By: Robert C. Hackney
Over the past forty years plus of legal representation of business owners, I have been asked this question in one way or another many times.
Here is a sample of the essence of the question: “I have some employees who have been with me for a few years. Recently, they have been making noises that they would like to have a “piece of the action.” While they have been valuable employees, I am the one who took the risk of starting this business, I am the one who is responsible for making payroll every week, I am the one personally responsible for the company’s debts. I am concerned that after they become partial owners their attitude might change, and not for the better. I am also concerned that if they leave in a few years, they will still own stock and be entitled to a part of the profits, and if I sell the business in ten years, they will be entitled to part of the sales price, when they weren’t here with me to keep building the business. Having said all that, they are still valuable employees and I do not want to lose them at this point. Do I cave in and form a stock incentive plan or an employee stock ownership plan? What should I do?”
My short answer to this question is a resounding, emphatic NO.
Let me explain.
Sure, there are some founders who start a company and believe that they have come up with a process or product that is so unique, so disruptive and so wonderful that will revolutionize their industry or increase the efficiency of something by more that 100%. Those founders usually structure their company to look like a public company from day one, and they include all of the bells and whistles including some form of stock option plan or equity incentive plan. But you need to remember that those companies are the exception, not the rule.
Stock plans are certainly an option and are appropriate in many instances for growing companies who want to attract the right talent, particularly in high growth companies and tech companies that need specialized employees. Stock plans are not always the best approach for all companies. One of the options that I frequently suggest is something that acts like stock ownership, but gives no long term equity rights or voting rights to those employees.
This can be done essentially three different ways:
1) through a profit sharing type contract;
2) through a specific phantom stock plan, or
3) through an overall equity incentive plan which includes stock options, stock grants, and also phantom stock grants, which are usually called Stock Appreciation Rights (SAR) in such a situation.
A phantom stock agreement or a phantom stock plan typically has the following attributes:
What is it really:
Shares of Phantom Stock usually represent the right to receive solely in cash the value of an equivalent number of shares of the employer’s company. It is nothing more than a form of incentive compensation that does not involve the employee owning any equity in the company. It could be geared to an event, such as a sale or change of ownership of the company, the retirement of the employee, death or disability of the employee or any other significant event determined by the company.
Value:
The concept is that the value of the Phantom Stock is tied to the value of the common stock of the company. This can be done by by a set number in the contract, based on a formula that is easy to determine, or by an appraisal of the common stock. The appraisal method is burdensome and expensive and therefore is rarely used, particularly by smaller companies. If the formula approach is used, it usually includes variations for adjustments that are made based upon things like capital improvements, or addition or subtraction of loss or gain tied to certain department of the company, products, or otherwise.
The main idea for the company is that it does not want the Phantom Stock to even have value in excess of the value of the common stock, which results in dilution to the shareholders. Therefore, even the set value formulation usually has some form or adjustment provisions. When should the Phantom Stock be valued? The date of the valuation is also specified in the agreement or plan, such as the employee’s retirement date, death, disability or the sale date of the company.
Vesting:
Like stock options themselves, there can be a vesting schedule so that this incentive can be earned over a period of time. The schedule is set forth in the agreement, and is always contingent upon the employee still being employed on the date of vesting. For example, an employee may be granted 10,000 shares of Phantom Stock, 2,500 of which each vest annually. If the employee quits after 5,000 shares have vested, he is not entitled to any additional shares.
Dividends:
Typically, an employee is not credited with any dividends that are declared for holders of common or preferred stock. Sometimes, however, the dividends can be used as an adjustment in the valuation determination.
Assignment and Transferability:
A phantom stock agreement always makes Phantom Stock not able to be transferred, assigned, pledged or hypothecated, whether by operation of law or otherwise, nor may the Phantom Stock be made subject to execution, attachment or similar process. This is a personal right to the employee, and can’t be given away or transferred, even to a creditor.
Voting:
There are never voting rights associated with Phantom Stock. Therefore, they have no right to vote for directors, to vote for a merger, or to vote for anything else.
Minority Shareholder Rights:
Minority shareholders are entitled to rights, like the right to inspect corporate books and records including corporate financial statements. Officers and directors of the company also have fiduciary duties to minority shareholders, including the duty of care, the duty of loyalty, the duty of oversight, and the duty of disclosure. Minority shareholders also have the right to bring a derivative claim on behalf of the corporation. Derivative claims can arise when a shareholder alleges that an officer or director has breached a fiduciary duty. For example, a minority shareholder could bring an action and allege that a director had used the corporate assets for his or her own personal gain.
Employees who are granted Phantom Stock are not entitled to any shareholder rights, since they are not shareholders. Therefore, they cannot inspect corporate records or financial statements, or bring any action that alleges a breach of fiduciary duty.
Entity Type:
While we typically see this mechanism used in a corporation, it can also be used where the employer is a partnership, a sole proprietor, a limited liability company or even an S corporation. Certainly it would not be called “Phantom Stock” as most of those organizations do not have stock per se, but the concept is equivalent. While it could be used in these situations, I would be concerned about using it in the S corporation arena. My thought is that although it is clearly not equity in the form of stock, it could be viewed as such by the Internal Revenue Service since it seeks to share profits or equity value with individuals who do not own common stock. An S corporation is only allowed to issue one class of stock, that being common stock, and for tax purposes only, I can see the IRS arguing that this is really a form of non-voting preferred stock.
Tax Implications:
The Phantom Stock concept is designed to accommodate a small number of a company’s most important employees, not as a plan to be used as incentive compensation for all of a company’s employees. In the event that a plan is designed to cover more than just the key employees, there is a risk that it could fall under the Employee Retirement Income Security Act (ERISA). ERISA compliance is complicated and expensive, so be sure it you are considering Phantom Stock, that you focus only on your key employees.
As for the individuals who receive Phantom Stock, income tax is payable in the year that they receive payment, although they need to know that such payment is ordinary income and does not qualify for capital gains treatment the way stock options do. In addition, employers need to be aware of and look at the Medicare and Federal Insurance Contributions Act (FICA) tax issues. The Medicare tax of 1.45% would always be due on the value of the Phantom Stock based on the year the Phantom Stock becomes vested. As for the FICA tax, if the employee’s base is more than the FICA base, no FICA taxes would be due.
Conclusion
The Phantom Stock concept is not nearly as complicated as a stock option plan or an equity incentive plan. In addition, the administrative cost of implementing a Phantom Stock Plan is minimal compared to equity plans.
Phantom Stock solves the problem of key employees feeling like they are not participating in the growth of the company’s value. Key employees have an opportunity to obtain value in excess of their regular base compensation, and are incentivized to keep focused on the company since their financial success is tied to its success.
This approach can also solve the problem of a disgruntled former employee who is also a minority shareholder, with minority shareholder rights, that wants to continue to make trouble for the company once he or she is gone. Employees like this are paid out upon termination, and the owner is not feeling as if a terminated employee will continue to obtain financial benefit while not contributing to the ongoing success of the company.
I should also note that many of these agreement are tied together with a confidentiality clause and/or a trade secrets clause to protect the intellectual property of the company, but that is a subject for another day.
My last comment is that I personally do not like the terms “Phantom Stock” or “Phantom Stock Plan.” It just sounds too illusory, and it gives me the impression that its just not real. That is not the case, since it grants substantial value to those who receive grants under a plan, and it provides benefits to the company’s owner by having incentives to give key employees while not taking the risk of having a small group of minority shareholders that might go rogue. I prefer to borrow a phrase from some of the full blown equity incentive plans that I have written, and refer to these rights as Stock Appreciation Rights.