What is a Phantom Stock Agreement?
A phantom stock agreement is an ingenious way for employers to provide the benefits of stock options to their employees without actually having to give them any real stock. In exchange for the promise of future compensation, an employee agrees, usually for some future time period, to give up a portion of their salary. Upon the occurrence of some specified event, such as the sale or IPO of company stock, the employer pays the employee a sum of money based on the value of the reserved stock and the amount of salary that was deferred. Employees are considered owners of phantom stock and entitled to dividends, in the form of cash payments or new shares (bonus stock), during the specified time period , before the occurrence of the specified event. But the employer retains the right to recall some of the deferred compensation as needed, plus interest. Phantom stock can be adjusted for stock splits, corporate reorganizations and the like. It is important that the employer retains the right to cancel phantom stock grants at any time for any reason. Many companies offer phantom stock plans instead of stock options for several reasons. The preferred method of compensating employees with ownership interest is to grant options in actual company stock. Phantom stock, however, is easier to implement and less risky. It allows employers to provide employees the benefits associated with equity ownership, without dealing with the administration of stock options.
Essential Terms of a Phantom Stock Agreement
Several key elements must be present in a Phantom Stock Agreement. Generally, these are: (1) the performance condition, (2) a vesting schedule and (3) the payout mechanism.
The performance condition is intended to align the employee’s interest with that of stockholders. The performance condition is met when the company meets one or more performance targets that have been established. These performance-based targets are often tied to financial measures such as EBIT or revenue, or stock price targets. However, the performance target could also be based on operational or non-financial objectives. Whatever the performance target, it is vitally important that it relate to something the employee can directly influence. If not, the employee may not exercise adequate effort to satisfy the target. The performance target is normally established by the board of the company at the date of grant.
The vesting schedule determines how the stock is earned. It is generally within the employer’s discretion to determine the vesting schedule. Phantom stock shall usually vest over a period of time, for example, a company could have a vesting schedule of three years with one-third vesting each year on the anniversary of the grant date. Vesting is often accelerated upon certain change of control transactions.
The payout mechanism will determine how and when payments will be made to the employee. Phantom equity payouts can be made in a variety of ways. It might be a lump sum payment on the date the stock vests, at the time of a change in control transaction, or sometime in between. It may also be payable in installments, for example, payment could be made over a three-year period after vesting. The payments could be made at different times, for example, upon a change in control the employee could receive a lump sum payment, but after that receipt, the employee would receive installments over the course of three years of phantom stock that vests based upon an annual period.
The payout mechanism may also determine whether the payout is in cash or stock. As a general rule, for accounting purposes, the employer should provide the payout in cash to avoid diluting its equity ownership. However, if the payout is made in stock, provide the employer’s board with discretion regarding the timing and form of payment.
Benefits of a Phantom Stock Plan
For businesses, phantom stock also provides an additional tool for certain incentive compensation plans. It can be an effective part of a business succession plan, aiding retention and providing incentives for key employees leading up to the point when a business owner hopes to sell the business. Employers can craft phantom stock plans that align interests of employees with that of the employer’s outside investors or lenders by carefully structuring the plan benefits so that the triggers occur at times that are most beneficial to the company.
For nonpublic companies, an incentive compensation plan is a risk-sharing arrangement that binds an individual participant’s compensation with his or her performance over a number of years. It is, thus, an appropriate way to align front-line employees’ performance with an owner looking for liquidity. In comparison, a bonus based on annual profitability will likely provide less incentive for motivation, retention or performance than a plan that contemplates a pay out upon a change in control, merger or other liquidity event. Phantom stock plans also provide a supplemental retirement strategy for a company that does not have enough employees to justify the set-up and ongoing administration costs of a qualified retirement plan.
In addition to this, the nonqualified nature of a phantom stock plan provides flexibility in structuring the plan without regard to the functional rules and limits for tax-qualified plans, which may create unintended consequences. For example, many retirement plans (e.g., 401(k), profit sharing and stock ownership plans) cannot discriminate in favor of employees who are considered highly compensated employees. This is an important consideration because the owners of a business generally qualify as highly compensated employees, and if a qualified plan is not designed properly, it will provide minimal benefits to the owners, while providing substantial benefits to the nonhighly compensated employees.
From the employee’s standpoint, a phantom stock plan offers the ability to receive benefits that might not otherwise be available to the employee, due to the tax qualification requirements imposed on nonqualified plans. For example, plan loans, an important benefit for many employees, are permitted under a phantom stock plan. In contrast, a qualified plan must be designed to prohibit participant loans.
Phantom stock plans also can create a future tax liability for employees that may be less than what the employee would have otherwise paid on a bonus or a distribution from a qualified retirement plan. Under Code Sec. 83, an employee’s income from a compensatory grant of phantom stock is generally not taxable until the stock is actually paid out, meaning that the employee can defer taxes until an uncertain future date. So, an employee who receives a $50 per share phantom stock award vesting in five years, for example, will only be taxed in five years on the value of any phantom stock that is vested at that time (as opposed to five years on the entire $50). In addition, the amount taxed will equal 100 percent of the economic interest, and not included in the taxable income for the taxation event will be any amount calculated as the fair market value of the stock at the time the employer has a liquidity event equal to the appreciation (or gain) attributable to the stock.
Phantom stock plans can only be offered by employers and to key employees. However, the flexibility and benefits they offer can be very useful to both.
Terms to Consider in Crafting a Phantom Stock Agreement
When it comes to drafting an effective phantom stock agreement, there are several key considerations. First and foremost is legal compliance. There are a number of relevant laws that must be followed, which can vary from location to location, at the federal, state, and local levels. Federal tax, state law, real estate, and securities laws all come into play, so it is highly advisable to work with a qualified corporate lawyer who can help ensure that your agreements comply with all current laws. Additionally, some states have rules of their own regarding deferred compensation plans, including phantom stock, and again, qualified legal help can help you navigate these issues.
Another consideration – especially if your company has multiple phantom stock plans – is to draft a phantom stock agreement that is customized to a particular plan design and that complies with your own company’s policies. In many cases, there may be features unique to certain phantom stock plans that are not applicable to other plans, and taking time to customize these agreements is well worth the effort.
Finally, just as with other types of employee contracts, when creating phantom stock plans you want to make sure that all terms are clearly defined. Avoid jargon and terms that may be confusing to employees and instead use straightforward language to clearly convey the intent of your phantom stock agreement. Consulting with legal professionals during the drafting process will allow you to clearly define terms that you need to use in your phantom stock agreement and will give you greater peace of mind knowing that your plan is in compliance with all state and federal laws.
Sample Phantom Stock Agreement Overview
This Phantom Stock Agreement ("Agreement") is entered into as of [insert date] by and between [insert name of corporation], an [insert state of incorporation] corporation (the "Company"), and [insert employee name], an individual (the "Participant"). The purpose of this Agreement is to establish a means by which employees of the Company may receive phantom stock rights that could permit the Participant to acquire cash from the Company and/or a stockholder (the "Stockholder") of the Company in connection with the consummation of a Change in Control Transaction. This Agreement is not intended to encourage employee stock ownership, but rather to provide the participant with certain special incentives.
The following terms shall have the meanings ascribed to them below: Change in Control Transaction shall mean any of the events set forth below: (a) the acquisition by any individual, entity or group (a "Person") of beneficial ownership of greater than twenty percent (20%) of the shares of the Company’s common stock or preferred stock, including the associated voting power pursuant to a stockholder vote or tender offer that (i) causes the tender offer to be accepted by holders of shares representing more than twenty percent (20%) of the voting power of the outstanding shares of the Company’s Preferred and Common Stock, and (ii) the offer is completed (regardless of the acceptance rate); (b) the sale or transfer of all or substantially all of the assets of the Company; or (c) any merger, consolidation or other business combination involving the Company. Event of Separation shall mean any reduction of the Participant’s hours of service to the Corporation, or the termination of the Participant’s service with the Corporation .
The rights and obligations of the Participants shall be determined as follows: (a) Discretion of the Board. All payments under this Agreement shall be subject to the discretion and authority of the Board, which shall follow the application of the formula set forth in the Plan. (b) Right to Terminate Participation in the Plan. The right of the Participant to participate in the Plan shall be subject to the following limitations: (1) unless otherwise provided for in a written employment agreement with the Company, the Participant’s right to participate in the Plan shall terminate upon the earlier of (i) the termination of the Participant’s employment with the Company due to an Event of Separation, or (ii) the termination of the Plan. (2) Nothing in this Plan shall confer upon the Participant any right to continue in the employ of the Company or any Subsidiary or affect the right of the Company or a Subsidiary to terminate the employment or compensation of the Participant, which shall at all times remain within the sole discretion of the Company. (3) Subject to the terms of the Plan or this Agreement, the rights of the Participant shall be subject in all respects to any Employment Agreement, Company policies or practices or regulations of the Company.
The Payment for phantom stock rights shall occur upon the earliest of the following: (a) the 30th day following the occurrence of a Change in Control Transaction that is a Stock Sale; (b) the earliest to occur of the 3rd, 5th, or 10th anniversary of the Date of Grant provided that the Participant shall have five (5) years of continuous service as an employee, director, or consultant with the Company, unless otherwise provided for in a written employment agreement with the Company.
Legal and Tax Issues
Phantom Stock Agreements can help businesses avoid the administrative cost of managing actual shareholder registries and issuing shares, but it’s important to note that this is ultimately just a performance incentive plan, and not an ownership plan. Employees and other recipients of phantom stock will have, at most, only a contractual right to damages for breach of a phantom stock agreement, to be exercised by the personal representatives of the employees’ or other recipient’s estate.
For the purposes of federal income tax, the receipt of phantom stock is treated as a non-taxable transfer because no cash or other property is actually transferred in relation to the phantom stock from the company to the employee or other phantom stock recipient, and therefore no income tax arises. A phantom stock unit does not represent ownership in the company, it is not considered to be stock in the company for any purpose, and it cannot be sold, assigned, transferred, pledged, or otherwise encumbered, and is not subject to taxes until there has been a change in ownership of the actual shares of stock of the company.
The taxation of phantom stock usually falls into one of two categories:
A formal phantom stock agreement, if properly drawn, should provide that the liability of a company to a phantom stock recipient will be based on and capped at the then-current net book value of the stock of the company at the time a payment is made, with exceptions for payments upon a termination of employment or a change in control event. Either or both these amounts can also be linked to specific market indices or other benchmarks. It is important that the phantom stock award be tied to the value of the company and not the business itself, so that the phantom stock is fairly representative of each phantom stock recipient’s true and unfettered economic interest in the company.
In the event of a change in control event or a termination of employment of a phantom stock recipient, the company may redeem the phantom stock units at their then-current net book value, or the phantom stock recipient may assert its right to redeem the phantom stock for cash on a certain date and, thereafter, redeem its phantom stock units. A change in control event means that there is a change in the control of more than 50% of the securities entitled to vote for the election of directors of the company or any controlling parent company, and a change in control event will be triggered upon the occurrence of the first such event from a specified date, i.e., the date of grant of the phantom stock award to the phantom stock recipient.
We are often asked whether phantom stock is safe. There are two perspectives to this question.
At the end of the day, what is important is that the parameters of the investment, the risks associated with the investment, and the potential upside of the investment are clearly laid out and understood by all parties. The documentation of such a program should always be formally memorialized in the form of a written agreement, and it is critical that if the plan is a complex one, implemented to meet special tax needs, a company’s own qualified tax advisor be consulted to ensure the plan is tax effective.
Phantom Stock Versus Other Equity Compensation
When comparing phantom stock agreements to other forms of equity compensation, the most obvious comparison is to stock options and restricted stock units. For the most part, phantom stock operates like stock options. A phantom stock agreement may mirror stock options to a degree by offering a right to an appreciation in the value of a specific number of shares at some later date. The similarity ends there, however, as stock options grant the option holder actual stock rights (the right to purchase the stock at a set price). Phantom stock, on the other hand, grants its right to something much more nebulous. It gives its holder the right to be paid what its share price is worth at some date in the future but does not give its holder a right to actual stock.
Restricted stock units, on the other hand, are different in that they actually result in the employee having personal rights to stock units. However, unlike stock options, restricted stock units provide compensation that is less likely to be dependent on stock market fluctuations . Restricted stock units typically vest slowly (as opposed to stock options vesting all at once), at which time the employee receives actual stock, but not the right to dividend proceeds (another factor that attracts employers to phantom stock plans).
The advantages of phantom equity over stock options and restricted stock units includes: Phantom stock may be preferable over options and units when a company wants to: At later dates when options are exercised or restricted stock units vest, however, phantom stock has some disadvantages over those alternatives. Phantom stock does not actually result in stock holdings and, thus, there may be issues with the phantom stock holder being unable to vote on matters, or be counted when calculating whether shareholder proposals get a majority of shares voted. In addition, phantom stock plans typically result in an expense deduction only when the phantom stock rights are paid out, as opposed to when rights vest. This may impact the timing of deductions for financial accounting purposes.