Using Phantom Equity to Grow Your Business: Pros and Cons
This is the second article in a series examining when an entrepreneur should consider granting equity or equity-like interests in his or her company, and if so, how to properly structure that equity or equity-like grant. To view the first article in this series, please click here. Today’s topic: Phantom Equity.
Phantom Equity Overview
Phantom equity is an equity-like grant that is tied to the underlying value of a unit (if the company is an LLC) or a share of stock (if the company is a corporation) in the company. More often than not, phantom equity is granted pursuant to a phantom equity plan, with individual phantom equity agreements for each of the applicable employees/executives. The individual phantom equity agreements will likely have some customized terms for each particular employee (number of units, vesting schedule, etc.), while other terms are usually standard across each of the phantom equity agreements (rights to certain payments, forfeiture upon termination, rights to certain information, etc.).
An example may be helpful. Let’s assume there are 100 units issued and outstanding to the members of an LLC prior to creating the phantom equity. Then, 10 “phantom units” are granted to key employees pursuant to a phantom equity plan. The end result is that the phantom unit holders would receive an amount equal to 9.09% (10 units out 110 units total) of certain payments made to the real unitholders (the holders of the 100 units) of the company. The key fact to remember is that these phantom units are not actual units of equity in the company, but they are counted as if they are actual units for purposes of certain payment or events of the company.
Generally, phantom units or shares are not paid for by an employee, but instead vest over time in exchange for the employee continuing to work full-time at the company during such vesting period. Typically, I see a one year cliff (from the first date of employment), then vesting in monthly or quarterly increments over the following two to four years. The one year cliff (meaning, no vesting occurs during the first year of employment) is done to protect the company from granting phantom equity to employees that leave the company for whatever reason within their first year of employment. Sometimes, an employee that is granted phantom equity will negotiate partial or accelerated vesting if the company terminates the employee “without cause.” This is typically not granted by most companies, but every situation is unique and I have seen it negotiated and granted to a few individuals.
A phantom equity holder will be entitled to payments in connection with certain triggering events. These triggering events will be set forth in either the phantom equity plan or in the phantom equity agreement. There is great flexibility for a company in designing their own particular phantom equity plan and what payments the phantom equity holders participate in.
The most company-friendly plans only provide for a payment in the event of a change in control transaction (i.e. the sale of the company). This means any dividends that flow to members or stockholders of the company (not otherwise in connection with a change of control transaction) will not be shared with the phantom equity holders. For example, if a company has 100 shares issued and outstanding to its shareholders and 10 phantom shares issued to is phantom equity holders that do not have a right to participate in dividends, and the Company is going to dividend out $1,000,000, then the holder of each share of stock would receive $10,000 per share ($1,000,000 split amongst 100 shares), while the phantom shareholders (10 shares) would receive nothing. If a phantom equity plan is structured this way, the clear message to the phantom equity holders is that they will only share in the success of the company if the company is ultimately sold. Phantom equity holders should understand the risk that he or she may not work at the company when it is sold, and therefore it is likely that such phantom equity holder will not receive any benefit from the phantom equity. This is because phantom equity is often contractually forfeited by the employee when he or she leaves the company. This allows the company to issue new phantom equity to future hires without further diluting payments made to real equity holders.
Valuation Hurdle/Phantom Appreciation Rights
Another key feature typically found in phantom equity grants is the concept of a valuation hurdle, or what is sometimes referred to as a “phantom appreciation right.” If a company has been in existence for a few months or longer, then the company likely has some ascertainable “fair market value” greater than zero. Let’s assume that a company’s fair market value is determined to be $5,000,000, and this company now desires to grant phantom equity to certain employees. If there is a valuation hurdle in the phantom equity plan or agreement, then the phantom equity holders only share in the value that is created (based on their phantom equity percentage) that is above $5,000,000. Using this same example, let’s assume the company is sold three years later for $10,000,000 and there are 100 units of real equity issued and outstanding and 10 units of phantom equity. In such example, the real equity holders (100 units) would receive all of the first $5,000,000 of proceeds from the sale, and then the next $5,000,000 would be split 90.91% to the real equity holders and 9.09% to the phantom equity holders (per the math at the beginning of this article).
No Ownership Rights/Control
From the company’s perspective, it is important that the plan and/or phantom agreements very clearly spell out that phantom equity does not grant any rights to the holder that would be typically granted to a normal equity holder under law. This provision should explicitly state that the phantom equity holder has no voting or decision making authority with respect to the company in connection with being granted phantom equity. It should also limit the rights of the phantom equity holder to demand certain information (financial or otherwise) from the company. Conversely, if you are the person being granted phantom equity, you should consider negotiating certain information rights into your phantom equity agreement.
Whether phantom equity or phantom appreciation rights are being granted, the tax situation is generally the same for the company. Generally, payments made by a company in connection with phantom equity or phantom appreciation rights are deductible by the company at the time the payment is made. Regardless, always be sure to discuss the tax consequences with a tax advisor before granting phantom equity or phantom appreciation rights.
Conversely, and as a big disadvantage to the employee being granted phantom equity instead of real equity, payments received by phantom equity holders are taxed as ordinary income. The difference between ordinary income and capital gains (which typically would apply to certain payments made to true equity owners) can add up to thousands (if not millions) of dollars of additional taxes paid by the employee if the company has a successful exit event. However, in positive news for the recipient, no taxes should be due by the phantom equity holder upon his or her receipt of phantom equity. With respect to true equity issuances, the recipient will likely owe tax on the fair market value of the equity received, unless such equity was actually purchased by the recipient for fair market value.
General Pros and Cons
There are a number of reasons phantom equity may make sense for a company as compared to other types of equity and equity-like plans. Below are a few final points to think about as you decide whether or not phantom equity may be a viable option for your company:
It allows certain key employees to share in the growth and success of the company while existing equity owners are not explicitly diluted and do not give up any control.
May serve as a golden handcuff to keep key executives from looking at other job opportunities.
Employees do not need to actually purchase the phantom equity; in other equity plans, the employees will likely need to purchase the equity at fair market value or have to pay tax on the fair market value of the equity that they receive.
There is a great deal of flexibility that can go into the phantom equity structure. The phantom equity can mirror true equity almost completely (participate in dividends, etc.), or it can be very limited (participates only in a change of control event, with a valuation hurdle).
If structured correctly, phantom equity can easily be forfeited without penalty to the employer or the employee if the employee leaves the company.
If structured poorly it can lead to extremely bad results, including the permanent dilution of existing shareholders or unit holders, and/or the forced disclosure of sensitive information to individuals no longer working at the company.
May require a valuation of the company by an outside accounting or valuation firm.
May not be as attractive to a key employee because it is not real equity, and the company usually has the ability to terminate the employee and consequently extinguish the phantom equity.
409A (deferred compensation) issues can add complexity to structuring and achieving the intended objectives of the company and the employee recipients.
When structured correctly, phantom equity is an excellent option for both companies and key employees. As I like to tell clients, granting phantom equity is somewhat akin to dating before getting married – there are clear benefits to both the employee and employer in putting a phantom equity plan in place, but if it does not work out, both sides can walk away with minimal, if any, strings attached.