Phantom stock plans are a deferred compensation tool companies can use to attract, motivate, and retain talented employees. These plans (also known by many other names, i.e., shadow stock plans, phantom equity plans, synthetic equity programs, etc.) offer employees some of the benefits of stock ownership without transferring company equity. While phantom stock plans bring many advantages, employers must avoid pitfalls and ensure smooth administration, especially when considering future change-of-ownership transactions.

While phantom stock plans offer a unique compensation approach, understanding their inner workings is crucial for employers and employees. As a form of equity-based compensation, phantom stock plans use stock price (or, in the case of partnerships and LLCs, unit price) as an underlying asset to compensate employees based on company performance. Plan participants receive “virtual” shares of company stock; just like ordinary stock, these phantom shares fluctuate in value based on the company’s financial performance. Employees do not purchase or own actual stock but receive a right to cash payments based on time or triggering events (e.g., achievement of performance targets, change-in-ownership transactions). Plans can use the total value of the stock as the basis for payments or base the payment exclusively on the appreciation of stock value between the plan date and the payment date. Phantom stock plans can benefit privately held companies that want to share in company success without losing ownership or control to plan participants.

The significant advantage phantom stock plans offer companies is flexibility. When implementing the plan, companies do not need to offer employees any ownership or control over the company’s management. Companies employing phantom stock plans protect themselves from diluting ownership control to participants in the phantom stock plan while aligning company and employee goals toward company success. Plans also carry comparatively lower costs than traditional equity or stock options plans. Companies can further tailor their phantom stock plans for success by thoughtfully creating granting and vesting periods (or by having either or both be based on combinations of performance and time metrics).

These plans are not without potential pitfalls. Like other types of equity plans, employees may become frustrated with diminished company value because it directly impacts their compensation. Unlike traditional equity plans, employees (who have no control over company management by virtue of participation in the plan) might feel their compensation is decreasing through no fault of their own. Companies not anticipating value growth cannot take advantage of the strengths of phantom stock plans. Other government regulations can also create traps; phantom stock plans must be carefully targeted to important employees because plans that cover all (or nearly all) of the company may be construed as employee retirement plans and thus be required to comply with ERISA. Tax implications also abound, as these plans fall under Section 409A of the Internal Revenue Code as nonqualified deferred compensation plans. Section 409A applies rules regarding the timing of deferrals and distributions for phantom stock plans and must be carefully planned for. These potential traps and the nature of phantom stock plans make a specialized tool in the toolbox practical for companies that can take advantage of their strengths while mitigating their weaknesses.

Phantom stock plans can be a dynamic and valuable approach for companies looking to retain and incentivize key talent in a growing organization, striking a balance between the practical nature of private company management and the upside of equity ownership. Successful implementation of a phantom stock plan relies on thoughtful design, clear employee communication and buy-in, and proper management.

The post Phantom Stock 101: A Primer on Invisible Equity appeared first on Meissner Tierney Fisher and Nichols S.C..