/>iSuccess is not just an elusive goal – it can also be difficult to maintain once achieved. For majority owners in private companies, achieving success is just the first hurdle, because once they arrive at this pinnacle, they may soon face a new challenge. Some of their key employees may want a piece of the pie and push for an ownership stake in the company. The dilemma for business owners when their employees are clamoring for ownership is that by issuing equity to employees, this dilutes the company’s stock and also provides employees with legal rights they can enforce against the majority owner.
There is no single answer that meets the needs of majority owners and employees in all situations, but owners who want to incentivize their employees through the use of equity should consider all available options. This includes the potential for owners to provide their employees with “phantom equity” or stock appreciation rights rather than actual ownership (equity) in the company. This approach may help thread the needle effectively for all parties.
Section 1: The Distinctions Between Equity and Phantom Stock
As a starting point, there are important differences between actual equity ownership in a company and phantom equity. Employees who receive stock (corporations) or units (LLCs) in their company have actual ownership, which generally provides them with an array of legal rights. These rights are subject to modification, but equity holders are typically permitted to vote on some issues, to obtain access to the company’s financial records, and to bring claims against the company’s management for violations of their fiduciary duties.
By contrast, employees who receive phantom stock (also called synthetic equity or stock appreciation rights (SARs)) enter into an agreement that provides them with contract rights but not actual ownership in the company. For example, under a phantom equity award, the employee may receive a guaranteed payment if the company’s profits or revenues increase by a specific percentage, if the company is sold, or if the company’s value increases during a specific period in time.
Section 2: The Majority Owner’s Perspective on Equity and Phantom Stock
From the majority owner’s perspective, there are both pros and cons to granting equity ownership that may make the phantom equity approach more desirable in efforts to incentive employees.
The Pros of Granting Equity Ownership
One of the most important benefits of issuing equity to employees is that once they become part owners of the business, their financial interests are more directly aligned with the majority owner. The employees are now officially on the team, and this connection assists with succession planning, it helps secure long-term retention of employees, and it allows for employees to view the business on a longer-term basis. Employees will appreciate that their shares may become much more valuable over time and in any future sale or merger of the business, the sale of their shares will provide a handsome financial return and at a lower tax rate than is applied to capital gains.
The Cons of Equity Ownership
Company owners who issue equity to their employees may come to rue that decision if the employees later become disruptive in their approach to the business or hostile to the owner. As noted above, issuing equity to employees will dilute the percentage of shares available to the owner. Further, employees holding equity are generally entitled to access the company’s financial records, to call shareholder meetings and to bring up issues for discussion at shareholders meetings. In addition, company owners are virtually always part of the senior management team, and they can be subject to claims by employees holding equity who contend that the majority owner breached fiduciary duties owed to the company.
Finally, and importantly, if the employee later resigns or is fired, that does not extinguish his or her equity in the company, and the former employee retains all the same rights of shareholders or members. The company should have a buy-sell agreement in place with the employee that allows for the majority owner to repurchase the former employee’s shares, but this buyout process may become protracted and contentious, which creates a major distraction for the owner who wants to remain focused on the business.
The Pros of Granting Phantom Stock Rights
There are a number of benefits for the owner in issuing phantom stock rather than actual equity. First, the rights granted in the contract are specific, and the employee can easily calculate the payment that will be made if the revenue or profit targets in the contract are achieved, which has a strong incentivizing impact. Second, the employee receives only those rights set forth in the contract, which will not provide access to financial records, the right to vote on company business or the right to bring claims against the company or the majority owner other than for breach of the contract itself. Third, in most of these agreements, the employee needs to remain employed to receive the rights granted, and as a result, the termination of employment eliminates all further rights. Thus, there is no need to go through a buy-back procedure to reacquire equity.
The Cons of Granting Phantom Stock Rights
There are no major cons to the phantom equity approach for the majority owner, but it may not satisfy the employee who truly wants to have an ownership stake in the business. In addition, the employee may be reluctant to accept this type of contract arrangement and accept the risk of being fired before any of the financial benefits have been realized. The majority owner may therefore need to provide some assurances to the employee such as agreeing that the payment will be made if the targets are met even in the event the employee is terminated or agreeing that the employee can only be terminated for cause during the period that the phantom stock agreement is in place.
Section 3: The Employee’s Perspective – Pros and Cons
The Pros of Equity Ownership for Employees
For employees, receiving actual equity in the business affords them the status of being co-owners in the business, which provides both financial and psychological benefits. When the employee also holds ownership in the company, the interests of the company and the employee are more aligned. Employees who are also stakeholders recognize that they are benefitting from the growing value of the business, and they also have some opportunity to participate in major decisions by the company. When they do cash out of their investment through some type of liquidity event, the employees will receive favorable tax treatment paying capital gains on the increased value of their equity stake.
The Cons of Equity Ownership for Employees
On the downside, employees who want equity may have to “pay to play” and spend a considerable amount to purchase the equity they receive in the business. While the upside is that the value of their equity in the company may increase significantly over time, their shares or units are typically illiquid and, as a result, they cannot monetize this value until a major event takes place, such as a sale or merger of the business. Further, growing private companies often do not issue dividends or distributions on a current basis. The net effect is that the employees who have equity in the business may have to wait many years before they receive a financial benefit from their ownership interest in the company.
The Pros of Phantom Stock for Employees
In contrast with the ownership of actual equity, phantom stock provides employees with a contract that offers more certainty about current payments. While private companies often do not issue distributions to owners, the point of phantom stock is to provide payments to employees when they help the company achieve financial milestones. When those financial targets are met, the employee is assured of receiving a payment based on the formula set forth in the phantom stock agreement. In short, phantom stock provides guaranteed payments to employees when the financial targets are achieved — there is a direct performance and award connection.
The Cons of Phantom Stock for Employees
There are three disadvantages to phantom stock compared to equity ownership. The first is that unless the phantom stock contract provides the employee with some protection, the rights that are granted to the employee in the contract are immediately extinguished when the employee is fired. This is obviously an important negotiating point for the employee to secure protection from a last-minute firing that pulls the rug out before a payment is required to be made to the employee under the contract.
The second disadvantage is that the payments made to the employee under the phantom stock contract are typically taxed as ordinary income rather than capital gains. The upside here, however, is that the payments are made under the phantom equity contract on a current basis and the employee does not have to wait for years for a liquidity event to take place that will monetize the value of the employee’s shares or units in the the company.
The final disadvantage to phantom stock awards is that they do not provide the employee with the rights of an equity holder. Specifically, the employee holding phantom stock does not have the right to (i) attend owner meetings, (ii) obtain access to the company’s financial records, and (iii) bring claims against the company’s management for breach of fiduciary duties.
Conclusion
Majority owners who want to incentivize their employees in growing the business should carefully consider whether issuing equity to the employees is the best option. Granting equity to employees will dilute the company’s stock and also provide the employees with legal rights they may wield against the owner – a case of biting the hand that fed them. But owners who choose to grant phantom equity to employees will avoid both these downsides while also providing the employees with potentially robust financial incentives.
Employees may also agree that phantom equity, despite the name, will provide them with significant financial benefits they receive on a current basis. Further, the owner can use the phantom equity program as a testing ground to see if it provides a win-win for both owners and employees over some period of time. If the phantom equity approach is successful, there are increasing instances of owners who are adopting hybrid plans where phantom equity is converted to actual equity upon triggering events such as achieving certain valuation thresholds, securing certain amounts of financing, or successfully launching an IPO. This hybrid approach may open the door for the owner as part of a succession plan for the business.
