it gets to be pretty expensive over time. And so we brought in the idea of potentially using full value units for Sam.

I’m going to do my best to use their fictitious names for the redacted presentation. But for him in particular, Michael, I think it’s on the next slide, where they had really focused on getting him an amount that was equal to, it’s not on the slide, but equal to 25 million. That was his goal at retirement and he’s 48 and he was planning on working another 15 years. He stated to them in a kind of open conversation, if I got to 25 million of value equal to capital gains exposure, like he had actual ownership and equity, then that would make him happy.

And so we had to kind of reverse engineer how we were going to get to that number and account for that bracket spread because the benefits paid out under these plans is ordinary income. And he was using his reference of capital gains. So right now there’s a 17% bracket spread between the two. And so we had to get really creative and account for that.

Each award, again, we had already talked about this, but we’re going to allocate 2% of that initial 10%. We’re going to allocate 2% a year each year over five years. At the end of five years, we evaluate the award, that year one award, whatever the differential is in value, and then we’re going to pay it out or buy it back over a period of five years, that soft buyback that we had talked about.

The other thing is we’ve got that they, if you remember, I said they wanted to give away 15%. We’ve got that other 5% that we’re holding back and keeping in the bank. So as they expand the pool, they can add in some of that 5% that they’ve committed that they want to share the blessings in their journey with that key employee pool, which will allow them to expand the pool to a much, much larger number.

And it’s really, again, designed to measure the company’s value growth over base. Where are we at today? Where is it going to end up five years from now? And then we apply the percentage, 2% of that growth, and we buy it back over a five-year period.

Michael Kenneth (36:26)
Yeah, I’ll add one comment on that. So as I mentioned earlier, we have to define that valuation formula within the plan document. And that valuation formula needs to be something that’s defined and easily understood. It can’t just be what the board feels the value is at a future date. And so in order to evaluate that, we also use, typically, a weighted average adjusted EBITDA over a period of historical years.

Partially because of the fact that we wanna smooth out financial performance, right? If we have a really great year because of a big project or a really nice opportunity, we don’t wanna be granting awards at too high of an enterprise value. And now we’ve kind of limited the growth potential for that company and vice versa. If we have a really bad year, take for example, COVID, right? As an example, a lot of companies that hit earnings, that hit profitability, that hurt enterprise value.

But if we granted awards at such a low point, we would then be paying employees substantially more than what was designed within the plan. And so that’s why we use a weighted average formula where we look at it typically over three years for the growth of this company, we’re looking at it over two years. So effectively three times the EBITDA for the current year plus two times the EBITDA for the prior year and divided by five. So we’re taking that average, having a little bit more of a heavier weight towards recent financial performance as opposed to two years ago. But again, with this company that you’ll go through in just a second, some of the numbers, they were growing by about $15 to $20 million of EBITDA per year over the last 24 months. And so we want to be able to smooth out that financial performance, again, with the goal of really granting the equity at what’s the current fair market value.

Ryan Barradas (38:11)
And typically we use a three-year weighted average EBITDA. So three times the current year, two times the previous year, one times the year before that, and divide it by six. But like Michael said, they were on such a steep growth trajectory, this company, that we chose to do two years as opposed to three years.

Michael Kenneth (38:34)
And then we just want to hit on a couple of the more legal aspects of the plan design. But, you know, obviously, with it being a plan and governed by 409A, we need to define certain trigger events within the plan and what happens to the benefits, what happens to vesting those types of things. And so, you know, we basically have it set up where a participant becomes fully vested if they pass away or become disabled during that plan period, meaning during that performance period, they would become fully vested whenever that event were to occur.

We also have them becoming fully vested in the event of a change of control. A couple of comments though on that or uniqueness associated with this plan that aren’t necessarily required to be in every plan is that what we would, what the company wanted to do is to replace the end of your plan value with the deal value in the event of a change of control. And so that hits on my comment earlier where we might have a formulaic value that says the company is worth $200 million, but the deal might be worth $300 million, right? Or some sort of value spread there. And David interjected. Right. Yeah, I’m using actually smaller numbers, even though hundreds of millions of dollars is still a big number, but smaller numbers here, but not all plans have to be designed that way.

The board could say, no, you get the plan value. We as real shareholders will receive the benefit of that difference. But this company was actually very generous and decided to use deal value as opposed to end of year plan value.

David Whaley (40:08)
Yeah. And there are two thoughts with respect to anything that are important to note. The first is that if you, your goal, again, back to that thing, then keep on coming back to goals, right? If the goal is to actually create an incentive to potentially sell the organization, you’re going to want to give away deal value, right? Because what you’re really giving away is this, this thought of we’re going to grow this thing for five to seven years and sell it. And you want to be able to hook the people into that deal value, right?

The second, the two things I always like to say is I know we don’t ever think of this. We want it to be the lesser of if we’re going to do those, because if we happen to have a deal value that happens to be less than the value, the EBITDA value, we want to make sure we have that. The second is an odd one. And it’s the oddity of the definition of disability. You’re going to be able to put in the plan the definition of disability that you want with respect to this. There are typically three spaces you have. Hey, disability is determined by a physician, right?

Disability as determined underneath the health and welfare programs, the life insurance programs that the company otherwise has, or disability as determined by social security. We’re not a big fan of the last one because it takes social security two, three, four years to actually determine that somebody’s disabled as of a date. We’re really big fans of actually utilizing the otherwise provided life or disability insurances that the company has.

And the reason why is because those programs will have an independent determination of disability. It gives comfort to the employee, but it’s also a design and mechanism that you know it’s not just somebody playing a game to try to get to disability, right? So we want to make sure we have that right definition in there. And it’s an odd one because sometimes I’ve picked up other people’s plans and there’s a little D disability. You kind of lost in there. We want to make sure it’s a big D defined disability.

Ryan Barradas (41:50)
The other aspect, when we did this, because it’s essentially the equivalent of tag along and drag along rights in a sale transaction, and that’s what we’re building in here, is that the employee has to remain with the company for a minimum of 24 months post transaction, post value realizing event, in order to get that delta between plan value and deal value. And in this case, our plan value is essentially, it’s five times EBITDA minus the forty percent discount, but for all intents and purposes, it’s three times EBITDA. And if we sell it eight times EBITDA, they’re going to be able to participate in that differential or that delta between it, which is another five turns on EBITDA, which is huge, but only if they stay with the company.

Why? We want to build in, you may have heard of stay bonuses. We want to build in some glue because when I acquire a company, I’m not just acquiring the company, its reputation, its current contracts and relationships. I’m acquiring the talent of that company because it’s the people that make the party. We want to retain those key people for a period of years and make sure that it’s very painful for them to leave post-transaction. Well, what does that do?

The employees are gonna get the benefit of getting that huge lift in value, but the employer or the owners are going to be able to have another negotiating tactic when they go and sell and argue a higher value because they’ve locked in those key people. Now, if they get terminated, like in this case, when we were going through plan design with the owners and CFO, the CFO is one of those people where there may be a duplication of duties and there’s efficiencies, they’re gonna be one of the first people potentially to get let go, maybe six months post transaction.

If they get terminated, they still get deal value. But if they quit, they only get plan value. And then participants who separate from service are only going to get their vested amount. And in this case, we just did a graduated vesting schedule of 20% a year each year over a five-year period until they become 100% vested.

David Whaley (44:09)
Ryan, if we’re looking to make that even a little bit more employee friendly, we don’t have to. You said that if they get terminated, they get deal value. If they terminate themselves, they get calculated value. So that’s the delta. Sometimes we’ll put in a good reason term. A person quits, but they quit because the employer cut their pay. They quit because the employer told them they had to move to Los Angeles from Boston.

They quit because they are going to end up not being the CFO at any level anymore. They’re going to be a comptroller that answers behind five other people. So we can build that in if that’s desired, but you’re going to want to have that built in or realize as well, there’s some ability to renegotiate some of those types of things like good reason down the road, right? So maybe that becomes a conversation or question with respect to a deal point in a transaction.

Ryan Barradas (45:01)
Let me remind everybody that’s on that we do have polling questions that are going to pop up. Yeah, perfect segue. So please remember to answer the polling questions in order to get CE. And then also we want this to be interactive. We have had no questions to date, but please use the Q&A function at the bottom of your screen to ask any questions that may be on your mind. And we will not call out the name of the person.

So if you’re fearful that it might be a stupid question, there is no such thing as a stupid question and we are happy to address any and all questions that you may have. Okay.

Michael Kenneth (45:47)
Ryan, do you want to maybe just summarize this?I know you hit on this a lot about the plan for Sam, but.

Ryan Barradas (45:53)
Yeah, so the SAR plan though they wanted to go back. They had three key employees, including Sam and one of them was the CFO and then another one of their key guys that they wanted to benefit for a lot of that past growth that had occurred because they had gone from 20 some million in EBITDA to 40 or 42 or 43. What we’ll see here on the next slide, the 65 million, I think we’ve got it at 63.9. The actual closeout of 2024 was just over 65 million. And so they wanted to go retroactive back to 1/1 of 2024, which you can do.

And they wanted to offer that to just as a nice benefit to those three key guys. So they only allocated 1% during that first performance period, but it was split between three guys. And then they’re allocating 2% from 2025, 1/1 to 2025 going forward, that’s going to be split amongst a broader group of folks. And again, with Sam, we talked about his full value units. We were allocating enough in his full value units to accomplish him achieving a $25 million equivalent at capital gains rate at that 15th year, assuming that the aggregate value of what he would receive from both the SAR plan and the full value unit plan.

And that was at a 5% growth rate. So we wanted to model it based on a reasonable growth rate. These guys, normally when we model plans out, we do a low growth, a moderate growth and a high growth scenario. So the company understands the range of liability that can exist depending upon where the company grows. And in this case, they wanted to do it based on 5% growth for this benefit that they were this target benefit equivalent, I guess, of this $25 million number that we were trying to get to Sam. Sam also, we negotiated with him because he said, well, if I owned actual membership, I would be getting distributions. And so we wanted to create a synthetic or a phantom dividend for Sam for distributions over and above tax. Their pass-through entity, their S corporation. If the company just distributes out enough to the shareholders to pay tax, no bonus because the shareholders are just getting that money and then turning around and paying the IRS. If there are distributions above tax, so if I have 10 million in earnings and I distribute out 4 million for the purpose of shareholders paying tax, no bonus for SAM.

Their current distribution policy though is they’re distributing out 40% of the net after tax, undistributed net earnings. They’re distributing that out to the shareholders. So each year, Sam’s getting a little bit of his synthetic equity grant each year over the next 15 years, really technically 14 because we’re going back a year retroactive to 1/1 of 2024.

But if he has say a half a percent of the ownership, he will get a half a percent of the net after tax distribution. So if that number was 100,000 of what the folks would get, that would be net-net pennies in the pocket to the shareholders. We gross that up and pay them out, say, 150, $160,000 in a bonus to net him $100,000.

And that was not included in the $25 million target number. One thing I’ll say is we had that $25 million number, but we have to account for that 17% bracket spread between capital gains and ordinary income. So we had to get Sam a higher benefit in order to simulate what he would get 25 million minus capital gains tax would be something like 18.7 million and change. And we wanted to make sure that he ended up on an ordinary income basis of getting that number, assuming a 5% growth rate assumption.

Michael Kenneth (50:22)
When we look at the kind of financial projections and valuation, I’m just going to walk through this table here real quick. So this looks again at the last kind of two years of earnings for the company. We can see what their adjusted EBITDA is for those two prior years. We then have our formulaic value, that adjusted EBITDA weighted average.

We’re multiplying it by 5x, taking a 40% lack of control or minority interest like marketability discount, and coming up with that end of year plan value. As Ryan mentioned, we’re effectively retroactively dating this plan to be effective for 1/1 of 24. So we can see the first year, we’ve had $27 million of plan value or company value increase, and then it’s increasing going forward. On the go-forward basis, we’re assuming this 10% annualized growth rate. As Ryan said on our analysis side, we’re looking at 5%, 10%, and 15%, which is actually pretty aggressive for a company. We normally look at, you know, two, four, six, three, five, seven, something like that.

When we were talking with the CEO and the CFO, the CEO’s comment was just, if we only grow at 5%, we have a big problem. And I’m gonna start replacing my leadership team with people that are gonna match the growth rates that I really wanna get to, which is that 10 to 15% a year on an annualized basis.

Just from a graph standpoint, we can just see that increase of company value. Again, this is over a 20-year time horizon, but they are really well positioned to have some pretty substantial growth on a go-forward basis.

Ryan Barradas (51:55)
Their actual numbers were 5, 10, and 15, which I’ll tell you are completely outside of the realm of normal. We usually see 3, 5, 7, 4, 6, 8 as the low, moderate, and usually 3, 5, 7, low, moderate, and high growth. But in this case, it was believable based on the current trajectory.

But the company growth and the company growth and value is going to be what it’s going to be. Projections only prove that paper can hold ink. What we have to do is make sure that we don’t get behind in terms of our set aside or a sinking fund. We don’t want to get behind that liability and we need to be able to make these contributions to that sinking fund to match up with that liability on a go forward basis.

Michael Kenneth (52:46)
And so this table just kind of gives an example of how those awards are being structured, you know, allocated and then redeemed over time. And so realize the text may be a little small viewing on the screen, but effectively what we’re showing here is by the end of 2028, that’s the end of the first award in the first performance period. Again, we’re starting 1/1 of 24. We’re going for five full years. So we’re getting to 12/31/28, 1/1 of 2029.

And at that point, we can see that the growth of the value of the company has been $145 million. We allocated 1% for that initial award in 2024. So that’s 1.4, almost 1.5 million. We’re then buying that back at $336,000 a year. Again, that’s just 1.4 million amortized over a five-year period. So what we can see is that we’re buying that 2028 timeframe, we’re buying that back over this five-year period.

Fast forward another year, now in 2025, we just, as Ryan mentioned, we actually just went up to visit the company this week. They’re allocating 2% to a much broader group of executives. I think there was 17 or 18 people that are in this first, you know, or this first 2% award period. And we do the exact same calculation. So we can see in that five year timeframe, the company value grew at $132 million.

We again have 2% of the equity that were allocated over that time period. So that total value then is 2.6, almost 2.7 million. Same structure, we’re buying it back over a five-year period, that’s $613,000. We can see that going for that five-year period. And that just continues, right? And obviously in this model or assumption, we’re making the assumption that we’re allocating 2% a year, we’re waiting the five years, we’re buying it back and we’re reissuing it at the end of each performance period.

So it becomes a cyclical or a circular reference, if you will, over that time period. But what it really looks at is when you look at the total annual payout, there’s a steady increase because this first year, we’re only paying for one award. The second year, we’re paying for two, then three, then four, then five. And then it’s five years ongoing. Now, as I mentioned earlier, the company may decide to reduce the amount of awards in the future, increase the amount of awards, skip an award period, whatever that might be based on that future decision-making of the company and the board.

But I think what’s important to realize is if I’m an executive, I want to be able to participate in as many awards as I can. And you’ll see that same ramp up period for the SAR payouts and for the allocation of those awards each and every year for those executives or those leadership team members.

David Whaley (55:31)
Yeah, and we talk about this, sorry, we talk about this in sort of two ways with respect to equity compensation. You can achieve the award, you can achieve the benefit of an executive compensation, of an equity compensation by dumping it, or you can achieve it by it growing. This is the demonstration of both a dumping and a growing. But imagine a world in which, and I’m going to try to grab a pointer here, that say this award doesn’t come in.

Because the company had to achieve X, Y, or Z to have that award be granted to an employee. Well, if that award doesn’t come in, then it ends up being all the way through, and I’m going all the way down, it doesn’t get paid over the whole five-year window. So we can create a world in which we say, hey, we’re gonna give you these, but you have to do something to get them, and then you have to grow the company to make them worth something over that five-year window.

You really can create a double standard if you’re really looking to do that of how to create a world in which we vary the long-term benefit. Or maybe that’s not achieved, but we’re gonna give you half or a quarter of what the total population or the percentage was for that year because we didn’t achieve the standards we desired with respect to that.

Ryan Barradas (56:48)
We have an answer. When buying back over the course of years, where is the money actually kept, the sinking funds, sometimes a type of investment account, any ERISA requirements or regulations. I’ll take the first part. So when we’re buying it back, we’re using insurance because it is a tax favored vehicle. It’s an asset of the company and we’ve got some key person benefits that are ancillary to the insurance, but the insurance is really there to be a sinking fund.

So essentially the corporation lays on the proverbial tax grenade upfront because they’re using after-tax money to fund the plan. And then eventually they’re going to get tax-free distributions out of the life insurance because of the tax benefits that are afforded to life insurance. So I take an income tax-free withdrawal of say a half a million. I pay out that half a million to the key employee.

And that’s where as a company, I received the income tax benefit because I got a tax free source of cash. I paid out a half a million dollars. I got an associated tax benefit of 200,000 or 40% in terms of deductibility of that compensation. That becomes a benefit to the company and the shareholders.

In terms of any ERISA requirements, the answer is no, because it’s not a plan that’s governed under ERISA and I’ll throw it to our friend, Mr. Whaley, so he can address that because it’s governed under 409A, which is completely different.

David Whaley (58:23)
Yeah, so what ends up happening here and the reason why the crowd of people you are allowed to provide this benefit to has to be managers, supervisors or highly compensated is because it has to be what’s referred to as a top hat plan. It is a plan designed to benefit a select group of highly compensated or management employees. Whenever it’s a plan that’s designed to benefit a select group of highly compensated or management employees, it means that you get out of the funding requirements of ERISA. ERISA requires you to keep this money in a trust separate from the company.

Whenever it’s not subject to those funding requirements, it actually sits on the company’s balance sheet, but it can’t be quote funded. And to not be quote funded means that the amounts that are set aside have to remain or the promises and the amounts set aside have to remain subject to claims of creditors of the corporation. Meaning if the company goes bankrupt, these don’t get paid, right?

So whenever you have it is, whenever it is, subject to claims of credit to the corporation, means that that insurance contract, that sinking fund is subject to claims of creditors. Now, some clients, some employees want a little bit more security. And we can put it in what’s called a rabbi trust. It’s called a rabbi trust because the private letter ruling that actually requested these or the advisory opinion that actually requested these was a synagogue asking to set it up for a rabbi of a synagogue. And so what you do is you literally put this money in a separate trust of the company and that trust can pay one of two people.

It can pay either the beneficiary of the trust of the plan, or it can pay claims and creditors of the company. And so we really have this spot that it’s not governed, but we can have it funded either on the balance sheet or off the balance sheet through a rabbi trust. But all those amounts have to be subject to claims of the company going bankrupt.

Ryan Barradas (1:00:05)
Next question is if the firm is an RIA with 1099 advisors, can they participate and can institutional clients of the IRA or RIA, for example, a bank participate? David.

David Whaley (1:00:21)
Yeah, so let’s take this a little bit different with respect to an RIA. The question really is, hey, can 1099 advisors, independent contractors, individuals or entities participate in a program like this? Yes. 409A makes it clear that it is service providers, regardless of whether they’re a service provider in the employment relationship or a service provider in the independent contractor relationship. Here’s our problem.

Our problem is so many of these are built on, you are going to remain employed. You are going to remain in the service of. It’s a much harder world to draft the service of whenever you have an independent contractor arrangement because the independent contract arrangement has to be such that they can do other things. Now, what do we do? put covenants not to compete inside of those, right? We say that you can do whatever you want, but you can’t compete with us. And if you compete with us, then it goes away. And so we have a little bit harder time with respect to that continued employment.

As for the ability to have institutions participate, legally, yes, that’s going to end up becoming an RIA question though, with respect to what compensation you’re legally allowed to provide to institutions under the RIA rules. So from an employee benefits perspective, yes, but that’s when I would have to call some of my partners in the institutional fund sector of our firm to be able to ask them the ability to make sure we don’t run afoul of those laws.

Ryan Barradas (1:01:40)
Also with the life insurance sinking fund, the common question that we get asked specifically by financial services professionals is how do you tie the growth and the value of the insurance with the growth and the value of the company? They’re not directly correlated. They’re not. There are going to be years where the insurance contract is going to grow at a greater rate than the company, and there are going to be years where it grows at a lower rate. We govern that by the funding.

So how much money we put into the insurance. And so we generally will design it not as a minimum death benefit, max funded non-MEC because we want to get the tax benefits of a non-MEC.

We give ourselves a little bit of cushion so we can put more money in. But if we have to, then because of adds or because they expand the pool, we may have to go and ensure either more participants or more insurance on individual participants. In the case of this case, we’re insuring five lives, only five, not the full 18 that are participating in the plan, with the lion’s share on the two primary owners.

So we’ve got a very large amount, over 50 million, on each of the two primary owners on Sam who are providing this big benefit to, and is also a very big key employee or key component of the success of this company. We’re doing a smaller amount, somewhere in the 20 to 23 million dollar range. And then we’ve got the CFO and the other key field guy that we’re insuring.

We have one more question: With a phantom stock plan in place, how would it complement or complicate converting to an ESOP at some point, i.e. the liquidity event triggering a payout? And we actually have one right now that we’re going through where we’re contemplating doing an ESOP as a very eloquent solution to a very complex family problem and what’s going on with the company.

But so long as the document is drafted correctly, and David, maybe you can speak to this because you’re the author of these wonderful documents that give us the flexibility and contemplate these things, maybe you can speak to that.

David Whaley (1:03:59)
Yeah, one of the things, and honestly, knowing that we’re gonna end up having a desire of a potential ESOP is a good catch. We talk about that changing control. We’re constrained a little bit with what the definition of a change of control can include, how big it can be. We are not constrained on how little it can be.

And so when we talk about a payment on a change of control, we can carve out a transition of the company to an employee ownership trust or to a family trust from being a change control. Thus, we would say, if this is what’s desired, we would say that the plan, whenever you’re selling to an ESOP does not trigger a payment. Now that means that the future operations of the company are gonna be layered with respect to what that executive compensation promise is. It couldn’t lower your value yet because you’re not funding it.

If you don’t lower your value, you get, because you’re not funding it though, you have to fund it at closing. And so that’s an immediate cash drain with respect to what happens at closing. We’re a bigger fan if we think that we’re going to end up having an ESOP transition or some other type of trust transition to actually accept those from the definition of change of control, because we can always accelerate by terminating the plan at that point, if we want to.

If we make it a change of control and then ignore that for the deal, it’s a harder standard to meet with the 409A cafe rules.

Ryan Barradas (1:05:21)
Michael, do you have anything to add to that?

Michael Kenneth (1:05:24)
No, I just agree with everything that David just said. Absolutely. I will just maybe I will add, think, David, you hit on a great point, though, that when you’re structuring these plans, you have to really think through all of those what ifs of what could happen with this company in the future. Right. What if we become an ESOP? What if we sell? What if we don’t? How do we terminate?

All of those types of things, because if you don’t think through it proactively, you know, you may be faced with a really difficult situation at some point in the future, right? I didn’t think an ESOP was on the table, then three years go by and now I’m ready to do it, but now I owe millions of dollars to these participants and I wasn’t planning for it, right? So you really have to think through that from a legal perspective as a part of the structuring of these types of arrangements and these plans.

Ryan Barradas (1:06:13)
Which really just goes to the point of one of the big reasons why we have Mr. Whaley on this. The documentation of these plans is so critical and it really needs to consider those real life scenarios. You could have somebody that goes through a divorce and when they go through a divorce that could take them out of being at their best. There’s all kinds of different scenarios that could come up for a company or for the individual plan participants. Michael.

Michael Kenneth (1:06:45)
Yeah, so I’m going to go through the next couple of slides just pretty quickly here just for the sake of time. But again, this just shows those payouts. We’re just showing in more of a graph format. I think the most important aspect of this part of it is the company now is setting the stage for this obligation. So now we need to be able to plan for how we’re going to pay for this obligation on a go forward basis. Right. The first couple of years could probably simply be funded out of just, you know, existing company cash flows.

But as we start to have these awards that we’re paying out, you know, two, three, four, five million dollars a year, we need to have a funding vehicle to be able to support that obligation on a go-forward basis. The next page here just looks at the award allocation. This is just an example of how this company would potentially be looking at allocating the awards. You can see here in 2024, they had kind of a discretionary allocation of the awards: 50, 30, 20.

Employee number one just happens to be Sam, if you’re following along with the case study and story that Ryan was just mentioning earlier. So Sam is receiving the full value unit, but he’s also receiving a large allocation of this initial SAR grant, that 1% SAR grant. And then on a go-forward basis, for purposes of the allocation, we just looked at allocating it based on their percentage of compensation. In other words, what is my comp relative to the total comp of the SAR participants and that’s how they’re allocating it.

Now in actuality, as we mentioned earlier, we just met with a client earlier this week. They chose a more discretionary approach for this first year of allocation. And in fact, they actually increased it from 13 participants to 17 or 18 participants, but that was just based off of their desire. But the important point I think is from a modeling standpoint, we were looking at this for each of these employees or executives and trying to model out what does this really mean for them?

And part of the reason for that is because we want to be able to target what a future benefit might be because we want to make sure, as Ryan mentioned earlier, that the plan is substantial enough to incentivize either a change or a continuation of really good behavior for the company, but also not to enrich somebody so much that in seven years I’ve made enough money and I’m out, right? And I want to retire.

And so we’re really targeting a kind of a fair balance there of making it rich enough to make it meaningful for all of these employees or executives, but also not to the standpoint that it is so rich that they have enough money outside of the company where they say, I’m 45 years old and I don’t need to work anymore.

Ryan Barradas (1:09:22)
They also wanted to contemplate, you’ll see in our original model was 13 employees in 2025. And then assuming that we had two new adds a year for the next three years to where we finally got to 19. And it could grow beyond that, but we wanted to not only show that to see what that impact would have on the plan, but the other participants.

Because essentially whenever you add new participants to the same pool, and it’s the same 10% of growth on a growth over base on a go forward basis, it becomes dilutive. So you have to educate the rest of the folks that are on that team that while you may be getting quote unquote diluted a little bit, you’re also sharing with more people that are going to give you maybe a slightly smaller piece, but of a much bigger pie. And so we’re all working together. And one thing that we’ve talked, we’ve talked a lot about growth, but it’s really growth in value, which means it’s a growth in EBITDA or growth in profit or profitable growth.

It’s not just growing top line revenue. We need to grow the profits of the organization itself.

Michael Kenneth (1:10:36)
So this page just looks at it for Sam specifically and you know his allocation of the SAR award again we can see you know the the first award being when he’s fully vested at the end of 2028 so he’s receiving that first payment in 2029 and then continuing on for that next five years and then we’re just adding in the future awards again assuming that allocation that we just went through on that previous slide.

I think one thing that we want to focus on is that target incentive is anywhere in the 30 to 50% range of a key executive’s compensation.

Ryan Barradas (1:11:09)
That’s assuming 10% growth. Generally, we do 5% and you’re really trying to target 20 to 30% of additional compensation because this is growing at 10%. It’s going to be a larger number and you can see that percentage of salary in terms of the benefit there at the bottom of what he’s actually getting.

The one thing that we’ve touched on a little bit that I really want to drive home is with these plans, communication and getting people to understand and realize and accept their responsibility, but more importantly, their impact on that benefit is really key and crucial. So we’re meeting with these in this case that we’re talking about that we’re going through as a case study, we met with three, those top three guys while we were up there and did our rollout for this company, but we’re meeting with the other 15 plan participants to get them to understand the impact of this on their financial picture going forward.

But more importantly, we wanna meet with them each and every year. And then we need to create some sort of celebratory environment. And so we’re going to have a dinner that we’re planning for this particular company where they’re gonna celebrate when they’re handing out these checks.

And remember Sam is getting 50% of that first 1% award, which was $336,000. So he’s going to get $168,000 check, which is a big deal. And we’ll invite spouses to that and get the spouses involved as well. But again, you’ve got a few things. You’ve got the vesting period, and then you also have that delta between deal value and actual value which is going to be a big lift.

And what we’ve done is provided that golden handcuff or that mechanism to hold them to the company because it becomes very painful to leave, but it only is painful to leave if they truly understand the magnitude of the benefit, what am I actually invested in and what’s my unvested amount that I would be leaving on the table if I were to leave. And we need to communicate that to them each and every year to make sure that they understand that leaving will be expensive to them and staying is going to be a big benefit. David, it looks like you want to add on to this.

David Whaley (1:13:33)
It’s not just that to me. It’s not just the amount of money that is on the table. It’s also the drivers, right? So we talked about what drops the money in their bucket. We talked about what grows their bucket. They need to be able to be educated sufficiently to make sure that they understand what’s going to grow that amount for them because that, and that needs to tie back to what our goals are again. Once again, we educate them to understand what is going to make their world better. Yeah.

Michael Kenneth (1:14:00)
We looked at it also for the CFO and just so we can show that same allocation there, know, targeting what is his total compensation? What is his allocation? His allocation of those SAR awards was going to be less than Sam, primarily due to, you know, his value contributions to the business. But again, we’re still targeting that same benefit for that key executive.

Ryan Barradas (1:14:23)
Real quick, were also and we’ll go ahead and launch the polling question number three. But as we’re going through the polling question, a lot of the CFOs compensation was coming through base salary and bonus. More conservative individual wanted more certainty. And so he’s getting a majority of his compensation that way. And so his benefit was a little less.

Michael Kenneth (1:14:52)
Absolutely. Then just for the sake of time, while you guys are answering that last polling question, I want to just jump into the full value unit award as we’ve talked about for Sam. We did talk about the kind of structure of it and the intention of it and that kind of targeted date in the future in terms of dollar amount that we want to get to Sam. This chart here, this graph just really shows effectively what amount of equity is he being granted on an annualized basis as a part of this full value unit award.

And so what we’re really targeting is, as Ryan mentioned, is again, that $25 million value on a pre-tax basis. So we have to get him enough full value units so that they are worth that 25 million pre-tax, 18.75 million after capital gains taxes 15 years from today. And so you’ll see this steady increase of the value of those awards. That’s simply just the time value of money and compounding.

But we’re basically giving him a static amount of equity on an annualized basis. We just have less years to reach retirement. And so we have to give him more of those awards. From a modeling perspective, we end up granting him almost, I think it was Ryan confirmed here, 7% roughly of the value of the company at the end of that 15 year period. So the first award may be half a percent and then another half a percent and so on and so forth of equity value to get to where it’s worth that $25 million.

But keep in mind that that was based on a 5% growth rate. If the company value grows faster than that, his targeted $25 million benefit is going to be worth much more than that, right, on an annualized basis for him.

Ryan Barradas (1:16:35)
And again, that target of 25 million is really a fictitious number, but it was assuming that he would have real equity and pay capital gains. Again, we’re accounting for that bracket spread, which is easy to do if you get, again, creative and create a simple mechanism to do that. Any of the growth above 5%, though, is not going, we’re not accounting for the bracket spread above or below that.

We’re just really pegging it to that 5% number. So if it grows at 10%, Sam is going to have a massive benefit, but it’s all going to be taxed as ordinary income. Again, all of the benefits paid out under these programs are taxed as ordinary income and deductible to the corporation on a go-forward basis.

Michael Kenneth (1:17:21)
So we’ve touched on this earlier, but just to show kind of an illustrative example of that change of control, it’s really just to show that there is a difference in these types of plans between plan value and potentially deal value or whatever that transaction proceeds are. And obviously as a work or a goal of this was for the company to be able to allow those executives to participate in it. And so we just want to be able to hit on that.

And as Ryan mentioned, going through the plan provisions, the only way that these executives receive that higher value, again, as if they fit those provisions in the plan, meaning they stay with that acquiring company and they don’t choose to leave before the end of that 18 or 24 month period.

Ryan Barradas (1:18:03)
This company was a second generation company and they’re not seeing any next generation coming to the business. So they’re really targeting potentially selling the company somewhere in the next eight to 12 years. And so this deal value and these tag along and drag along rights are very, very real for this individual company. Now that may change, you know, a plan is only as good as the day you make it, things change, your thoughts and feelings about the company, the employees, the economic conditions, everything changes.

So we’ve got a lot of flexibility to deal with those ebbs and flows. Michael, if you could just go to the last one, we’ve got, this is just the insurance design, but in this case, and this is a very large case, so don’t think that every case has to be this large but this is the insurance funding.

We’re putting away eight and a half million dollars a year for the first 10 years and then two and a half million years 11 through 14 in order to fund those benefits. And so the company’s investing at the very bottom here. I’m gonna use my deal. I think I’m going to, won’t let me, of 95 million.

And what they’re going to get out of that is they’re going to get out the total life insurance proceeds, which are the distributions plus the death benefit that will eventually come. And we’re assuming those death benefits occur at age 88, but they’re also receiving the associated tax benefit of those payments that are being made to the participants. So that total is, Michael, do the math for me real quick. Is that 100 or 225 million?

And then so the net that they’re actually getting a positive 100 just under $131 million total that are accruing to the benefit of the company itself. That’s just again, we’re funding this using a life insurance again, if you go to the next slide, there’s a summary, we’ve got a total amount of $57 million on the first, the younger owner who happens to be the CEO, $50 million on his brother, $23 million, almost $24 million on the key employee, Sam, and then six and five on the other two key employees in order to fund this plan. And we’re keeping those policies separate.

We’ve got a separate pool of policies that are funding the SAR plan and another pool that are funding the full value unit plan because those liabilities tend to be different on a go-forward basis.

Michael Kenneth (1:21:03)
Just a couple of last quick slides and then obviously open up to any other questions before we adjourn. But one, just from an accounting standpoint, we have to be mindful of the accounting treatment of these types of plans. So as you’re making these synthetic equity awards, we have to account for the vested portion. There’s an assumption that’s being made that whenever an award is being allocated that there’s a that the award is going to vest. And so that will be a small hit to earnings.

It will also be residing on the balance sheet on a go-forward basis as well as a deferred compensation liability or some sort of labeling of that. And so we just have to be mindful of that, specifically for companies where balance sheets are something that’s constantly looked at. So example, a construction company where you’re using your balance sheet to qualify for bonding purposes, you’re using it for pre-qualification on bids, those types of things.

We just need to be mindful of that from an allocation perspective and investing in a financial reporting standpoint. And then obviously when we’re funding it with insurance, we want to make sure that we’re accounting for that properly as well. Typically on the insurance side, that’s really just an allocation change in terms of assets, right? You’re moving from cash to cash value of the insurance policy, but we need to be mindful of that.

For most plans like this, we’re kind of asset heavy first. In other words, we have the funding vehicle in place, but we’re growing that liability. And over time, we’re going to have it where the asset is matching up with that liability, meaning the funding source is matching up with the present value of those projected benefits that we’re going to be paying out into the future.

Ryan Barradas (1:22:41)
So we want to make sure that we don’t get behind the funding. So if we have a really high growth year, then we need to contribute more into the plan. And this company chose to fund the liability, assuming a 10% growth rate in all years. The reality is it won’t be 10%. Like I said, we never have linear growth in a company.

And so what we also do in the modeling period is we’ll model, again, that low moderate and high growth scenario, but second, we’ll do almost like a Monte Carlo simulation. So show growing at 10%, 20%, zero or negative and show those what more of a real life scenario to see what that impact is, not only on the benefits that are provided for the individuals, but then also for the liability that’s going to exist there for the company itself.

Michael Kenneth (1:23:38)
And then lastly, just wanted to hit on a couple of legal considerations and questions. I know that we’ve answered or talked about a lot of these today, but I think maybe David, just to kind of streamline the conversation, I think one hitting on the first part, so what is actually drafted, right? What are the actual legal deliverables, if you will, from enacting a plan like this? And then second, what is reported to the IRS? I think would be really valuable for the audience to know.

David Whaley (1:24:05)
Yeah, I mean, from a legal perspective, what you need is a legally binding commitment. Typically, that is a plan document and an award agreement. The reason why it’s a plan document and an award agreement is because you have a baseline plan that you’re going to make individualized grants to differing people with, right? So you’re to go through and make it to differing people. So you want a form that actually says, hey, this is what generally is. And then we have a grant agreement that says, this is yours. And that’s enough to meet the standard of being a legally binding commitment.

We need all the terms we talked about either in the plan document or in the award agreement with respect to vesting, with respect to payout, all those different factors. But that’s really what we’re looking for from a legal perspective. What’s reported in the IRS is actually relatively little. Whenever you enact a plan, a top hat plan, there’s a requirement that you actually file a top hat statement with the IRS and the Department of Labor. It’s a joint filing. It goes in by email and you literally say, we have a plan. We’re not gonna do any more filings for it.

The one other thing I will say with respect to this, there are some tax implications from a wage perspective, from a FICA perspective and FUTA perspective with respect to these grants as they become invested. So there will be some reporting with respect to the means of some of these payments as they become invested due to people, due to the IRS in connection with this. Don’t miss that. Make sure you account for it. We’ve done a lot of times where I’ve had to go back and fix some of those challenges. They’re not unfixable. They’re just not fun.

Michael Kenneth (1:25:27)
Perfect. And then one other question from a legal standpoint, David, what flexibility exists? So what if I draft a plan that has provisions that I’ve decided subsequently to change those provisions, right? Whether vesting schedule, whether payout period, anything like that, you know, is there the ability to change plan documents or do you terminate one plan, move to a different plan? Just curious.

David Whaley (1:25:53)
Yeah, so it’s really twofold. If we’re really looking to have a sea change with respect to what our promises or program is, we freeze one and move to the other. And then we burn off the one, right? If what we want to do is make some modifications to what we have, we are constrained a little bit by 409A. What we functionally, the challenges we have in 409A is to change the when and how payments are made. When they start, the installments are lump sum. Those are the hard things.

Interestingly, everything else in 409A is relatively easy to modify. If we don’t accelerate or decelerate the timeframe of a payment, which is what 409A governs, we can do a lot. So we can get rid of a vesting schedule. We can modify the means in which things are calculated into the future. We can modify the means in which things are accrued inside of our buckets to be paid.

We just have a real hard time changing the time and form of payment of those buckets.

Michael Kenneth (1:26:53)
Great, perfect. I don’t know, we just have a couple of minutes left here. Obviously wanted to hit on just again, recap of the learning objectives. And I think we’ve accomplished all of those and right on schedule, which is awesome.

Ryan Barradas (1:27:06)
We have a question. How is bonding affected by the funding of insurance premiums and benefit liability?

Michael Kenneth (1:27:16)
Yeah, I would say from a bonding standpoint, you know, it’s really how does the overall plan change the balance sheet for the company and specifically the working capital, meaning current assets and current liabilities. From a current asset perspective, we’re just moving cash to cash value of life insurance. And so we have kind of a clean transfer that’s there. Obviously, if there’s any insurance costs or those types of things, you may have a reduction in the current asset amount.

On the benefit liability, it’s a long-term liability, at least until we start getting to the spot where we’re starting to pay out those benefits. So from a bonding standpoint, there’s no real concerns upfront, but on an annualized basis, we just want to see how does that liability or that long-term benefit plan start to creep in to current liabilities as we start to have to make these payments out to participants? And does that have a substantial change to the working capital of the company?

So upfront, no real issues, but over the long term, just something that we want to be mindful of on an ongoing basis.

Ryan Barradas (1:28:22)
Great. That wraps up. Again, just as a reminder, if there are any other questions that anybody has, please feel free to email us. You’ve got our information here. We will also be emailing out a copy of the materials that we went through today along with a recording. So if there’s anybody that you want to share this with, whether it be a colleague within your firm or an outside colleague, please feel free to share those things with them.

And then also if there’s ever a case that you would like to brainstorm with any one of the three of us, we’d be happy to be available to brainstorm with you because discovery as David pointed out on the front side and really figuring out what the goals are and the current situation is incredibly important when designing these things properly.

So without further ado, I will wrap this up. Thank you so much for your time. We really appreciate it and recognize that it’s very valuable for each and every one of you. And we look forward to sharing more interesting things and concepts with you in our next iteration of WP90x. Thank you again and hope you have a wonderful day.