Part 3 – Phantom Stock 

By: Wright Lewis  [9/23/22]

This article is Part 3 in a series outlining various equity-sharing arrangements businesses can use to attract and retain employees. Part 1 discussed stock options, and Part 2 discussed restricted stock. While the term “stock” applies only to corporations, equivalent plans can be deployed by limited liability companies. The “Great Resignation” of 2021 was the impetus for this series and, despite abnormally high inflation and rising interest rates, the Bureau of Labor Statistics (BLS) reported unemployment rates of just 3.7% for August 2022, roughly in line for the year, and just 0.2% above the July report which was the lowest unemployment rate in 50 years. According to BLS, there were 11.2 million job openings at the end of July, but less than 6 million people who are unemployed and looking for a job. Competition for talent continues to be a significant issue. 

There are many reasons businesses choose to share equity with their employees: as a reward for prior contributions or outstanding performance, to create a sense of ownership in the business, to foster an entrepreneurial culture and mindset, and to drive attainment of the company’s long-term goals but, in the current labor market, offering equity (or equity-like arrangements) to employees also allows small businesses to compete to attract and retain top talent. There are many forms of equity sharing plans, each with their own nuances and trade-offs. Companies can share equity in the business through stock purchases and grants, stock options, ESOPs, and profits interests, or offer equity-mimicking arrangements like phantom stock, stock appreciation rights, and change of control bonuses. No matter the form of equity sharing plan, the key to the company getting the maximum benefit out of the plan is to consistently communicate the value of the plan, provide participants with information about the state of the business, and consult plan participants so that they feel like true owners of the company. 

​Phantom stock is a contract between a company and its employee (or other service providers) designed to emulate the economic effects of stock ownership. When a company makes a grant of shares of phantom stock, the recipient generally receives the right to receive their pro rata share of (i) any dividends paid by the company to stockholders and (ii) the net proceeds of a sale of the company. Some phantom stock plans forego the right to receive dividends, which results in a “must be present to win” scenario for the recipient. In other words, a phantom stock plan that does not include the right to dividends is just a right to receive a bonus in the event of the sale of the company. This limited form of phantom stock is more appropriate when a sale of the business is likely and is sometimes tied to a requirement that, if requested, the recipient agrees to work for the acquirer for some time after the sale. 

Phantom stock can be granted for full value or limited to appreciation value. If a phantom stock grant is for full value, when the phantom stock is cashed out, the recipient receives 100% of its value. With appreciation value, the recipient only receives the difference between the value of the phantom stock on the date of the grant and the date it is cashed out by the company. Appreciation value is particularly appropriate for mature companies who are looking to incentivize new management to grow the value of the company, because the new management’s equity-based compensation is directly tied to their contribution to the company’s growth. 

Phantom stock granted at appreciation value is often referred to as “stock appreciation rights” or “SARs”. Stock appreciation rights may provide the option to receive the cash value of the phantom stock (cash-settled SARs), convert the phantom stock to actual stock (stock-settled SARs), or a combination of the two, on or after a certain date (which may be before a sale of the company). The latter two options can be accomplished by the company withholding some of the shares, withholding some or all of the cashed-out portion of the exercise, or by the sale of some of the shares. SARs may also be paired with options grants and used to fund the purchase of the options or granted as a combination SAR/option grant that entitles the recipient to exercise either the SAR or the option (but not both). SARs can provide significant flexibility to the employee, who may be able to exercise their stock appreciation rights and receive actual stock in the company without having to pay out of pocket. Stock appreciation rights may require shareholder approval in certain circumstances. 

If you read Part 1 of this series, you might notice that phantom stock is similar to stock options in a few ways. Holders of phantom stock do not have voting rights as stockholders. If phantom stock is granted at the fair market value of the company’s stock on the date of the grant (e.g., appreciation value), the grant is generally not taxable until it is exercised (as may be the case with SARs) or sold. Like stock options, the trade-off for this “free ride” is that any proceeds received by the recipient from the sale of the company are generally taxable as ordinary income (rather than at capital gains rates), with an exception for stock appreciation rights exercised at least one year before the sale. However, unlike stock options, the holder of phantom stock does not have to pay any exercise price, making phantom stock particularly useful for more mature companies that often carry higher valuations. 

Phantom stock grants may also be subject to vesting. As with stock options and restricted stock, vesting can be time-based (e.g., ¼ of the shares vest annually) or based on attainment of certain metrics by either the employee or the company, as appropriate. Acceleration of vesting upon a change of control (e.g., sale of the company) is customary.

It is important to note that phantom stock plans should be reserved for only a limited number of high-level employees to avoid having the plan classified as a non-qualified plan subject to the Employee Retirement Income and Security Act (ERISA). 

In order for a company to obtain the maximum benefit out of an equity sharing plan, whether via phantom stock or otherwise, the benefits of the plan should be communicated to participants and potential participants on a regular basis. It is also essential to recognize that the emotional aspects of the plan are equally as important as the financial aspects. The primary purpose of an equity sharing plan is to fundamentally change how employees feel about the company so that they take ownership of its successes and failures. A well-designed and implemented equity sharing plan will benefit the company through higher productivity, improved morale, greater retention, higher-quality applicants, and ultimately, better financials. 

For more information on how Dunlap Bennett & Ludwig can help you with your legal needs, contact us by calling 800-747-9354 or emailing clientservices@dbllawyers.com.

Read How to Attract and Retain Employees During the Great Resignation: Part 1 – Options

Read How to Attract and Retain Employees During the Great Resignation: Part 2 -Restricted Stock


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Posted in: Business Law, Employment Law

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