The Phantom Equity Alternative

Accredited InvestorCompanies looking to compensate their employees and other service providers in equity will often employ stock options or restricted stock (for corporations) or profits interests (for LLCs). An alternative approach that should be considered is to offer so-called “phantom” equity, which is essentially a deferred compensation plan, where the employee receives cash payments that are calculated as if the employee had received an equity grant. (A similar alternative is stock appreciation rights, or SARs, but I will focus on phantom equity here.)

For example, the recipient could receive a cash payment at the time the company is sold that’s equivalent to the distribution that would have gone to someone receiving 1% of the company’s common equity at the time of the grant. There can be other triggering events besides a sale, depending on the plan, including regular company distributions of earnings. Like true equity, the plan can have vesting, repurchase and similar provisions seeking to incentivize the recipient’s continued employment with the company for a lengthy time. So, the employee receives the benefits of equity without the parties having to go through the trouble of documenting an actual issuance of equity. Unfortunately, the term “phantom” seems to imply that it’s somehow fake equity, meaning employees can be skeptical of the concept, so it takes some explanation.

Like any employee compensation plan, phantom equity plans need to be carefully structured using the advice of a qualified tax professional, seeking among other things to avoid issues with Section 409A deferred compensation penalties. As I do not myself have such expertise, I’ll leave out discussion of tax consequences here, except to note that a disadvantage of phantom equity from the employee’s perspective is that the cash payments are taxed as ordinary income, not capital gain, though the tax is assessed only if and when the cash is paid, not when the phantom equity is granted.

One advantage of phantom over true equity is that it’s generally easier to document, saving on legal costs (wait, why am I writing this?). Recipients of phantom equity will not need to be directly accounted for in operating or stockholder agreements, making simpler the mechanics of drafting provisions such as share transfer restrictions, management, and distribution of company earnings. Outside investors may prefer the simpler capital structure, though of course they would take into account the company obligations inherent in the phantom equity when valuing the company and their investment.

From the company’s perspective, phantom equity also avoids creating new shareholders or members that have statutory rights under state law, such as the right to examine records, which as a practical matter are not valuable to the typical service provider.