Written by: Julia Dennis & William Lowman

Planning for key employees is an important aspect of the growth of any business. Key employees can either drive value to your company or create a roadblock down the line when preparing for an exit transaction. This is why, as a business owner, it’s never too early to plan for ways to retain and reward key employees through the ultimate sale of your business.

Luckily, your first resort for keeping a key employee happy does not automatically mean giving up ownership. We have seen an uptick in companies using constructs like “phantom stock,” “equity participation shares” and other similarly named plans that, in essence, motivate an employee by enhancing their opportunity for participating in the growth of the company and giving them “skin in the game” all without selling actual shares in the company.

Why not actual stock?

Employees and employers alike are sometimes surprised to find out that issuing actual stock to an employee typically means that the employee must pay income and employment taxes on the value of the stock in the year in which they receive it (as if the stock was cash compensation). There are ways around this, such as requiring the employee to pay for the stock or issuing options to buy stock at a later date. But unless the employer is willing to give them the cash to pay for the stock, which additionally also triggers income and employment taxes, employees will rarely exercise their stock options until an exit transaction is imminent, and will have at that point already forfeited the potential tax benefits of stock ownership. In addition, employees holding actual stock in their employer have the rights to call owner meetings, inspect books and records, review financials, and exercise various other rights of a stockholder under state law. For pass-through entities in particular, employees will have to be issued K-1 statements that will hold up the filing of the employee’s own personal tax returns, and they may potentially have to pay taxes on “distributable” income of the company that they never actually receive. Further, once an employee holds actual stock, it is very difficult to get it back (in the event of a termination, for instance) without that employee’s sign-off. For all of these reasons, we are seeing more and more emerging and established companies steer clear of awarding actual stock to their key employees.

What is a Phantom Stock Plan? 

A phantom stock plan is a compensation plan that provides key employees the financial benefits of actual stock without the tax and other legal issues involved in ownership. This allows key employees to still participate in the growth and profitability of the company. 

Who are the Key Employees?

Key employees are typically those that meet the following criteria: they are highly compensated or they carry out management-level duties (as defined by the Department of Labor), and in either case, they must be able to negotiate their compensation packages. Employees that do not fall into one of these buckets are typically not eligible for phantom stock plans. 

How is a Phantom Stock Plan Structured?

The value of the phantom stock units can be measured by the value of the company stock. There are two main types of phantom stock plans: “appreciation” plans and “full value participation” plans. The full value participation plan pays both the value of the underlying stock and any appreciation in the value. The appreciation-only plan pays just the increase in value of the stock share going forward from the issuance of the shares. For either of these plans, employers will often pick a percentage of the company or a specific number of shares that are used as the basis of the calculation of the value of what is due to the key employee. 

The payout under the plan will often be based upon revenue, EBITDA, multiples and ultimately the value of the company upon exit.  

Further, the employer can choose to vest the plan benefit over a certain number of years, give vesting credit to certain employees for years served, or make the plans fully vested from inception.

When is the key employee paid?

A phantom stock plan will typically payout upon the occurrence of an exit transaction. The payment of the value accruing to the key employee will typically be structured to be contingent on them remaining with the company through at least until the end of the transaction and often up to one or two years after the completion of the transaction. Some plans also have other payment triggers, to the extent they occur prior to an exit transaction, such as the key employee’s death, disability, retirement, or termination of employment. Regardless of the payment trigger, the plan will specify if the payment will be made in one lump sum or as payment installments over time once one of the payment triggers occurs. 

At ShuffieldLowman, our corporate law and mergers & acquisitions team are here to advise clients on their options when looking to retain and reward key employees before, during, and after the exit transaction. If you have any questions, you can contact a member of our team directly or contact us through our website. Phantom stocks programs should be reviewed by an attorney to ensure it is drafted properly and meets the requirement as set by IRS code 409(a).