Understanding Phantom Equity: Implications for Startups

Many startups offer additional benefits, like company stock, along with salaries to attract and retain talented employees. As a startup founder, you can choose from multiple employee equity offerings, such as Employee Stock Ownership Plans (ESOPs), stock options, and phantom stock. Among other plans, granting phantom stock is regarded as an excellent strategy. 

Phantom equity plans offer a unique way to motivate key employees by offering them the economic benefits of stock ownership without granting actual shares. They are particularly beneficial for Limited Liability Companies (LLCs) and startups seeking flexible compensation solutions. 

This blog covers the different aspects of phantom equity plans, including their meaning, types, advantages, challenges, tax treatment and others. 

What Are Phantom Equity Plans?

Phantom equity plans are a form of deferred compensation that provides select employees, often senior management, with benefits similar to stock ownership without granting them any actual equity in the company. Often referred to as shadow stock, these plans offer your employees virtual shares that track the real stock price. 

When your startup performs well and the stock price grows, employees benefit from the gains through a cash payout. Similar to a bonus, phantom equity also entitles recipients to cash payouts during significant events like company acquisitions, public offerings, or achieving specific financial milestones, such as revenue or profit targets. 

Each phantom plan includes an agreement outlining the vesting schedule and specific conditions that participants must meet before the shares vest. This agreement details the goals required, the rewards for achieving these goals, and any voting rights associated with the plan.

Unlike traditional stock options, phantom shares do not offer an equity stake in the startup.  This means that while employees benefit from an increase in share price, they do not possess any of the voting rights or gain dividends associated with actual shares.

Why Companies Prefer Phantom Stock Plan

Equity-based compensation, like phantom equity, offers a compelling way to motivate employees. By syncing their interests with the company's success, phantom equity plans incentivize employees to work harder and become invested in its long-term growth. 

However, phantom equity is particularly well-suited for specific situations:

• Shareholder Dilution Concerns: Issuing additional shares can dilute existing shareholders' ownership. Phantom equity avoids this dilution by offering a share-price-linked reward without issuing actual stock.
• Regulatory Constraints: Certain companies may face legal or regulatory limitations on issuing stock options. Phantom equity plans offer a flexible alternative that can still incentivize employees.
• Strategic Talent Management: Phantom equity can be used strategically to attract and retain top talent, particularly in situations where immediate cash compensation might not be possible.

The number of phantom shares awarded typically considers an employee's seniority and performance. While the promise of a reward exists upfront, the benefits of phantom equity are long-term. The payout schedule outlined in the plan can range from two to five years, and some payouts may be conditional on achieving specific milestones. As a result, employees are likely to stay with the company to see their phantom stock rewards mature.

Phantom Stock Plan vs. Stock Option Plan

Here is a comparative analysis of a phantom stock plan with a stock option plan to highlight their differences:

Actual Stock Issuance

• Phantom Stock Plan: Phantom stock plans do not involve the actual issuance of company shares. Instead, employees receive virtual shares that track the value of the company's stock.
• Stock Option Plan: Stock option plans involve granting employees the option to purchase actual company shares at a predetermined price.

Employee Coverage

• Phantom Stock Plan: Phantom stock plans are reserved for senior-level employees, offering them a stake in the company's growth and success without diluting actual ownership.
• Stock Option Plan: Stock option plans are typically offered to a wider range of employees, which also includes lower-level staff, allowing for widespread participation.

Payout Structure

• Phantom Stock Plan: Participants in a phantom stock plan receive cash payouts equivalent to the value of the phantom shares, typically triggered by specific events like an acquisition or IPO.
• Stock Option Plan: With stock options, employees have the option to buy the company stock at a fixed price, potentially leading to capital gains if the stock price increases.

Types of Phantom Stock Plans

Phantom stock plans are broadly of the following types, each with its own way of calculating payouts:

Appreciation Only Phantom Stock Plans

In an appreciation-only phantom stock plan, participants receive a cash payout equal to the increase in the company's stock price from the issuing price of the phantom stock to the redemption price. For example, if the issuing price of the phantom stock is $20 and at redemption, your company's common share price is $30, the cash payment per phantom stock would be $10.

Advantages of Appreciation-Only Plans

• Reduced Administrative Costs: Since there are no actual shares involved, the administrative burden of managing stock ownership is significantly reduced.
• Increased Flexibility: You can design the plan and tailor it to meet your specific needs without the constraints of actual stock ownership.

HFull Value Phantom Stock Plans

In a full-value phantom stock plan, employees would receive a cash payout that is equal to the full value of the underlying asset (common stock) at redemption. Using the same example, if the issuing price of the phantom stock is $20 and at redemption, your company's common share price is $30, the cash payout for every phantom stock would also be $30.

Advantages of Full-Value Plans

• Increased Employee Motivation and Retention: Offering the full value of the stock motivates employees to contribute to your startup's success, leading to higher retention rates.
• Potential for Larger Cash Payments: Since participants receive the full value of the stock, including appreciation, they have the potential to receive larger cash payouts.

How Does a Phantom Equity Plan Work?

Implementing a phantom equity plan involves the following process to ensure fairness and clarity for all participants:

Step 1: A plan administrator, often a committee or board of directors, is appointed. It oversees the phantom equity plan, including the issuance of phantom shares and the calculation of payouts.

Step 2: Employees are granted phantom shares as per the terms and conditions specified in the agreement.

Step 3: These phantom shares typically vest over time, during which employees earn the right to receive payouts based on the value of the shares.

Step 4: The value of phantom shares is determined by the company's stock price or a predetermined formula specified in the plan.

Step 5: Payouts are triggered by specific events, such as a company sale, merger, or IPO, or by meeting certain performance goals. 

Step 6: When a trigger event occurs, employees get a cash payout that is equal to the value of their vested phantom shares.

Let's consider a situation where your startup grants an employee 100 phantom shares with a value tied to the company's stock price. If the stock price is $20 per share when the shares vest, the employee's phantom shares are worth $2,000. If the stock price increases to $40 per share by the time of a trigger event, the employee will receive a cash payment of $4,000.

Clear communication and transparency are crucial to creating trust in the phantom equity plan administration process. It helps ensure that employees understand the plan's terms, how their payouts are calculated, and when they can expect to receive them.

Advantages and Disadvantages of Phantom Equity

Phantom equity plans offer several benefits but also come with certain drawbacks. Understanding these can help you decide if such a plan is right for your startup.

Advantages of Phantom Equity

• Increased Employee Motivation and Retention: A phantom equity plan creates a performance-based compensation system using phantom shares, which helps encourage sustained employee performance over time.
• Reduced Administrative Costs for the Company: Beneficiaries of phantom shares do not become shareholders, which means that there is no impact on the company's cap table. Hence, the administrative burden of managing stock ownership is significantly reduced.
• Potential for Larger Cash Payments: Phantom equity plans can offer your employees the potential for larger cash payments compared to traditional bonus plans, especially if the stock's value increases significantly.

Disadvantages of Phantom Equity

• Tax Implications for Employees: The benefits your employees receive from these plans will be taxable as ordinary income. As these benefits are paid in cash, the employees will not be able to opt for capital gains tax treatment.
• Limited Flexibility in Terms of Plan Design: Phantom equity plans have specific rules and structures that may limit your flexibility in designing the plan to meet its specific needs.
• Accounting Implications for the Company: Phantom equity plans may have accounting implications for your company, as they are treated as liabilities on the company's balance sheet.

Tax Treatment of Phantom Equity

Regardless of how you make payments for a phantom stock plan, the gains are considered ordinary income and taxed accordingly. For employees, this means higher tax rates compared to capital gains tax rates. While long-term capital gains are subject to taxation at a maximum federal rate of 20%, ordinary income can be taxed up to 37% at the federal level, not including state and local taxes. 

For employees, this income is reported on their W-2 and must meet the current withholding tax requirements. Phantom equity plans do not receive any special tax treatment or benefits that defer taxes beyond the payment date. Depending on the timing of the payment, you might not have to pay FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act) taxes if the compensation is provided at the end of the year and the employee's income has already exceeded the wage base limit for these taxes. However, Medicare taxes must still be paid, as they are not subject to the wage base limit. The tax liability for employees generally arises when the payout is made, not when the phantom shares are granted.

For companies, phantom equity payouts are deductible as a business expense in the year the employee reports this income, which can provide you some tax relief. However, you must comply with IRS regulations, particularly those under Section 409A, which governs non-qualified deferred compensation plans. Any failure in compliance can result in significant penalties, including immediate taxation of the deferred amounts and additional interest and penalties.

Tips for Maximizing the Benefits of Phantom Stock Plans

Here are some useful suggestions to help you avail the maximum benefits from your phantom stock plans: 

Clearly Convey the Terms of the Plan to Employees

It is important to ensure that your employees fully understand the terms of the phantom equity plan. This includes detailing the type of phantom shares being issued, the vesting schedule, and the associated tax implications. You can organize workshops or Q&A sessions to explain the plan in a way that excites employees about the company's future and their stake in it.

Set Up a Vesting Schedule for Phantom Shares

A well-designed vesting schedule motivates employees to stay and contribute to the company's growth. It provides a clear path for them to earn their phantom shares, fostering loyalty and encouraging performance that supports the company's objectives. Consider using a milestone-based vesting schedule to ensure that the schedule reflects the company's strategic priorities.

Design a Rewarding Compensation System

Integrate phantom equity plans into a comprehensive compensation strategy that includes salaries, bonuses, and other benefits. By combining various forms of compensation, you create an attractive package that can help retain the best talent. Regularly adjust your compensation strategy to make sure that it aligns with the present industry standard.

Provide Employees with Clear Visibility on the Value and Ownership of Phantom Stock

Regular updates on the value of phantom shares and clear explanations of how they will be converted into cash payments can enhance employee satisfaction and motivation. Transparency about the tax implications and payout conditions will also help employees better plan their finances. You can use any of the available internal communication channels, such as newsletters or intranet updates, to keep employees informed about the value of their phantom shares.

Conclusion

Implementing phantom stock plans can be a strategic move for your startup, offering numerous benefits in terms of employee motivation, retention, and alignment with your company's long-term goals. However, the intricacies of these plans require careful planning and expert guidance to ensure they are tailored to your specific needs and circumstances.

Qapita can be an invaluable partner in this journey with specialized services for cap table management, ESOP grants, valuations and much more. As a leading provider of equity management solutions, we offer a comprehensive platform for managing ownership equity workflow and providing structured solutions for liquidity events. Our experts are always available for a one-on-one consultation to assist with the administration of your phantom shares and ensure compliance with all legal requirements.

Ready to take the next step? Contact us for a free demo now!

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