Unlocking the Potential of Phantom Equity: Incentive and Compensation Strategies to Attract and Retain Top Talent

Navigating the landscape of employee incentives can be complex, particularly when exploring non-traditional compensation methods. Phantom stock, also known as synthetic equity, offers a unique solution for business owners seeking to incentivize and retain key personnel without giving away ownership in the company. Below, PilieroMazza attorneys answer commonly asked questions regarding the nature of phantom stock, outlining its structure, benefits, and the strategic considerations involved with this valuable tool for attracting and retaining top talent.

What is a phantom plan and phantom stock?

Phantom plans have become especially popular in place of other incentive plans, such as employee stock option plans and stock appreciation rights plans. The primary reason phantom plans continue to supplant more traditional incentive plans is they do not require the owner(s) to give up any actual equity in the company. You can think of phantom stock as the ghost of the real stock of the company, similar in spirit but not in substance. Phantom stock mirrors the value of regular stock, but it does not confer actual ownership, or equity, in the company. Nor does it come with the commensurate rights and obligations of actual stock, such as ownership and voting rights.

Phantom stock offers participant holders a chance to benefit from the company’s future growth, without holding actual equity. A holder of phantom stock is essentially holding a promise for a future payout. This payout is generally tied to the company’s success, giving holders of phantom stock a vested interest in the company’s long-term success. As such, the phantom stock is typically tied directly to the value of of the company’s actual stock. An increase in the company stock means a corresponding increase in the value of the holder’s phantom stock.

The “phantom plan” under which phantom stock is issued is a contractual agreement between a company and the individual who holds the phantom stock. This is usually an employee of the company, although holders of phantom stock  can be independent contractors, other service providers, or third-party entities..  The “holder” of the phantom stock is generally referred to as the “participant,” as the holder  is “participating” in the phantom plan. The phantom plan governs the terms of the phantom stock that is awarded to the participant, and multiple “participants” can receive awards of phantom stock under a single phantom plan, as explained in more detail below. However, note that the term “participant” does not imply active engagement. Rather, the participant is simply eligible for a potential financial benefit that tracks the company’s performance.

How does the phantom plan operate?

The phantom plan is essentially the blueprint that spells out the rules for granting phantom stock—think of it as the “operating manual” for this unique form of equity compensation. The phantom plan establishes the terms and conditions by which phantom stock will be issued, or awarded, to the participants. When an individual participant is identified as a candidate for phantom stock, that participant will sign a separate agreement called an “award agreement.” The award agreement works in conjunction with the phantom plan. While the phantom plan sets the stage, the award agreement is similar to a personalized script that details each participant’s unique phantom equity opportunities. The award agreement can be tailored to each specific participant, providing the company with flexibility to individually structure each participant’s phantom equity award.

Thus, in short, enacting a phantom plan involves two documents.

1. The first document is the phantom plan itself, which establishes the operation of and procedures for the issuance of the phantom stock. The plan includes information such as (i) the persons or entities eligible to participate, (ii) how the phantom stock is valued, (iii) how many shares of phantom stock are available in the phantom stock pool (the total number of phantom shares earmarked to be awarded to all participants under the plan), and (iv) the triggering or payout events that activate the conversion of phantom stock into cash payouts for participants.
2. The second document is the award agreement, which is specific to each participant. The award agreement includes information such as (i) the name of the participant, (ii) the total number of phantom units awarded to the participant, (iii) a vesting schedule for the phantom shares, and (iv) events whereby the phantom shares may be forfeited by the participant.

Who can be a participant in a phantom plan?

As noted above, it is most common for employees of the company to be participants in a phantom plan. However, phantom plans are not exclusive clubs; they’re open to a wide array of contributors, from employees to the consultants and contractors who also propel the business forward. Holders of phantom stock can be independent contractors, other service providers, or third-party entities.

What are the benefits of a phantom plan?

Rather than providing actual equity to an employee or consultant of a company, phantom plans provide participants with the financial upside of stock ownership, without many of the downsides for business owners who may not want to dilute their own stock, or engage in complex shareholder agreements that often accompany a distribution of real equity. Benefits to the company can include:

1. Incentive Benefits: Participants gain a direct financial stake in the company’s success.
2. Retention Benefits: Companies that have embraced phantom plans often report higher retention rates, as employees with a financial stake are more likely to remain invested in the company’s growth and success.
3. Alignment of Interests: The interests of key employees are better aligned with those of the company and ownership.
4. Increase in Morale: Participants are made to feel like partners in the company, vested in its victories and growth.
5. Equity Preservation: The plan simulates stock ownership for participants without actually providing it, ensuring that ownership does not become diluted for other shareholders.
6. Flexibility and Customization: Companies can design and tailor plans to match individual needs and provide different award structures to each participant.
7. Tax Advantages: Although the intricacies of the tax benefits may vary, phantom plans often present unique and favorable tax considerations for companies when compared to traditional stock option plans.
8. Alternative Compensation Method: Beyond the employee incentive context, phantom stock plans can be used as a creative alternative compensation method for non-employees in a variety of contexts.

What events trigger cash payouts for phantom stock?

Ultimately, a phantom plan is intended to provide the participant with a financial reward. For this reason, each phantom plan will define certain “triggering events” that allow the participant to cash in on their phantom stock. A “triggering event” is a specific condition outlined in a phantom plan that, when met, allows a participant to convert their phantom shares into cash rewards. These triggering events can be specifically tailored to each participant, but typical triggering events include:

1. a change in control or a sale of the company;
2. death or disability of the phantom plan participant;
3. termination of employment, or a separation from service, such as a voluntary resignation; or
4. retirement of the participant.

A change in control or sale of the company is the most common triggering event for a benefit payment, and is almost always included in the plan. Death and/or disability, separation from service, and retirement are less common and would provide an additional benefit to employees.

How is phantom stock valued?

Phantom stock is tied to the value of the company in the same manner as actual equity. As the value of the company’s stock rises, so does the value of the phantom stock.

There are two main valuation methods for phantom stock.

1. Full Value Plan: Under the full value plan method, the value of each phantom share mirrors the current market value of an actual share of the company at the time of payout, regardless of the actual value of the company’s shares at the time of the award. This approach considers the entire current value of an underlying share of stock, not just the increase from the date the phantom stock is awarded. This method may result in a larger payout for the participant as it includes the full value of the stock at the payout time, not just the difference between the value of the stock at the time of award and the value of the stock at the time of payout.

2. Appreciation or Share Increase Plan: Under the appreciation or share increase method, the value of the benefit payment is tied only to the increase in the company’s value from the date of award to the date of payout. To implement this, a “Base Value” is set at the time of the grant. Often, the “Base Value” is the value of the company’s actual stock at the end of the previous fiscal year, but the company can ultimately set the base value at an amount of its choosing. The “Base Value” acts as a financial anchor, setting a benchmark from which appreciation is measured; it can be strategically chosen based on past performance or expected future milestones. Once the phantom equity is vested, the payout is the difference between the base value and the value of the company’s actual shares at the time of payout.

As an example, assume Joe is issued 500 phantom shares of XYZ Corp. in 2020 that are worth $50 per share and that the phantom plan of XYZ Corp. establishes the sale of the company as a triggering event for a payout. In 2023, assume 100% of the equity of XYZ Corp. is sold to a third-party buyer at a price of $70 per share. Upon the completion of the sale, the cash payment he receives for his 500 phantom shares is as follows:

1. Full Value Plan: A cash payment from XYZ Corp. equal to the current value of the shares (i.e., the sale price): $70 x 500 = $35,000.
2. Appreciation Plan: A cash payment from XYZ Corp. equal to the difference between the current value of the shares ($70) and the phantom stock base value ($70 – $50 = $20) x 500 = $10,000.

Note that the issuing price of phantom stock can be set by the company and does not have to be tied to the company’s stock at the time of award. However, when paid out, the value will ultimately be tied to the company’s stock. See below for an additional example, assuming the price of the actual stock at the time of the payout is $40:

Note that when determining payouts, the chosen valuation method must align with the plan’s triggering events, which could influence the timing and size of the financial reward.

How do vesting periods work?

Vesting is the process by which awarded phantom shares become eligible for cashout. Companies typically provide for phantom shares to vest over time (often a 3-4 year period) to incentivize ongoing commitment to the company. However, some plans fully vest upon award. Immediate vesting may be used as a recruitment tool or reward, granting new participants immediate benefits and aligning their interests with the company from day one. If a triggering event occurs during a participant’s vesting period, he or she will only be entitled to payments for the phantom shares that have vested.

In certain cases, such as a buyout, plans may accelerate vesting so participants can fully benefit from their phantom shares, recognizing their contributions up to that point. Note that the plan may provide that some, but not all, participants are entitled to acceleration of vesting upon a triggering event. Selective acceleration can be strategic, allowing companies to reward certain roles or milestones. The customization of award agreements is fundamental, as it gives each participant a clear roadmap of their vesting schedule and potential accelerations, tailored to their role within the company.

How should employers decide how many phantom shares they can issue

An important consideration for the company is how many phantom shares will be set aside in a phantom share pool to eventually be awarded under a phantom plan. A “phantom share pool” is essentially a reserve of phantom shares the company plans to distribute, mirroring the concept of a budget allocated for future investments. Deciding on the number of phantom shares involves balancing the company’s current market valuation with future growth expectations.

The company must also consider how the awarded shares will impact the company on a fully diluted basis upon a future sale or another triggering event. Although no actual shares of stock are issued, the phantom stock should be incorporated into any waterfall projecting the distribution of proceeds on a sale of the company or change in control. In financial planning, a “waterfall” illustrates the sequence of payouts upon a liquidity event, and incorporating phantom shares into this clarifies the payout structure when the event occurs.

Can participants in a phantom plan forfeit their phantom stock?

Forfeiture of a participant’s phantom stock typically occurs when the participant leaves the company for any reason. In a phantom plan context, forfeiture means participants give up their rights to any payouts from their phantom shares if certain conditions are met, such as leaving the company. Companies include forfeiture clauses to align phantom stock benefits with ongoing employment, ensuring that only those contributing to the company’s success reap the rewards.

Upon a forfeiture event, and subject to applicable state law, the participant generally forfeits both vested and unvested shares, and will not receive any cash payments upon a later triggering event. Note that, though uncommon, some plans do permit participants to retain vested shares for a period of time after leaving the company.

Are phantom stock recipients entitled to dividends?

As phantom stock is not actual stock, holders are not entitled to dividends. However, companies are permitted to distribute “dividend equivalent rights.” This is compensation that allows phantom stockholders to receive payments akin to dividends, mirroring what they would receive if they held actual shares. Companies may grant these rights to further align phantom stock with the benefits of share ownership, particularly when aiming to attract and retain top talent.

Closing Thoughts

PilieroMazza attorneys are well-versed in helping employers design and implement incentive and compensation plans to attract and retain top talent. If you need assistance or have questions regarding phantom equity, please contact Abby Baker, Sarah Nash, Robert Troiano, or another member of the Firm’s Employee Incentive and Bonus Plans practice group.

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