If you want your managers to strive for short- and long-term profits,try this phantom-equity plan

Dennis Dautel and Rex Gore were looking for something that would encourage their managers to pay closer attention to the short-term profitability of the jobs they were overseeing. But Dautel and Gore didn't want the managers to lose sight of the fact that outstanding customer service was essential to the company's long-term growth.

The duo own Clean Cut Inc., a $1.8-million landscape-maintenance business in Austin. The company employs 50 to 75 people, depending on the season. Employees work in five teams, and each team has a leader who deals with customers and schedules and supervises the crew. Leaders make the on-site decisions that determine whether a job comes in over or under budget.

Landscape maintenance is a dirty-hands, low-margin industry with no barriers to entry or lack of competition. Team leaders are not M.B.A.s but lunch-bucket guys with a talent for supervising people. They're more likely to be interested in an incentive compensation plan that is simple and gives more short-term rewards than in one that makes long-term promises.

But a straight profit-sharing plan, says Dautel, can encourage supervisors to shortchange customers. Profits go up, but the company's reputation and long-term prospects suffer.

On the other hand, long-term incentive plans, such as employee stock ownership plans or stock-option plans, don't offer any immediate reward for good work. Also, they sound complicated. Besides, Clean Cut's co-owners, who have been the sole owners since the company's founding, in 1985, weren't keen on giving away stock.

So Dautel and Gore devised their own incentive plan, which allows team leaders to use a portion of the profits their crews generate to buy a stake in their own team's growth. Here is how Dautel and Gore expect their phantom-equity plan to work.

Let's say that George, a team leader, decides to buy into the phantom-equity plan. For the past six months his team has generated, on average, $24,000 a month in revenues. Dautel and Gore propose to value any team's business at twice its monthly revenues. So George's team's business is worth $48,000. Plus, it's only fair, Dautel says, to add to the price the depreciated cost of the capital equipment assigned to the team. George's team currently uses, say, $12,000 worth of trucks, trailers, mowers, and so on. In total, George will be buying into a business currently valued at $60,000. George decides to "buy" a 25% share, worth $15,000.

In a paper transaction, Clean Cut lends George the $15,000 to be paid back over five years. Neglecting any interest (to keep the example's calculations simple), George owes the company $250 a month for five years. The money will come out of his 25% share of the team's profits.

Profits? Out of $24,000 gross monthly revenues, Clean Cut subtracts

Overhead at 20% $4,800

Direct labor 11,000

Equipment, repairs, and 3,200


Supplies and materials 1,000

George's salary 2,000

Total expenses $22,000

The monthly profit for George's team, therefore, is $2,000 ($24,000 minus $22,000). Since George "owns" 25% of the team's business, his share of the profit comes to $500 a month. Subtracting the $250 loan-amortization payment leaves George with $250 a month in additional income. As the team's profits rise or fall over time, George's 25% share, of course, changes in direct proportion.

Now, let's say it's 10 years later. George is ready to retire and wants to cash out by selling his "equity" -- his share of the team's business. By keeping his customers happy and adding on new accounts, he's built his monthly revenues up to $40,000. Assuming that the capital-equipment numbers haven't changed (again, to keep the example simple), the business George's team does is worth $92,000 (two times $40,000, plus $12,000). When George retires, the company buys back his 25% share for $23,000 ($92,000 times 0.25). George never used a dime from his own pocket to buy his share of the business, yet he was able to enjoy extra income out of profits while he was working, and he was able to retire with a nice nest egg.

It's easy to imagine how other companies might adapt Clean Cut's phantom-equity plan. All you need is a business in which teams or divisions operate fairly independently of one another and in which accountability for performance is easily assigned.

Also, Dautel cautions, you must be able to calculate a team's profits, which is not as easy as it sounds. If, for instance, you ever have more than one team working on a single job, if teams sometimes borrow people from one another, or if some capital equipment is used by more than one team -- if, in other words, the teams aren't always completely independent, then the accounting procedures required to determine each team's profits can get hairy. For Clean Cut, Dautel has custom-designed a Macintosh-based accounting program that performs all those calculations.

Before Clean Cut could put its phantom-equity plan into action, Dautel says, he and Gore had to decide when and for whom phantom equity made sense. "It's not worth doing if you can't explain the principles of the plan to the people involved," Dautel says. "If they don't understand what's going on, then they still won't be thinking like owners."


How to make it work

Here are some of the larger issues you'll need to consider in designing a phantom-equity plan:

* Valuing the business. There's no fixed rule about how you place a value on the part of the business you want to "sell" to an employee. It's important only that you be consistent. The business should be valued the same way when the employees buy in as when they cash out.

* Making shares available. There's also no fixed rule about the size of the share you let employees "buy." It should be large enough to give them a real stake in the business.

* Accounting for losses. What if profits decline or a team has a loss? If you don't want the employees taking dollars out of their own pockets to make the monthly amortization payments, you should consider extending the period of the loan so that monthly payments are lower.

* Cashing out. When it comes to valuing the employees' equity at retirement, you have to guard against a last-minute run-up of revenues that would inflate the price. Instead, consider valuing the business on an average of monthly revenues -- over, say, the last six months or more. And you don't have to buy out the phantom equity all at once. Provided it's in the agreement, you could spread the payments over several years.