Especially in the post-COVID environment, attracting and retaining great employees has become a priority for most employers.  Many owners find themselves struggling with the idea of parting with precious equity in their business in an effort to hold on to their best talent, not realizing that there are other options available.  A phantom equity plan may be one such option.

Phantom equity is essentially a type of employee benefit which provides key employees, often rising stars or those already holding essential positions in senior management, with many of the same benefits of equity ownership without actually giving them any company ownership. The employee benefit is often called “Phantom” or “Shadow” equity because it works like traditional stock or membership interest, but no actual ownership is transferred.  

The benefits of this alternate approach are that employees are incentivized to assist with the growth and performance of the company because they get to share in the profits of the company when specified target benchmarks are achieved.  From the employers’ perspective, this alternate approach allows the company not to complicate its ownership structure and acts as a means to keep equity in the hands of current owners who are often the founders or descendants of the founders of the company. 

While phantom equity is not a true equity benefit, the value tracks the equity price or value of the company.  The employees get a payout on the growth of the company and simultaneously management ensures that equity of current shareholders does not need to be diluted.

In their most basic forms, there are two different types of phantom equity plans: appreciation rights plans which do not include the current value of the actual equity themselves, and pay on only the value of any increase in the value of the company over a certain period of time that begins on the date the plan is granted, and plans that pay the value of the underlying equity as well as any growth on that value.  

Phantom equity plans allow the company maximum flexibility to achieve its goals. Phantom equity plans can also be changed any time at the discretion of the company leadership.  Employees receive the benefit of not having to spend cash to buy a stock option or to purchase membership interest, but the company does not get the cash infusion received when equity is purchased.  As a result, if cash is needed to fund the retirement of current equity holders, then phantom equity might not be the best option. 

Like the employer, employees also benefit from the flexibility of appreciation rights.  Depending on how the plan is structured, the employees typically can choose when to exercise their rights at any point between the time the rights vest until the time they expire.  Operationally, employers need to ensure that they fund enough of a cash reserve to make these payments when due.

Phantom equity may qualify as a deferred compensation plan under the IRS regulations. As a result, any phantom equity plan must meet the requirements set forth in the Internal Revenue Service Code Section 409(a).  Such a plan must be carefully developed and properly vetted by an experienced attorney, with all of the required plan details specified in the plan and properly disclosed to its participants.

Companies may also wish to consider whether traditional employee benefits can be used to attract and retain great employees. Shifting key employees with whom the company has a positive track record from at-will employees to contract employees can provide the benefit of additional security to the employee while ensuring retention for the company.  In addition, some employees will stay for a great bonus plan or even just an increase in salary which may be less costly than parting with equity, especially when faced with the costs and difficulties of recruiting and training new talent.

Jacquelyn Jordon Core and Michael T. Voytek are Founding Partners at Jordon Voytek. Jacquelyn and Michael focus their practice on mergers and acquisitions and corporate structuring and restructuring, as well as contract advice and assistance. They are available to assist businesses of all sizes with general counsel services, meeting their day-to-day legal needs. To contact them please contact Jacquelyn directly at Jacquelyn@JordonVoytek.com, or by phone at 304.777.0790, or contact Michael directly at Michael@JordonVoytek.com, or by phone at 203.360.6232.