Should You Consider a Phantom Equity Plan?
By Procopio Senior Associate Aaron Sokoloff
Whether you’re a brand-new startup or a veteran of several funding rounds, every emerging growth CEO wants to find the right path to incentivizing employees while conserving capital. One creative approach that might be right for you is a phantom equity plan.
Phantom Equity – what is it?
Phantom equity is essentially a cash bonus plan that is designed to mimic the effects of having an ownership interest in a company. While the terms vary from plan to plan, they typically give the holder of a “phantom unit” the right to a cash payment on the sale of the company that equals the amount they would get if they held an equivalent number of ownership interests. There is often a threshold sale value for paying out phantom units, which mimics the effect of an option’s exercise price.
Phantom equity can be a practical and efficient solution for companies that want to give service providers upside, and also conserve cash in the near term by giving additional incentive compensation on exit, without giving actual ownership interests in the company. Below is a summary of some of the key advantages and issues for companies considering the use of phantom equity:
- LLC-specific advantages. The tax treatment of options for LLC interests is uncertain, and tax-favored “incentive stock options” cannot be granted by LLCs, which means that LLCs need an alternative when they want to give equity compensation to service providers. Because phantom equity approximates the economics of an option, it is often a good choice for LLCs that want the advantages of equity compensation.
- Avoiding securities law complexities. Because phantom equity can be structured as a form of cash bonus and not true “equity,” it may help eliminate certain steps otherwise required to comply with securities laws, such as filings and state fees. However, this may require some legal analysis on a case-by-case basis, because the specific terms of a phantom plan may cause it to fall into a “gray area” where it may start to look more like a security.
Issues to consider
- Explanation to employees. Since phantom equity is not as common as options, and less intuitive than straight equity ownership, you may have to spend more time explaining how such a plan works to employees and “selling” them on its value.
- Tax treatment. Since phantom equity is essentially a cash bonus plan, it will generally be subject to ordinary income instead of capital gains treatment. However, the relative advantages of stock options, and even “incentive stock options,” in private companies are probably overstated in this respect because employees rarely exercise their options prior to a liquidity event. The most common liquidity event for startups is generally an acquisition (as opposed to an IPO), and options are typically cashed out at acquisitions. Thus, employees with options typically do not hold the underlying stock for a period that would allow long-terms capital gain treatment (or “incentive stock option” treatment). Thus, in practice, the tax differences between phantom equity and traditional stock options may not be as great as they appear.
- Employee departures. One of the terms that varies among phantom equity plans is whether an employee keeps their “phantom units” after they leave the company. In the case of regular cash bonuses, employees typically forfeit these when they leave the company. However, this may be perceived as unfair with respect to phantom units, which are meant to track more closely the advantages of holding equity (which employees can often keep after termination to the extent it’s “vested,” subject to paying an exercise price for options). If a company wants to set up a phantom equity plan so that departed employees continue to be entitled to the benefits of their phantom units, they should discuss this with legal counsel; this type of term may increase the risk that phantom equity would be viewed as a “security” subject to the requirements of federal and state securities laws.
As you can see, there are some benefits to adopting a phantom equity plan, but it isn’t always the right fit, and if it is pursued it must be executed properly. Legal counsel is strongly advised for anyone considering this approach.
Aaron Sokoloff is a Senior Associate at Procopio and a member of its Corporate and Securities, Mergers & Acquisitions and Strategic Joint Ventures, and Emerging Growth and Venture Capital practice groups. He counsels clients on venture financings, seed financings, bridge financings, and exits. He is also experienced advising entrepreneurs on company formations and advising technology companies on general corporate and legal issues, including contracts, equity compensation, and corporate governance. In addition, Aaron is leading the efforts of Procopio’s Business & Technology team on practice improvements, knowledge management, and attorney education, and is actively involved in the firm’s LaunchPad incubator.