Phantom Stock: What is this employee benefit and how does it work? I am a business lawyer here to answer any of your questions. Ask me anything!

I am still really confused why this is a benefit to employees. It sounds like a stock you don’t actually own, you don’t actually earn, you can’t ever sell that can be devalued very easily by a company that chooses to be unscrupulous. Why do you want this as an employee?

u/Littlebigs5, I understand your concerns, and there is the opportunity for the employer to be "unscrupulous" as you say. If it's done right, though, and both sides have a lawyer review it and negotiate it, it can be a good agreement that helps both the employee and the employer.

The employee can negotiate provisions that restrict the employer from, basically, being unscrupulous, like you said, and better guarantee that the employee gets an active and consistent amount of profits-revenue from the employer.

As far as devaluation goes, that's actually often harder to do with phantom stocks than traditional stocks! Normal stocks can be diluted easily by the issuance of additional stocks. So, if you have 100 stocks and there are 1000 stocks, you've got 10% of the shares, but the employer can issue 9,900 more stocks so that your 100 stocks would only be worth 1% instead of 10! However, if you get a 10% phantom stock grant, then you'd get 10% of the business's sales price if/when the business sells! yes, it's possible for employers to dilute phantom stocks, as well, but you can easily restrict that by negotiating the provisions :-)

I understand that phantom stock is discontinued if an employee is terminated, but what happens to those shares then? Do they go back into your pocket? Can you sell phantom stocks?

u/alexbovs great question! Yes, it would go back to the company, and effectively those stocks would "cease to exist." Technically, phantom stocks can be sold, but normally we structure them so that they cannot be sold since, obviously, you wouldn't want a stranger to own phantom stock in your company.

Also, it's not always the case that a termination forfeits your rights to phantom stock income. There's a perverse incentive for the employers selling their businesses to just fire a phantom stock employee immediately before selling the corporation, so that they don't have to pay any phantom stock money to the employee. We often solve this with an agreed upon holdback period, so that (for example) the employer would still have to pay the same phantom stock monies out to the ex-employee if the business is sold w/in a 6-12 month window after the employee is fired.

Why might a company want to issue phantom equity instead of actual equity? & What should a company consider when designing a phantom stock plan?

Issuing "actual equity" comes with a lot of risks for employers. The biggest risk is that, if anything falls through (the relationship with the employee) or if the employee quits or decides to move away, or even dies, then the employer still has to pay full rate to the employee. With phantom stock, the business only has to pay the employee if the employee works for the company.

Also, for the employee, they would have a "taxable event" when granted shares in the business, and the business may not pay actual cash for the employee to pay taxes with. So, for example, if the shares are worth 100K dollars, then the employee would likely have to pay 25K or so in taxes, even though, they have not been given any cash to pay these taxes with. A phantom stock program avoids this issue, entirely, so that the employee only pays taxes on money he/she's actually received.

Issuing "actual equity" comes with a lot of risks for employers. The biggest risk is that, if anything falls through (the relationship with the employee) or if the employee quits or decides to move away, or even dies, then the employer still has to pay full rate to the employee. With phantom stock, the business only has to pay the employee if the employee works for the company.

Can't these issues be addressed simply with the types of shares issued (non-voting, redeemable, etc.) and a shareholder agreement?

u/KINGCOCO yes, they can, but again, that may make a taxable event that the employee doesn't want to deal with (they may not want to have to pay the IRS 25% of the equity granted). There's also the drawback that the employer has to disclose all of their dirty laundry, so to speak, since now it's an actual business partner, not "just" an employee.

What’s the difference between phantom stock and profit sharing?

u/Zazenp it depends on how the employer structures it. Most of the time (not all the time though) employers will grant a profit share with the phantom stocks they give out, such that the employee is paid a portion of the company's profits during the time they work for the company. This is basically the same thing as a traditional profits share with like a C-Level employee.

However, often profits shares are limited to profits that that particular employee generates, only, such that, the employee does NOT benefit from other employee's revenue generation.

These are all "knobs" that you can dial in, depending on how the parties want to structure it.

Also, typically, phantom stocks include, in addition to a profits share, a share in the proceeds from the sale of the business, such that if the business is sold while the phantom stock owner-employee is with the company, they'd get that same % of the sales price. This can be a rather large amount of money, too, obviously if the company sells for millions.

I think this is happening to me. Does this sound like phantom shares? I'm working for a startup that is a private company. My compensation package claims to include X common shares valued at $Y/share, but I've never received any certificates, request for a brokerage account to hold the shares, or anything like that.

u/phriot, I'd need to talk with you specifically about it, and if you have copies of those initial agreements, I'd love to see those as well, but yeah, this does sound like it's very vague and amorphous. Usually if they say "Common Shares" that means real equity, though, and the judges tend to favor employees more than employers in these sorts of things, so you may have some arguments that they've wrongly failed to pay you for that additional income. If you'd like to discuss further offline, my email is [email protected]

Thanks for the quick reply! It's good to know that it's probably real equity. I'll definitely reach out if I want to pursue this further.

u/phriot sounds good!

If I were to sign a phantom stock agreement from my employer, what are some things that I should look out for before signing?

u/TheDaintyDilettante, I'd highly suggest speaking with a lawyer and having a professional review the proposed agreement, since these are often written very differently. There's not really a "form" that we lawyers and business owners have come to, at this point, since it's a very new legal technology.

I'd check for restrictive covenants, such as non-competes and non-solicitations. I'd try and negotiate a hold back period like we discussed earlier on this thread, so that you can't be "fired" immediately before a sale takes place, so that you wouldn't receive your well-earned portion of the business's sales price.

You might try to negotiate a "for cause" requirement to fire you, so that the employer would need to jump through some extra hoops to fire you and effectively stop your phantom stock income.

If you have some extra money that you could pay the taxes on, you might consider asking the employer to grant you actual equity stock rather than "phantom" stock, too, since you could then hold that as an asset that you and your family/heirs, etc., would all benefit from for years to come!

My relative has some RSUs from his employer, and they're about to go public. Should he get excited?

u/heidismiles, he should most definitely get excited! Typically, an IPO increases share prices by a huge amount, easily doubling the price tag, and he will probably be able to take advantage of that so long as the RSU requirements are met :-)

Nice, thanks for the response!

u/heidismiles sure thing!

My job came with an employee ownership % in my offer. Exact verbiage:

You are eligible for the Company’s stock option plan which will be implemented as part of the Company’s equity raise.  Your initial equity option grant will be 2% of the outstanding shares with a total vesting period of 5 years.

We've grown substantially and have yet to have the need to do an equity raise. If we don't ever need one, is this essentially worthless?

u/Itsbeardie, yeah, that's a common, and difficult, situation. I'd be happy to go over it with you in detail, please email me at [[email protected]](mailto:[email protected]) and mention this thread. I'd need to learn a little more about the case before I can get you an answer, but what you're saying (sadly) makes sense.

Lots of startups fail to hire lawyers at the beginning and end up writing not-so-great-or-clear legal agreements--this one sounds like it may be one of those :-(

That said, I've found that often employers didn't "mean" to give their employees a dumb or meaningless "benefit," and if you bring it to their attention, they will often give you something else that's more meaningful/impactful.

There's also securities laws out there that protect employees from bad agreements, if they rise to that level of badness.

How common is phantom stock? Are a lot of companies using it or moving towards using it over traditional stock or is this a newer fad? How popular do you think this will be for smaller businesses and start-ups in the coming years?

I represent over 5000 companies, and I have seen a real trend towards using phantom stock more. I don't think this is a "fad." I think it's a solid solution to the problems we discussed with u/Potential-Way-627's comment, above, for both employers and employees alike. I don't think that traditional stock is what most employees really want, at not when they learn about the added taxes they'd have to pay.

Is phantom stock coming about in response to employees becoming indifferent to vested profit sharing agreements?

u/Chariot-of-Belenus, that's an interesting take on it. I'm not really sure what the employee response is, overall, but normally phantom stocks "vest" in the same way that other more traditional profit sharing agreements do. I'd say about half of the phantom stock agreements I've written including a vesting schedule based on time or milestones that the employee needs to meet in order for the phantom stocks to "vest."

Have you gotten the impression that employees are sick of the whole "vesting" thing?

Yes and the more seasoned employees are going to see it as the same thing. Employees are changing jobs faster than ever and because they aren't getting raises. A vestment period is meaningless when they are taking the job because of the raise in wage not something that may or may not happen.

u/Chariot-of-Belenus, that's a great point, totally makes sense! Hopefully, that encourages employers to issue phantom stock immediately, without a vesting period.

Do you think more companies are going to offer increased phantom stock options for employees since the job market and turnover at many companies is so hot right now? Or do you think it is wise for companies to hold off on offering this option since turnover is so high in a lot of industries right now?

Great question, I think the former will be true: employers will continue to offer additional bonus opportunities and quasi-ownership like phantom stock so as to "create stickiness" with employees, more.

When an employer loses an employee, it typically costs the company 33% of that employee's annual salary in lost business capacity, strain on other employees, and costs to find replacement employees (and training the new people, too). So it's very much in the best interest of the employers to hold on to great talent!

What's the downside of phantom stocks? What are the benefits?

The downside is that it's not "real equity," and the employee loses it if they quit, if they die, if they stop working for the company, or if they get fired for any reason.

"Real/traditional" equity lasts, it's basically property that can be transferred to other buyers, or down to your heirs if you pass away. If you are fired or quit, or move or whatever, you still get the benefits of the traditional stock (it's very difficult for people or companies to take that stock away from you).

That said, once you're granted real stock, you have to immediately pay taxes on it (at least for that taxable year), and if the stock is worth 100K, you'd likely have to pay around 25K cash to the feds for it, even though you have not received additional funds (you've just received the stock).

The detriment to the company is that, no matter what happens with that employee, they will always be a business partner! Business partnerships are usually tough relationships, too. Not to mention the fact that the employee may sell their equity to someone you don't know "from Adam." Or, if God forbid they pass away, you may be dealing with their heirs who may be very different from you in terms how they want to do business.

What are the most common issues you see when clients come to you with phantom stocks?

Are there specific business or tax issues/misunderstandings?

u/billsilverman1124 Usually when a business owner's interested in granting some sort of equity or phantom stock to their employee(s), it means that the employee is doing really well, and the business owner wants to keep them around and make them more like a fellow business owner that's incentivized to help the business to do well, and disincentivized for the business doing badly.

Usually, the tax implications, the fact that the employee would have to pay around 25% taxes on the grant of actual equity from the employer, makes the employee prefer phantom stocks or some type of profits share. But if the employee has the money to pay the taxes on the grant of actual equity, and prefers actual equity, this is usually a great sign for the employer--it means that this employee is "all-in" and wants to stick with the company for the long haul!

I think that often employees don't know or understand the tax consequences of actual equity, and so when I explain to them the benefits of phantom stock, they're usually glad to hear it.

Some employees are turned off by phantom stocks since it's not "actual equity," like we've discussed. I get that. But in my experience, often employers really want to grant some equity to the employees that are going to work hard and stay for the long haul, but the employee may not want to live the life of a business owner--they struggle with the "swings."

How is phantom stock treated for income tax purposes?

u/Vegetable-Golf4022, we discussed this a little with u/Impossible_Frame_267's comment, above, but basically it's treated as regular income that you would get on a normal pay stub with withholdings, social security, etc., taken out. It's basically just a bonus that you get through your W2.

How does phantom stock affect ownership percentages? For example, if I own all 100 shares of my company and want to give out 20 shares of phantom stock. Would my ownership go from 100% to 80%?

u/Conscious-Mine-5903 great question! In your example, your equity would not go down at all from 100 to 80%. You would remain at 100%. The only difference is that you may (depending on how you structure it) pay your phantom stock owning employee 20% of your net profits (after expenses) when you pay out dividends, and/or if you were to sell your company you may (again, depending on the structure you use) pay them 20% of the sales price.

How does capital gains tax work for phantom stock since assets aren’t actually transferred over?

u/Impossible_Frame_267 yeah, I'm glad you brought that up! All money paid via phantom stocks is considered regular income, and treated just like a bonus that an employee would get. There is no capital gains tax rates or special treatment for phantom stocks, currently.