There is nothing pejorative in the use of the terms “phantom equity” or “synthetic equity.” Rather, these terms simply indicate that phantom equity has some attributes akin to actual equity, while at the same time it is in many respects very different from actual equity ownership. To clarify, there is no real equity ownership with phantom equity. Rather, it is a contractual obligation of the business to make payments in the future, upon the occurrence of one or more circumstances, often known as “trigger events.” There is a helpful article on this very subject on Forbes.com. CLICK HERE to read Forbes.com article on phantom equity
Phantom equity can provide a key employee (or several) the economic equivalent of being an owner, but without actual ownership. This can serve as a powerful incentive for the employee to work diligently to help grow the company. The interests of the owner and the employee are thereby aligned. This “equity” incentive can make all the difference in certain situations when compared to someone who gets the same hourly wage or salary regardless of how the company performs over time. At the same time, the owner can retain all ownership for himself/herself/itself and thereby be free from the restrictions and potential challenges of being required to get approval from other shareholders to take corporate actions, including when it comes to taking on investors or selling the company.
By the way, there is no requirement that phantom equity can be granted only to employees, current or past. Rather, given that phantom equity is a contractual promise of the company to make one or more future payments, such contractual obligations can be granted in favor of anyone (or even a legal entity). As with stock options or equity grants, phantom equity can be designed in a manner which provides for immediate or future “vesting” of such rights to payment. Likewise, the phantom equity program document can set forth other terms and conditions associated with a holder of a phantom equity “unit” being entitled to receive the associated payment or payments in the future. For current employees, such additional terms can include continued employment. For non-employees, such additional conditions could include non-competition and otherwise complying with obligations made in favor of the company or its ownership. If such other terms and conditions were breached, by employee or non-employee, the program document would provide that the relevant phantom equity payments would be forfeited. Therefore, phantom equity can serve as an incentive for future performance and compliance.
Upon the grant of phantom equity, no money changes hands, and therefore there is usually no “taxable event” at such time of grant. When phantom equity is paid out at a future date, such payments from the company to the holder of phantom equity are usually deemed as ordinary income, whether or not such person is then a current employee of the company. The amount and timing of such payments (as well as their related tax treatment) are among the topics to be discussed with the company accountant.
So with the availability of phantom equity, does this mean that granting actual equity is never a good option? No, there are still circumstances when it makes sense for the company and for ownership to grant actual equity to one or more important employees. But we increasingly find that phantom equity (in all of its many varieties) or some hybrid of actual equity grant and phantom equity is a better solution than traditional solutions like equity grants, stock options and the like. Let’s look at two examples to illustrate the point.
Example #1 is Jim, father of seven children and 100% owner of his successful ranching enterprise in Montana. Jim started his ranch many years ago, and it has now become very profitable. Jim loves what he does, but he is now approaching the age of seventy-five and is ready to start withdrawing from day-to-day operations. Jim wants to ensure that his ranch continues to the next generation and each of his children has expressed a desire to be part of the ranch going forward. Jim overall net worth is significant enough that he needs to start doing serious tax and estate planning to reduce the size of his taxable estate. These circumstances seem to indicate that Jim would be well-served (as would his family) if he started to transfer actual equity to his children. Doing so would enable Jim to reduce his taxable estate and incentivize his children to safeguard the ranch into the future, as they will move from being employees to actual owners. In Jim’s circumstance, transferring real equity through gifting, sale or some hybrid of the two, will probably be his best move.
Example #2 is Maria, the founder, and owner of a very successful online women’s clothing boutique. Maria started her company a few years ago from nothing, it has grown rapidly and is currently very profitable. Even so, all indications are that her company will continue to experience significant growth in the coming years. Maria designs most of the items she sells, and although she has several employees at the current time, only two of those are what she considered “key” employees. Accordingly, she feels the need to offer an incentive compensation package only to those two key individuals. Maria loves her work, and she can see herself doing this for quite some time. Even so, she is relatively young, she has a lot of dreams and would be open to selling her company to investors in the near future (for the right offer). Maria is most likely a good candidate for phantom equity, which could provide the requisite incentive compensation to her key employees, but also permit her to retain full ownership of her company. Both of these could be very important considerations as she seeks to continue the growth of her company and also as she potentially engages with investors or purchasers of her company in the near future.
As with many other forms of current and deferred compensation, with phantom equity, there will always be accounting and other important considerations which will come into play. Therefore, as you are sifting through various options and alternatives, you would do well to consult with your accountant, your financial adviser, and your business attorney. Each of these professionals will have a unique perspective and skillset and be an important part of the professional advisor team. Your accountant will have responsibility and expertise with regard to tax and accounting issues; your financial adviser will guide you in the relevant aspects of your personal and business finances (now and in the future); and your business attorney will draft most of the applicable legal documents which will govern your phantom equity plan, stock option or any other type of compensation arrangement you have chosen to implement.