Consider phantom equity instead of giving employees stock compensation

by margento | November 18, 2022

Phantom Equity is just one of the many vehicles to incentivize employees. This article will explain what it is, why you should consider it for your business, and how it differs from regular stock-option plans. 

“Focus more on making the pie bigger than on exactly how to slice it” – Ray Dalio.

The more money you can make for other people, the more you will make yourself. This is not just limited to your customers; this applies to the team you work with. Think of your profits as a pie. Giving equity to your employees is one way to share the pie (aka profits). 

Let’s say you are a business owner that has made some key hires, and you want to give them a percentage of your business but not the whole business. This gives your team a piece of the pie in your business and gives them “ownership” so that they would treat the company as if it were their own. This has many incredible benefits, such as someone willing to work harder and be more dedicated to your company’s success. At the end of the day, if you give a slice of the pie to someone who can help you grow the total size, your pieces ultimately become bigger, so it’s a win-win situation for you and your teammate.

One of the biggest things that will influence growth in your company is a stock-option plan because of the high level of buy-in you will receive from your high-level employees. However, stock-option plans can have adverse tax consequences for the owner of the company and the employees and incur expensive legal fees to establish.

The alternative to giving your typical stock options is something called phantom equity.

What is Phantom Equity?

Phantom equity is equity that is not vested but has events that can trigger its vesting. Remember that vesting is when someone acquires the stock for legal and tax purposes. Phantom equity can be triggered at an event such as a sale of the company. For example, phantom equity vests if the company changes ownership or is sold. That means if an employee is working for a start-up and granted phantom equity, there could be a clause in the agreement that states if the company is sold, then the employee can liquidate their shares of the company and the owner. The benefit at the end of the day is that the employees can participate in the wealth generated when the company is sold.

As an owner of the company, you want your employees to have owner-like thinking and owner-like behavior so that the entire organization is more focused on succeeding. It’s essential to keep in mind that you want to only give a proportional amount of phantom equity to the contribution an employee makes to the company. One of the pitfalls to watch out for would be giving a disproportionate chunk of equity for the level of contribution from your employee.

From a wealth perspective, phantom equity is significant because as the company earns more enterprise value, the owner and employees increase their wealth when the company is ultimately sold.

How does Phantom Equity affect your taxes?

It doesn’t! That’s one of the great benefits of phantom equity. Let’s consider ordinary equity for a moment. When an employee is granted your typical stock-based equity of a company, the downside is that there is a transfer of equity, and the employee must pay tax on the value of the equity they are receiving. Depending on the value of that equity, this could be a hefty tax bill to pay. For example, Jeff Bezos can’t just give shares of Amazon to someone. The person who receives those shares will have to pay tax on the value of the shares they receive.

It’s a taxable event. Phantom equity, on the other hand, doesn’t vest until a trigger occurs, such as a sale of the company. Which means no tax is paid until that happens.

What if your employee leaves?

Your access to phantom equity is given over a period of 5 years. Each year, 1% of the phantom equity gets granted. That way, the employee could earn 5% phantom equity if they work with you for five years. But what if that employee leaves early? You could agree that if the employee leaves, you can have them lose the phantom equity. This incentivizes the employees to stay with the company long-term and grow the business.

This protects the owner of the company.

Legal liability and how that affects phantom equity

With phantom equity, the employees are not legally liable, which benefits the employee. Since if the employee had ordinary shares of the company and that company was sued, there could be held responsible for actions taken against the company.

Conclusion

The more aligned you can make your team and their success in life with your outcomes as the company owner, the more successful everyone will be overall and the faster the company will grow in that direction.

It allows those granted phantom equities to generate wealth when your company is sold. It keeps employees thinking about the company’s enterprise value, protects the employees from adverse tax consequences, and protects the company’s owner if someone leaves. It’s a win-win situation!

If you have any questions, please feel free to contact us.

We’re always happy to help!

Contact Argento CPA today if you have any questions or looking for expert advice.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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