Five Reasons Why You Should Provide Phantom Equity for Your Employees

gazillion bailout

What you’d like your company to be worth.

“Control your destiny or somebody else will.”
–Jack Welch

You’ve probably heard the stories of how random secretaries from Microsoft or Facebook became gazillionaires because of the shares of the company stock that they held. If you’re a small business owner, you want to align the interests of your employees with yours and allow them to take part in the upside of the company if everyone delivers on what they’re supposed to.

The idea that likely comes to mind is that you want to give them some ownership in the company. It’s often a way to provide incentives and compensation that doesn’t require cash and salary up front, keeping your initial costs to a minimum and freeing up capital to deploy in growing the company. You want them to have skin in the game. You want them to work for a lower salary than you’d otherwise have to pay. Who doesn’t?

Research from Rutgers University supports this notion. Employees who are owners of their companies, participating in employee stock ownership programs (ESOPs), find a higher commitment to their employers. Furthermore, it’s not the size of the ownership stake which increases the commitment, but, rather, it’s the mere fact of ownership. Productivity generally increases between 4-5% in the year that employee stock ownership is established and that increase is maintained going forward.

But, is giving out a stake in your company the best way to go?

Probably not.

Let’s look instead at something called phantom equity.

Phantom equity is when you give your employees (or anyone else, for that matter) a contractual right to the proceeds of the company – profits, distributions, and proceeds from a sale – rather than actually giving them ownership in the company. This is exactly what we did at the company I co-founded and subsequently sold, and it helped us to align incentives properly AND avoid some of the complications that occur when you give ownership of your company to employees.

There are a lot of reasons that you would want to give phantom equity to your stakeholders (employees, contractors, etc.) rather than giving them actual equity.

  • If you have to raise capital, you’re already diluted from giving out shares if you’ve distributed them to employees. Early and mid-stage investors do not like to see their ownership stakes diluted in downstream capital raises, and giving equity to your employees only serves to further that dilution.
  • There are tax implications for the employees. Yes, there are also tax implications if you give them phantom equity, since the money that you distribute will be in the form of ordinary income rather than capital gains. However, one of the biggest issues we ran into when we issued equity and before we converted everyone over to phantom equity was that our company was a LLC which received partnership tax treatment. At the end of the year, once we’d filed our taxes, we had to send everyone a K-1 with a check for the taxes that they incurred as a result of owning the company – regardless of whether or not we’d issued a distribution. There were also issues with wages, as LLC owners cannot receive W-2 wages. It also affected SEP contributions and the tax implications of having the company pay for health insurance. Having multiple owners made filing our corporate taxes more time-consuming and expensive, and it complicated the personal tax filing for everyone involved. We were better off providing phantom equity distributions as bonuses. Even though the recipients received less money, they were happier because the tax situation wasn’t as complicated and it didn’t cause them to question whether or not we knew what the heck we were doing.
  • A sale causes difficulty with the shareholders. If you’re looking to get your company acquired, the acquirer is going to want to deal with as few shareholders as possible – ideally one or two. While it’s the seller’s responsibility to handle the distributions, and, if necessary (see below), wrangle the shareholders into agreement, having to deal with fewer parties in the process reduces complications and takes one bargaining chip against the seller off the table.
  • The controlling owner risks losing control. If you want to run the company the way you see fit, then you need to maintain majority control of the shares in the company. If you’re not careful with how you distribute the shares, particularly if you’re including incentive bonuses in equity, you could wind up with a minority share in the company. While this probably won’t lead to your downfall, once you own less than 50% of the shares in your own company, the other shareholders could all get together and remove you. Another way around this issue is to create special voting shares or require supermajorities in your corporate bylaws.
  • You need more cash on hand to prevent orphan shareholders. In many equity agreements, the company purchases back the employee’s shares if the employee leaves. While you could create a Ulysses contract which states that the employee agrees to give the shares back for nothing if he leaves, I think it’s more just if you give them a fair value for the value that they create and the increase in share value that they’ve contributed to. Therefore, if you have an agreement where the company buys back the shares for fair value upon an employee’s voluntary termination, then you will need to have extra cash in reserves to fund the buybacks. When you’re in growth mode, that’s money which you could be using to grow the company and to gain market share rather than needing to keep in held back just in case someone leaves. If you don’t include such a buyback clause in the equity agreement, you could find yourself in a situation with a lot of small shareholders who are no longer part of the company. The administrative burden on keeping track of those shareholders is not trivial, as you have an obligation to send them distributions and tax returns. With phantom equity, you don’t need to have this arrangement, since it’s a contractual agreement tied to the continuing performance of the employee.

It’s great, as a business owner, to want to include your employees in on the growth and the benefits of a successful entrepreneurial venture. However, giving away equity may create unintended consequences for the business owner. Instead, give employees phantom equity. Make sure that you work with a skilled attorney who understands how to structure the phantom equity contract to achieve the outcomes you desire and who also can guide you through the contingencies you’ll need to plan for when issuing phantom equity.

We switched from equity ownership to phantom equity and never looked back.

About Jason Hull, CFP®

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively.

Comments

  1. Hey there, another great article. However I have differing view here. I am an employee at a company that does use phantom equity, and I don’t really understand the difference between phantom equity and (I think the much more aptly named) profit sharing. With both, I get a little kickback each year based upon how well the company performed. With both, once I leave the company, I get nothing thereafter.

    The thing is, though, I really like having the option of owning a piece of the company that I am helping to build. I think of it as diversifying my portfolio. I think of it as working now to save up for my future – not in the paycheck that I earn, but in equity in the company that I am helping to build. I’m upset that once I leave, then my investment in the company I have worked for disappears immediately.

    My company apparently did issues equity to their employees initially, and from what I can tell, it was a disaster. The unexpected tax burden caught everyone off guard – and this is probably why they switched to ghost equity. But why not split the difference with stock options? If I understand correctly, stock options give the employee the right to buy or to claim ownership of equity in the company at a fixed price – if they so choose. Terms can be written into the options contract so that the business owner isn’t incentivizing people to take the equity and leave – for instance, you can have a “cliff, ramp, and plateau” in the vesting schedule.

    I don’t know… what do you think?

    • John–

      Thanks for the kind words and for commenting!

      I think I’m familiar with the situation of which you speak! 😉

      The options component makes valuation and sale of a company more difficult. As the seller, you now have to account for all of the options (of course, you could assume immediate vesting), and, if you’re independent long enough, you’ve now diluted the equity.

      The phantom equity doesn’t have to end if an employee leaves the company. It’s all contractual. Everything is negotiable. However, I imagine that the value of a semi-permanent phantom equity contract is much higher than the value of a phantom equity contract that exists as long as the employee/”shareholder” remains an employee. It’d have to come much closer to an EBITDA or revenue multiple valuation.

      To your point about the semantics, I don’t think that there’s much of a difference in phantom equity or profit-sharing in the way that you and I are defining it, but some profit-sharing plans don’t include the benefits that would accrue as a result of a sale; they only share the profits that occur as a result of operations. In the broadest sense – if the owner(s) make money then the other stakeholders make money – they’re equivalent. If you take a more narrow definition of profit-sharing, then they’re different, at least how I envision it.

      If the owner isn’t looking to sell the company, then some of this becomes moot, although tax issues complicate true equity ownership, as you either have to be a C-corp (which means double taxation) or file a bunch of K-1s for your shareholders (which means higher tax preparation costs both for the company and for the shareholders). If the owner is looking to sell the company or to attract investors, then the cleaner the stock books, the better.

      Did that address your question? The bottom line is that everything is negotiable, and you could contractually get everything you’re looking for in an actual equity ownership stake without the hassle and the tax prep issues (aside from the difference between ordinary income tax rates and long term capital gains rates) if you’re a skilled enough negotiator.

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