Phantom Stock Plans Pros and Cons

By Drew Stevens - July 29, 2019 - Securities

Your business is growing, and you’re at the point where you want to talk to a business lawyer and consider some sort of employee equity inventive plan. However, no matter if you’re a corporation or an LLC, you may be concerned with some of the legal implications of starting to give out units or shares in the company.

Depending on how your operating agreement is structured (or, for corporations, how your articles of incorporation, applicable shareholder agreement, and code of regulations are structured), you may also be concerned with having to restructure these documents to allow the company to authorize the issuance of units/shares or additional units/shares. Further, for startups or businesses that never set aside an options pool and already have 100% of their equity issued, dilution may be a serious concern.

What is Phantom Stock

For those with dilution or structuring concerns, phantom stock (also referred to as shadow stock) can be a great alternative to more traditional equity incentive plans like stock options. With phantom stock, your employees don’t actually become shareholders or own actual units in your company. Instead, the employee receives “phantom” shares that provide the full, cash value of the stock or units of the company, which can increase or decrease over time.

For those of you who aren’t a Columbus securities lawyer, an example can help break this down. Ian Industrious has been your top employee for years, and you want to keep him around. You grant him 100 phantom shares in summer 2019, when your company’s shares are worth $100 each.

Ian Industrious lives up to his family’s name, and your company expands and grows, so by summer 2021, the company’s shares are worth $200 each. Ian Industrious wants to cash out, so your company is writing a check to Ian for the new value of his 100 phantom shares, $20,000.

A not-so-fun example: despite Ian’s best efforts, your company goes thru a rough patch. By summer 2021, your company’s shares are worth $80 each. Ian Industrious still wants to cash out, so you’ll be writing him a check for $8,000.

Positive Components of Phantom Stock

There are a number of pros for considering rolling out a phantom stock plan. Chiefly, phantom stock can remove dilution concerns and offer closely held and smaller businesses a large amount of flexibility. Founders don’t have to worry about messing with their cap tables for the umpteenth time. Exiting stock and unit holders don’t have to be concerned with voting percentages as phantom stock holders don’t have the actual voting rights associated with stock or units.

Further, phantom stock programs can be highly customizable with milestones and vesting criteria. If an employee leaves before her or his phantom stock vests, the phantom stock, true to its name, can simply disappear. Contrast this with stock options, where a cash-strapped startup may be forced to buy back stock that a departing employee fully owns.

Another big plus is the tax consideration. With phantom stock, an employee is generally not taxed until the employee exercises the option to redeem the phantom stock, and the cash value is paid out. An employee is taxed at the ordinary income rate, and the business gets a deduction.

Phantom Stock Concerns, Considerations, and Issues

Phantom stock is not without its issues that need to be taken into consideration. For one, care must be taken in how many, and what types of employees, are eligible for phantom stock. If phantom stock is offered to too many employees, ERISA (the Employee Retirement Income and Security Act) may be invoked. For those concerned with ERISA compliance, a possible strategy is to shoot for the popular “top hat” plan exemption.

Additionally, 409A compliance can also be a major consideration. Failing to comply with 409A can result in hefty tax penalties, including a 20% penalty tax.

Securities Lawyer Columbus Ohio

Selecting and implementing the equity incentive plan for your growing company can be tough. If you feel that you’d like to talk to one of our securities lawyers, contact our firm today.

Read Also: An Overview of Stock Appreciation Rights