What is Phantom Equity? Phantom equity is a useful tool for companies looking to attract and retain top talent without diluting the ownership interests of existing owners. It can be a more attractive incentive plan than stock options or annual cash bonuses linked to performance, especially for small, closely held companies.
Phantom equity is a type of synthetic equity where the recipient receives payments when certain conditions are satisfied, but, importantly, they do not receive any ownership, voting, or informational rights to the company. Instead, the recipient receives the right to a cash payment triggered by certain events, such as a change in control of the company.
These terms can make phantom equity an appealing long-term employee incentive plan for small, closely held companies for several reasons:
It does not cause dilution.
Unlike actual equity, phantom equity does not come with ownership rights, so the ownership percentage and voting power of the equity holders of the company are not impacted when phantom equity is issued. This aspect is especially appealing to companies that have a small number of equity holders because the addition of another equity holder would cause a major shift in the voting and decision-making dynamic of the company.
It provides flexibility for the company.
When drafting a phantom equity plan, the company has the flexibility to determine the calculation of the payments to phantom equity holders, any conditions to those payments, the vesting schedule of the grant, any performance-related metrics that are tied to the vesting schedule, and other terms.
It keeps the capitalization table clean.
In general, buyers prefer to purchase companies with “clean” capitalization tables, meaning that the fewer equity holders the buyer must buy out the better. As phantom equity does not give recipients ownership rights, the recipients do not become true equity holders of the company. Not to mention, the company does not have to update its capitalization table every time it grants phantom equity like it would if it granted actual equity.
Delayed taxation.
If done correctly, the granting of phantom equity is a non-taxable event for the company and the recipient. Neither party will be taxed on the grant until the triggering event takes place and the recipient actually receives their payment.
Compared to traditional equity incentive plans, phantom stock can be a more agile, less burdensome method companies can use to secure high performing employees for long-term commitments. If you have questions about how phantom equity could benefit your business, reach out to our M&A and Corporate team today. You can also watch our recent podcast on smart strategies for using phantom equity to incentivize key employees here.
Shelby Julien is an Associate Attorney at Berenzweig Leonard. She works on a range of matters, including employment law and corporate transactions. She can be reached at sjulien@berenzweiglaw.com or (703) 663-8179.