Incentivizing Key Employees with Phantom Stock

Creating incentives for employees to perform better can take many forms, such as merit
bonuses or grants of equity through restricted stock or stock options. Each strategy should have
the effect of aligning the employee’s interests with the long-term success of the company, and
hopefully creating an economic incentive for the employee to increase their productivity and
the overall success of the company. Grants of equity can certainly be a powerful tool to attract
or retain key employees for longer periods of time, but phantom stock plans may be a better
strategy for some companies.

Why not give employees equity?

Many larger companies employ equity-based incentives with great success, but for a closely
held company these strategies come with a downside for company owners: dilution. By giving
away equity the current owner’s percentage of ownership will go down. In addition to dilution,
grants of equity will also give the new equity holders certain rights as shareholders (or
members in a limited liability company). These rights may include the right to vote, the right to
receive distributions, or the right to inspect the company’s financial records. The majority
owners will also owe the minority owners a fiduciary obligation. Any decisions or actions
undertaken by the majority owners, must be done with the utmost good faith and loyalty to the
company and the other owners.

What is phantom stock and how does it work?

The first point to understand about phantom stock is that it is not equity, so it is not stock in a
corporation nor is it a membership interest in a limited liability company. Phantom stock is
merely a contractual obligation to pay an employee a bonus upon defined triggering events.
The triggering events could be the sale of the company or issuance of dividends to
stockholders, or termination without cause to name a few. When a triggering event occurs, the
phantom stock units receive the same economic treatment as the true shares of stock. For
example, if an employee is awarded 1000 units of phantom stock and upon the yearly payment
of dividends, the true equity holders receive $10 per share, the phantom stock owner would
receive a bonus of $10,000. Phantom stock uses the value of the actual stock to calculate
employee bonuses.

Much like equity incentive plans, phantom stock plans can have a wide range of variables to
control the economic benefit given to employees. Some common characteristics include vesting
periods, forfeiture events, or setting the initial value of the phantom stock like a stock option
and basing the bonus calculation on the appreciation of that value. These variables can allow
the company to tailor the plan to balance the need to create a strong incentive for employees,
but also stretch that incentive out for more long-term success without giving away part of the
company.

Any business owner considering granting equity to key employees should consider exploring
the benefits of phantom stock as an alternative. The employment attorneys at Rudolph Friedmann LLP can
guide you through the decision-making process.