What is Phantom Equity?
Phantom equity is a type of long-term incentive plan that provides participating employees the benefits of appreciation in the value of the company without actually providing employees with stock ownership. A phantom equity plan is an alternative to granting employees "real" equity and is a common component of executive compensation packages. As described further below, a phantom equity plan may involve appreciation rights or phantom units.
Awards under an appreciation rights plan are like options. As the name suggests, these awards vest upon achievement of certain performance goals. Awards may be made on a vesting schedule over a multi-year period. Upon the vesting of an award, the employee is entitled to receive the cash or stock equal to the excess (if any) of the fair-market-value on the vesting date over the exercise price. For example, under an appreciation rights plan, an employee may be granted 100,000 options with an exercise price of $1 per share that vest over a period of five years. If the options vest and the fair-market-value on the date they vest is $3 per share, the employee may exercise the option. The employee may then sell the stock (if publicly traded) for $3, and the difference between $3 and $1 per share is $2 per share or a total of $200,000 (i . e., $2 times 100,000 shares). Most plans provide for settlement of the appreciation rights in cash rather than stock (although actual stock issuances may be made if that is what the participant wants). Therefore, upon vesting an employee could receive a lump sum or a series of cash payments over a period of years.
A phantom unit plan, unlike an appreciation rights plan, is like a stock incentive plan. Phantom units are not like options because employees do not have to pay anything to receive the benefit. In fact, phantom unit plans are structured to emulate a stock incentive plan. Therefore, a phantom unit plan award is like a phantom stock grant. The value of a phantom unit is tracked like a stock grant. Phantom units are usually subject to vesting but do not have an exercise price. Upon vesting, phantom units are usually paid out in cash, much like phantom stock plans. The value of the payment will equal the increase in value of the unit(s) at the time of payment over the initial value of the unit(s).
A phantom equity plan may be appropriate for key employees who are concerned about the company’s capital structure and do not necessarily want to have any stockholders "in the family." This plan also incents employees to create equity value over time.
What a Phantom Equity Agreement Should Include
Although the various phantoms differ from one to another, there are some common elements. Most phantom equity agreements include awards that are determined by either a formula or other pre-established criteria, vesting schedules, payout conditions and valuation methods. The following examples are suggestive of the terms that you may wish to include in your phantom equity agreement:
(i) Formulae or Criteria for Determining Awards. A phantom equity plan that is based entirely on a formula should have a single trigger when defining who receives an award. A phantom equity plan based on pre-established criteria should include a comprehensive list of the forms of consideration that can be used to fund it. A phantom equity plan can include several form of formulae or lists. For example:
(ii) Vesting Schedules. However structured, it’s vital to ensure that appreciation rights vest over time so that employees do not leave the company before the phantom shares deliver actual value. Although there are multiple ways of defining vesting, phantom equity is often subject to four-year vesting schedules that provide for the distribution of 25% of an award on each anniversary of its grant year. Different types of awards, moreover, may vest on a different basis due to their function or valuation. For example, awards based on future earnings will have different vesting conditions from those based on share value.
(iii) Payout Conditions. Most phantom equity arrangements provide that the marital interest in a phantom share award that is unvested at the time of divorce is 50% – i.e., the spouse gets half when it vests. Other conditions include either a payout on the date of vesting, or, for paid-up phantom shares that are fully vested on the date of valuation, on the date of separation. Other plans tie the payout to multiple conditions such as the occurrence of the date of termination, a designated corporate event (e.g., sale, merger, dissolution), a designated date, or the passing of holder of earned equity.
(iv) Valuation Methods. In most cases, phantom equity benefits that qualify for long-term capital gain treatment are valued by reference to the fair market value of the company at the time of vesting. Other plans use different events or dates to measure value, including the date of vesting, the date of termination, the date of a specified triggering event (e.g., dissolution or a change in control), or a specific date (e.g., December 31 of the calendar year immediately following the exercise date).
Phantom Equity Agreement Benefits for Employers and Employees
For employers, the advantages of a phantom equity plan extend beyond having to avoid issuing new shares. A phantom equity plan can be easier to institute than traditional equity plans. This includes relatively simple documentation and the actual granting of phantom equity rights under the plan. In consideration for a phantom equity right, an employee gives up something of value to the employee, such as annual or semiannual bonuses (whereby the employer is making a business sacrifice to the employee in exchange for the opportunity to offer phantom equity). Phantom equity plans are much easier and cheaper to set up and maintain, as compared to a stock option plan or restricted share plan. Also, the employer does not require the services of an external administrator, which is often required in connection with an option plan or restricted share plan.
Phantom equity is not treated as equity or stock ownership for tax purposes. This provides for a significant tax benefit to an employer. For example, an employer should not be subject to any tax filing (such as a T4 or T4A) in connection with phantom equity, since the amount payable to the employee under the phantom equity right is treated as compensation, not as a payment on the exercise of a right of a shareholder.
Phantom equity plans are tax deductible for the employer at the time paid. This compares favourably to traditional equity compensation, where taxation occurs on vesting or exercise and it is often unclear whether the applicable deduction is available to the employer to offset the taxable income of the employee who received the equity.
For the employee, the major benefits of phantom equity plans are: alignment of interests, retention strategies and cash flow advantage.
The interests of the employer and employee become aligned, as it is in the interest of the employee to increase profits and share value and the employee will receive a payment accordingly.
An employee is much more likely to continue in employment to receive a future payout, rather than cashing out early under a deferred bonus arrangement. The threat of losing 10% of an employee’s pay causes many employees to move elsewhere in order to receive a cash payout. A phantom equity right, however, allows the employer to increase the size of the payout if the employee stays longer.
Having a phantom equity right allows the employee access to the otherwise locked up value of share price appreciation.
Phantom equity plans can be implemented in years with poor cash flow (such as year 1), without the potential capital cost and dilution of real equity compensation.
How to Draft a Phantom Equity Agreement
Phantom Equity Agreements allow an investor or company to gain exposure to future growth in the value of a company without taking an ownership stake in the form of real equity. This instrument is similar to a stock option in that its value is tied to a company’s future value, but unlike a stock option there is no underlying real equity being issued. The right to become an owner is "phantom" in that the "stock option" being issued is not redeemable for actual stock in the issuer. Rather, the pay out if the right is exercised is in the form of either cash or phantom equity units in the company.
A Phantom Equity Agreement defines the contractual relationship between a company and the grantee (option holder). An agreement may in some ways look like a standard equity purchase or subscription agreement with some sections that reflect the rights of a grantee under the agreement and the covenants of the options or phantom equity units provided for. Such rights include the right to:
· Receive any dividends or distributions equivalent in amount to those received by other shareholder holders;
· Demand conversion into real equity;
· Demands, and if exercisable, require or elect to be exercised as a result of, a sale of a Substantial Interest in the Company equity; and other rights that may be of interest to the grantee or available to the grantor if the Company is to remain private and/or closely held.
You can follow a process similar to that outlined below from inception to execution of an agreement.
- To begin, determine where your company fits within the context of your business sector and whether that takes the form of a start-up corporation that will be seeking to raise money, a public company through an equity financing, through non-dilutive financing or private equity financing. This information will directly affect the type of agreement you choose to use.
- Choose a structure that meets the long-term objectives of the issuer. There are many types of structures, ranging from 409A-compliant restricted stock units to unfunded stock appreciation rights grants, and the choice of such structure is critical to how the instruments will be taxed, and what taxes are assessed. You should engage tax and legal counsels at this stage to avoid unnecessary taxation of the company or the grantee.
- Because the agreement is a contract between the issuer and the grantee, it should contain detailed provisions including but not limited to vesting schedules, tax payment obligations, rights of first refusal or other restrictions on transfer, and the rights and obligations of the grantee in the event of a sale of all or substantially all of the assets of the issuer.
- Provide proper notice and execution of the agreement, consistent with the terms defined therein. It may be necessary to file a Form 8-K or comparable form if a company is publicly listed. Drafting the proper notice schedule and execution process is essential to a proper implementation.
- After the final Phantom Equity Agreement has been implemented and adhered to, ensure that all parties are aware of their responsibilities and covenant their compliance with the terms of the agreement and with continuing obligations under federal securities regulations.
Examples of Common Clauses in a Phantom Equity Agreement
There are several common clauses that you’ll find in almost every phantom equity agreement. Percent standing, which is the amount or percent of profit or gain to be paid. Termination clause, which discusses the duration of the agreement and the circumstances that can lead to termination. Change of control clause, which is an anticipated event due to its impact on the company and the executive team. And performance benchmark which is a pre-established target on various measures of performance, such as revenue or gross profit, on which plan payments are based.
The term or duration of the contract contains the date or period or time at which payment of any incentive will cease . One factor to consider is the rate or timing being used for the phantom equity. If the rate is predetermined or fixed, then the risk of exposure to termination will likely not be that much. But if you are working with a business that is volatile or one that has an unpredictable nature then the termination clause can add significant value to management if it provides protections from being terminated. Termination is typically set for the following scenarios: The occurrence of a material event or a material breach that doesn’t get corrected in good faith. There’s been a failure to meet certain expectations as outlined by the agreement. A change in control or organizational structure. Or mutual agreement by both parties.
Phantom Equity Agreement Example
This Phantom Equity Agreement (the "Agreement") is made and entered into as of the ___ day of _____, 201__ by and between [NAME OF COMPANY] (the "Company") and [NAME OF EMPLOYEE] ("Employee").
WHEREAS, Employee is currently employed by Company; and
WHEREAS, by this Agreement, the Company desires to provide Employee with an interest in the Company’s compensation structure, in lieu of participation in the Company’s equity incentive compensation plan or other forms of equity compensation; and
WHEREAS, Employee desires to participate in such a compensation arrangement on the terms and conditions set forth herein.
NOW THEREFORE, in consideration of the mutual covenants and agreements herein contained, the parties hereto agree as follows:
- Employment Status. Nothing in this Agreement shall be construed as creating any right to continued employment. All Employees are employed "at will", meaning that either the Employee or the Company may terminate employment at any time and for any reason. The Company reserves the right to change its Employee compensation policies and practices at any time.
- Phantom Equity Compensation. For the term of employment, the Company shall pay (or grant) to Employee, phantom equity amounts (hereinafter "Phantom Equities") as determined by the Company’s assessment of Employee’s performance compared with other employees of the Company and without regard to the vested percentage of equity ownership for which each employee participates, if any, under the terms of the Company’s equity incentive compensation plan or any other compensation arrangements for the benefit of the employee. The payment and vesting of such amount shall be set out in writing from time to time in the express sole discretion of the Company.
- Administration. The principal duty of administration shall be that of the Company, which shall, from time to time, make the various determinations concerning participation in the plan by the Employee or others, including determining who is an Employee, who has or has not terminated employment in any plan year, amounts of bonuses, etc. Twice each year, or at such other times as the Company may determine, the Company will inform the Employee in writing regarding the amount of Phantom Equities.
- No Right to Full-Time Position. Neither the execution of this Agreement nor the decision to pay Phantom Equities under this Agreement shall give the Employee any right to continue in any specific position with the Company or give any right to any specific level of compensation or benefits.
- No Interest. The Employee shall not have any right to any interest on any Phantom Equities account.
- No Transfer, Assignment, Sale, Encumbrance or Disposition. Any and all interests of the Employee in any Phantom Equities shall not be transferable or assignable in whole or in part or: (a) subject to any order of any court in any divorce proceeding in which the employee may be involved; or (b) assignable or subject to seizure in any proceeding by any trustee, bankruptcy or otherwise. No claim, debt and/or other liability which the Employee may have against the Company or the Company’s agents or representatives shall in any manner affect or be affected by this Agreement.
IN WITNESS WHEREOF, the parties hereto have executed and delivered this Phantom Equity Agreement as of the day and year first above written.
Phantom Equity Legal Compliance
Legal considerations and compliance issues surrounding phantom equity agreements include ensuring that these contracts comply with relevant employment law, tax law, securities law, and other state and federal regulations. As is the case with other forms of equity compensation, phantom equity contracts must be drafted according to the purpose and intent of both the company and the recipient of the phantom equity grant, including the administration of the agreement in a way that best suits the company’s strategy for offering phantom stock or phantom options.
For instance, phantom equity agreements should be unilaterally amendable by the company and not transferable by the recipient. However , phantom equity agreements that are treated as cash-settled to avoid tax complications with Internal Revenue Service ("IRS") code Section 409A may not be restricted from transfer. Other regulatory issues include compliance with applicable income tax laws, securities and exchange laws, and job termination, severance, and non-compete laws.
The IRS does have certain requirements for phantom equity agreements to ensure they are exempt from some tax compliance issues. Internal Revenue Code Section 409A, for example, provides some guidance on discounted stock options and establishes rules regarding the taxation of deferrals. The enforceability of phantom stock options or phantom equity agreements that require approval by shareholders may also be contingent upon compliance with state law regulations or restrictions.