Companies interested in offering incentive-based compensation to attract and retain top-level talent have several options for their employees, but phantom stock options allow a company to offer such compensation without offering equity–an option with potential, often significant and overlooked potential downsides.
In arrangements where a company grants an employee equity, a specific property right is established making the employee a minority owner in the company. This triggers statutory rights and responsibilities to the minority owner as well as contractual obligations under the company’s corporate documents (by-laws & buy-sell agreements in the instance of corporations, and the operating agreement of LLCs). Furthermore, majority owners in closely held companies owe a high standard of fiduciary duty to minority owners. These new minority owners may now have voting rights and the right to review company financials and other documents. These may not be things the company intends to grant to the employee. Additionally, for s-corps and LLCs, minority ownership also comes with individual tax liability.
Further problems can arise if things go south with the employee and the employee quits, is terminated for cause or dies. In order to get the equity back, it has to be re-purchased. A company needs to carefully spell out specific triggering events in its corporate documents in order to force the employee to sell his/her equity back to the company. Absent doing so, the company could be left with an ex-employee/minority owner who sticks around receiving distributions indefinitely.
Phantom stock can present a simple, flexible solution allowing your company to offer an employee incentive compensation and a “stake in the action” while keeping complete control and ownership of the company in the hands of the founders.
Under a phantom stock plan, the company establishes a phantom stock account for the specific employee and grants fictional shares of company “stock” to him/her. The arrangement is created by contract. The contract (called the phantom stock plan) can be tailored to meet the specific goals and plans the company wants to achieve. Since actual equity is not transferred to the employee, the phantom stock exists only as a bookkeeping entry and is therefore appropriately called “phantom” stock. These are also sometimes referred to as “top hat plans”. The value of the phantom stock is usually tracked with the company’s stock, though it can also be stipulated to or established by a written formula. Phantom stock arrangements can be structured to give an employee a specified number of phantom shares for each year that he/she is employed by the company and/or issuance is tied to specific performance metrics or company goals/milestones. Whenever granted, the phantom stock may be immediately vested or subject to any vesting schedule that the company chooses.
Because Phantom stock plans are contracts between the company and the employee, specific provisions can be drafted to address what happens if the employee leaves the company on his/her own and if the employee is terminated for cause. Under these circumstances the company can draft provisions forfeiting the phantom stock, significantly reducing its value, or delaying payment. These types of arrangements are sometimes called “golden handcuffs”. The company can structure the arrangement in such a way to incentivize an employee to stay with the company. The company promises the employee that he/she will receive the value of the phantom stock at a specified date in the future, like retirement, the sale of the company, death/disability or some other agreed-upon date. The payment can be made in a lump sum or in installments.
Here are a few other examples of benefits unique to phantom stock plans:
- Employees can be compensated for the overall success and growth of the company.
- Employers usually institute the plans because they want to increase their employees’ economic stake in the business and to enable their employees to share in the company’s growth.
- Can be used with c-corporations, s-corporations, b-corps or limited liability companies.
- A phantom stock does not dilute the other owners’ interest in the company.
- The phantom stock is an accounting device only, it does not actually convey any true ownership rights in the company, therefore the current ownership of the company remains unchanged.
- It does not create the limited liability company or S-corp tax obligations that owners are responsible for.
- It does not grant the employee any management or voting rights in the company.
- It does not require the employee to “buy-in” or the company to lend any money to the employee in order to enable them to buy into the company.
Our firm regularly assists companies in creating and maintaining phantom stock plans. All plans are different, just like the goals of a company. We help our clients create plans that advance the company’s goals.
(MLMW, is a business, employment, estate planning, and litigation law firm. Craig T. Watrous is a Colorado business and employment attorney and partner at MLMW, based in Denver, Colorado. Craig regularly represents clients in connection with phantom stock plans. Craig can be reached at email@example.com or (303) 722-2165.)