phantom carry private equity

Carried Interest: How It Works and What In-House Lawyers Should Know

Carried interest, or carry, has been a frequent topic in political debates. While some characterize it as a structural tool used to align the interests of private equity funds and their investors, others characterize it as a tax loophole. Regardless of which side of the debate you fall on, as an in-house lawyer you should have a general understanding of how carried interest works.

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An Overview of Private Equity Funds and Carried Interest

Carried interest allocates a portion of the future profits of a private equity fund or other investment fund to the investment professionals that source, evaluate, and manage the fund’s investments. It is intended to incentivize the investment professionals to maximize the fund’s profits and return on investment. This in turn benefits the fund’s investors.

Taking a step back, private equity funds are composed of general partners and limited partners. The general partner is an entity that is formed to make investments for the investors’ benefit. The general partner entity is usually formed as a limited partnership (LP). The limited partners are the investors.

A limited partnership agreement (LPA) governs the relationships between the general partner and the limited partners for a given investment fund. The general partner only earns carried interest to the extent it generates profits above a certain threshold. The carried interest is distributed to the fund’s investment professionals according to the terms of the LPA.

Most private equity funds retain an investment adviser or a management company in order to take care of the day-to-day responsibilities of managing the fund. An investment advisory agreement will be entered into to govern the provision of services and the payment of management fees.

Distributions

The fund’s limited partners make capital contributions to the private equity fund. This money is then deployed into investment opportunities. Upon exit from an investment, the private equity fund will distribute the net proceeds.

The manner of the distributions of the net proceeds will be outlined in the LPA. The waterfall provision is typically structured so that:

• The initial capital contributions made by the limited partners is returned to them. This return of capital is frequently accompanied by a preferred minimum return. This preferred minimum return, also known as a hurdle rate, is around 8% of the initial capital contribution.
• Following the return of the initial capital contributions to the fund’s investors, the remaining profits are allocated amongst the fund’s investors and the general partner. The general partner typically receives 20% for its carried interest.

Vesting arrangements to pay the carried interest overtime helps to align the incentives of the general partner and the fund’s investors. Vesting the carry increases the likelihood that everyone will stay motivated to maximize the fund’s profits throughout the life of the fund.

The vesting schedule usually tracks the fund’s investment period. There is typically a multi-year vesting period ranging from one to six years. Adjustments are often built into the vesting schedule to account for early departures of certain investment professionals.

Clawback Provisions

Clawback provisions protect investors in circumstances where the general partner is overpaid early in the life of the fund. This can arise in situations where the fund experiences success early on and then underperforms later on.

Carried Interest Structures

Different carry structures are deployed by different private equity funds. In the United States, the deal-by-deal carry model is the predominant structure. Private equity funds based in Europe most commonly have a whole-of-fund carry structure.

Whole-of-fund carry structures spread the carried interest across all of the private equity firm’s investments. This means that net gains and losses are calculated in the aggregate across the firm’s various investments.

In order to reward lower-level investment professionals, sometimes another type of structure called phantom carry is deployed. Phantom carry, also known as synthetic carry, is essentially a bonus pool funded from carried interest dollars tied to the fund’s performance.

Taxation of Carried Interest

Carried interest has attracted attention for its tax advantages. The carried interest granted by the general partner entity is structured as profits interests. The general partner and the investment professionals who receive income with respect to the carried interest can qualify for the long-term, capital gains tax rate. This tax rate is significantly lower than the tax rate for ordinary income.

The Tax Cuts and Jobs Act (TCJA) enacted in 2017 changed the required holding period in order to qualify for the long-term capital gains tax rate. As a result of the TCJA, the required holding period is now three years rather than just one year.

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The Many Flavors of Carry

Private equity firms with a solid track record can negotiate carry, fees, and payout arrangements that are favorable to the General Partner. Newer firms are at a slight disadvantage when negotiating compensation. As a result, management fees, carry, payment approaches, and profit calculation formulas are negotiated terms that vary from firm to firm.

As a result, there are many different carry structures of varying complexity. For example, some private equity firms determine carry on a deal-by-deal basis while others spread it across all the firm’s investments. Sometimes, carry is granted up-front for the life of the fund, other times it is granted annually. Formulas also vary on how carry might be forfeited for those who leave the firm.

Whole-of-Fund Carry

With whole-of-fund carry, the General Partner can only withdraw carry after achieving a hurdle rate on the entire capital invested and after Limited Partners have received their capital and returns. Essentially, Limited Partners have a preferred right to returns. This structure protects investors against early payments of carry on funds that ultimately do not perform to agreed hurdle rates. It also benefits fund managers by lowering tax rates on carry.

Certain countries, such as the U.K., allow a base cost shift tied to inflation that increase the cost of the asset each year and reduces base cost and tax on carry held for longer periods, as typically happens with whole-of-fund. This does not apply for the U.S. where there is no inflation-related increase in base cost.

Investments at a private equity firm are typically made by a small team of managing partners. One executive’s investments may do really well, while another’s may lag. Whole-of-fund only rewards collective success; it does not reward individual performance. Therefore, managing partners must be very comfortable with shared risk and rewards when they sign-up for whole-of-fund carry. Whole-of-fund also draws out the timeframe over which fund managers get rewarded – while this may be okay for senior executives, it may frustrate ambitious junior executives who may want faster access to cash so they can move on to better opportunities at other funds, so they can buy a house or that Ferrari the have been eyeing. Although this approach encourages fund managers to collaborate and improve overall performance, it could also foster adverse interpersonal relationships within the firm’s investment team.

Deal-by-Deal Carry

Most fund managers prefer a deal-by-deal carry arrangement where carry payments are made on each deal that meets or exceeds its performance levels, after investors are paid back their capital and returns for that specific deal. To protect investors, some firms structure deal-by-deal carry with escrow or “claw-back” arrangements. While deal-by-deal carry rewards individual investment performance and shortens pay periods, it takes away the tax benefits of whole-of-fund and has its own set of adverse and advantageous ramifications.

Deal-by-deal carry increases investor risk, for which investors demand additional reward. Therefore, deal-by-deal arrangements tend to have lower carried interest. For example, one of Europe’s top private equity firms has a deal-by-deal arrangement with only 10% carry.

Take As You Go Carry

Take-as-you-go is a hybrid compromise where payments are made to carry from the returns of a particular investment after investors have been paid their principal and hurdle on that specific deal and have been made whole on investments and preferred returns from past deals.

For example, say Deal-One resulted in a $1 million loss of investor capital but Deal-Two realized outsized gains. Because Deal-One resulted in a loss, it has no carry. Carry on Deal-Two is only paid after investors have been made whole on Deal-One (i.e. paid $1 million capital plus a preferred return) and paid capital and hurdle on Deal-Two.

Phantom Carry

Phantom carry, also called synthetic carry, is basically a bonus pool funded from carried interest dollars based on fund performance. This bonus pool is used to give lower level team members (pre- MBA junior analysts, admin staff, etc.) an incentive and an opportunity to share in the firm’s upside. Phantom carry itself comes in different flavors conjured up by the firm’s managing partners, with some guaranteeing payments while others do not, with varying tax treatments for each.

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What are Carry Benefits?

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Expertise: Asset Management | Investment Banking

The carry of any asset is the cost or benefit of owning that asset. For example oil would have a negative carry as it requires storage, but a bond would have a positive carry as it pays interest.

There are many strategies involving a carry, for example:

• A mortgage originator borrows money in the wholesale markets at a rate of 3%
• The originator then lends that money out to homeowners at a rate of 6%
• The originator has made a profit of 3% on the carry

Private Equity Carry

Currency Carry Trade

https://www.youtube.com/watch?v=8In5PK1yUAA There is also the idea of currency carry. The logic behind this concept is that one can borrow in a low yielding currency and then convert it to a higher yielding currency to earn the carry. A fantastic illustration of this is when the LTRO's were announced in Europe in late 2011 / early 2012, banks could borrow Euros from the ECB at 75 basis points (0.75%), convert the Euros to dollars and buy US Treasuries which pay 2% and, assuming the exchange rate was unchanged, earn 1.25% risk free.

This trade and idea becomes far more attractive when you consider that most currency trading is done with leverage, often at 10:1. For example, a trader in Frankfurt working for Deutsche Bank could have borrowed €1,000,000 from the ECB, leveraged it through money markets at 10x to €10,000,000, converted it to dollars approximately $13,500,000 (EURUSD at the time was roughly 1.35) and then bought US Treasuries for a yield of 2%. Every year the trader would be making $270,000 (€200,000) on the US Treasuries while only having to pay $10,500 (€7,500) in interest to the ECB. This gives a return of 19.25% (ignoring the money-market rate required to leverage up 10x).

In reality however, exchange rates do change and in the example above, the banks borrowing from the ECB under the LTRO would have made even more through currency carry as the Euro fell drastically against the dollar in mid-2012 so clearly there is more to the trade than just looking at borrowing and investing rates in different currencies.

Carry is NOT the same as arbitrage, because the investor can lose money if the prices of the asset change against them.

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What are the Advantages and Disadvantages of a Phantom Equity Plan?

I was recently asked to describe the advantages and disadvantages of a phantom equity plan.

Phantom equity plans are particularly useful for private companies without publicly traded shares of stock.  Privately held companies have unique organizational traits that require a substantially different approach to executive compensation. Often, executive compensation arrangements that are appropriate in a publicly traded organization (i.e., incentive stock options) are not appropriate in privately held companies. Phantom equity plans are one of the most frequently used long-term incentives in privately held companies. Generally, a phantom equity plan grants rights to receive the value of the appreciation in a specified number of company shares. Phantom shares are typically stand-alone rights granted to executives and are not granted in tandem with stock options.

What is a privately held company?

A privately held company is a company that does not have equity securities registered under the Securities Exchange Act of 1934.  Phantom stock plans used by privately held companies can be exactly like those used by publicly traded companies, except that executives are only able sell their shares back to the company.

What is the tax treatment of a phantom equity plan?

There is no taxation upon the grant of phantom stock because the executive is not in constructive receipt of any value at that time.  Upon exercise of phantom equity, the executive recognizes ordinary income equal to the value of the phantom equity at exercise minus the value of the phantom equity at grant.  Any phantom equity appreciation payment is subject to federal and state income tax withholding.  For the company, a phantom equity appreciation payment is a compensation deduction from its computation of taxable income.

What are the advantages and disadvantages of a phantom equity plan?

One disadvantage of a phantom equity plan for a company is that phantom equity is a costly form of long-term incentive in that it requires a charge against the company’s income statement and is potentially an “uncapped liability” to the company.  For executives, phantom stock rights do not represent a true ownership position in privately held companies that do not have publicly traded shares.  Additionally, phantom equity shares do not carry voting rights or similar rights associated with stock ownership.

An advantage of a phantom equity plan is that, for a company with significant growth in net worth potential, a phantom equity plan provides a cashless alternative for receiving income as the phantom share appreciates in value.  Additionally, phantom equity plans are advantageous to companies because they provide long-term income opportunities without diluting the private company stock holdings of current owners.

Hall Benefits Law, LLC recommends that you consult ERISA legal counsel (i) to assist in determining whether a phantom equity plan is the appropriate executive compensation plan for your company and (ii) to assist with drafting, implementation and administration of a phantom equity plan that complies with all necessary legal requirements.

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9 frequently asked questions about phantom stock plans

How to pay incentive compensation based on company value.

This article was originally published on Oct. 12, 2020 and has been updated

Phantom stock plans can be a valuable method for companies that seek to tie incentive compensation to increases or decreases in company value without awarding actual shares of company stock.  Here are answers to nine frequently asked questions about phantom stock plans and what they could mean for your company.

1. What is a phantom stock plan?

A phantom stock plan is a deferred compensation plan that awards the employee a unit measured by the value of a share of a company’s common stock, or, in the case of a limited liability company, by the value of an LLC unit.

However, unlike actual stock, the award does not confer equity ownership in the company. In other words, no actual stock is ever awarded to the employee under a phantom stock plan. Instead, the employee is granted a number of phantom stock units, and the plan provides that each phantom stock unit is equal in value to one share of common stock.

2. Why might a company want to issue phantom equity instead of actual equity?

Phantom equity does not have some of the drawbacks associated with providing actual equity. Situations in which a company may not want to issue  actual equity  include:

• A foreign parent may wish to award phantom stock units to executive employees of a U.S. subsidiary to avoid the complications of selling stock on a foreign exchange.
• A U.S. parent may wish to incentivize executive employees of a subsidiary without awarding shares of parent stock to tie their incentive to the subsidiary level value rather than the parent level.
• Equity grants may give rise to voting rights or unforeseen minority rights under state law.
• Additional legal documents and agreements, such as a shareholder’s agreement, may have to be amended or drafted, increasing complexity and legal fees.
• A company may wish that former employees do not own company stock after they separate from service.

3. How does a phantom stock plan work?

A company can grant an employee a designated number of phantom stock units or a percentage interest in the company’s value pursuant to a prescribed valuation method; this can be done once or multiple times. The phantom stock plan should indicate the number of phantom stock units or the participation percentage interest to be granted to the employee.

For example, the company could grant the employee a 5% interest initially and increase the interest to 10% after the employee completes five years of service.

Whether granted up front or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule determined by the company. For example, vesting may be cliff or graded, time-based, or based on the achievement of specified financial performance goals. 

In addition, special forfeiture provisions can be included in the phantom stock plan to eliminate the company’s obligation to make payments to an executive upon specified events (e.g., if the employee breaches non-compete restrictions in the plan or the employee’s employment is terminated for cause). 

4. How is the value of a phantom stock unit determined?

The value of a phantom stock unit may be measured by the value of a full share of company stock, or it may be based just on the appreciation in value during a specified time frame. (If based only on the appreciation, this is commonly referred to as a stock appreciation right.) The value may be a specified value, determined by an express written formula or determined by a third-party appraisal.

The method used for valuation should take into account adjustments that the parties agree are appropriate. For example, a company could exclude gain or loss attributable to operations or sales of certain divisions of the company. Other adjustments that might be considered include subtractions for capital investments made by the shareholders during the course of the plan, additions for any dividends paid to shareholders during this period, and the amount of accrued deferred compensation attributable to the phantom stock units themselves.

It should be noted that the value of the phantom stock units fluctuates from year to year as the value of the company changes. For example, if the company has a bad year and the value of its stock decreases, the value of the phantom stock also decreases. Thus, regardless of any vesting schedule, there is no locked-in value inherent in the phantom stock. 

In addition, companies should be aware that events outside the company’s control also affect its value if a third-party appraisal is used. For example, legislative increases or decreases in corporate tax rates may result in companies having more or less cash flow, accordingly (with all else being equal). Similarly, a major event like the coronavirus pandemic affects market values for many companies. Companies should consider the possibility of such unexpected fluctuations in value, regardless of whether it relies on a third-party valuation.

The phantom stock plan should specify what events should trigger, or give rise to, a valuation (i.e., what events should entitle the employee to receive benefits under the plan) and at what precise point the value of the phantom stock units should be determined.

Typically, the valuation will follow an event that triggers phantom stock unit payouts so that the amount of such payouts can be determined. Companies can choose what the triggers are—examples include a separation from service, a change in control, or a specified future date or fixed payment schedule. In most cases, a valuation is required upon the employee’s termination, death, or disability. In other cases, valuation may be required periodically, such as annually, or on a specific future date.

To the extent possible, any date specified for measuring the value at a triggering event should be based on practicalities consistent with the company’s business practices. For example, once a triggering event has been identified, the company should consider whether the value should be determined on the exact date of the triggering event; or whether it makes more sense to look forward or back to the nearest quarter or year-end, depending on what financial information may be needed to calculate value.

5. How does the executive receive value from the phantom stock?

The number of phantom stock units, vesting schedule, form of payment (i.e., lump sum or installments over a period of years), and triggering payment events are typically set forth in individual grant agreements. Actual payouts of the phantom stock units are usually deferred until a predetermined future date or until the employment relationship is terminated due to retirement, death, or disability.

The phantom stock plan must specify when the phantom stock unit payments should commence and at what point a valuation of the units is generally required, as described above. If payments are to be made in installments, the phantom stock unit plan or grant agreement should also specify whether interest will accrue on the unpaid installments.

When designing these provisions, the company should take into account possible phantom stock valuations and company cash flow. It should be noted that even if payments are made after the grantee terminates service, the nature of the payment is generally still treated as compensation for tax purposes and reported on Form W-2.

6. How is phantom stock treated for income tax purposes?

Phantom stock plans are deferred compensation plans and, as such, must be designed and documented to conform to the requirements of section 409A. For income tax purposes, if the plan is compliant with section 409A, the deferred compensation attributable to the phantom stock will not be subject to income taxation to the employee until it is actually paid to and received by, the employee.

At the time the payment becomes taxable, the company is entitled to a deduction in a corresponding amount (subject to general limitations under section 162 with respect to the amount being reasonable and not excessive). However, unlike actual stock for which the increase in value on a disposition may be eligible for favorable capital gains tax rates, phantom stock unit payouts are taxable to the employee at ordinary income tax rates.

To ensure these tax results occur, companies should ensure that the terms of the phantom stock plan are in compliance with section 409A prior to the plan becoming effective. A violation of the section 409A rules could cause immediate taxation, plus an additional 20% tax, as well as the assessment of penalties all prior to any actual receipt by the employee.

7. What are the payroll tax consequences of phantom stock?

For the Federal Insurance Contributions Act (FICA), deferred compensation is includible as wages in the later of either the year in which the related services are performed, or the year in which the deferred compensation becomes vested.

The vesting and forfeiture provisions contained in the phantom stock plan or individual grant agreement determine whether and when the executive’s rights are vested. As the phantom stock units become vested, the value of the phantom stock units is includible as wages subject to FICA taxes. This is the case even though the amounts are not subject to income tax until actually paid to the employee.

If the employee’s base pay (before adding in the phantom stock unit payment) exceeds the Social Security wage base, no additional Social Security tax would be assessed on the phantom stock payments. However, the company and the employee would each be subject to Medicare payroll tax since the Medicare tax is imposed on total wages, without any wage cap.

8. Can entities taxed as partnerships use phantom stock?

Although partnerships do not have common stock, as noted above, entities taxed as partnerships, including LLCs, can implement plans very similar to phantom stock plans. In the case of a partnership, however, the value of a phantom stock unit is tied to partnership equity value rather than common stock value. All other aspects of the plan would be the same. Because the phantom stock units are not actual equity in the partnership, such a plan should not raise any concerns over partners being considered employees.

9. What should a company consider when designing a phantom stock plan?

Because a phantom stock plan is a nonqualified deferred compensation plan, companies have a lot of flexibility in plan design as long as that flexibility is exercised before the plan becomes effective.

Companies should address the following when formulating aspects of the written plan:

• What are the objectives of the plan?
• What behavior or performance levels is the company trying to incentivize?
• Who will be allowed to participate? (Consider current and future positions)
• What percentage of the company’s value should be dedicated or reserved for this plan?
• Should participants receive the base value of the phantom stock units, or only participate in growth over and above the base value?
• Is the potential payment opportunity under the phantom stock plan in line with the company’s compensation and business objectives in three, five, 10, or 15 years given certain performance assumptions?
• How frequently will phantom stock units be granted (e.g., a single upfront grant or annual grants)?
• When will phantom stock units vest? If phantom stock units are awarded annually, will each new grant be subject to a fresh vesting schedule?
• How will the phantom stock units be valued (i.e., based on a formula or an appraisal)?
• How will the phantom stock units be valued in the event of a merger, consolidation, or a change in control of the company? How should a change in control be defined?
• Will special vesting rules apply in the case of death, disability, or attainment of specified normal retirement age?
• Will any funding mechanism be used to help the company meet “fund” its future obligations to pay the amount owed to recipients?
• Should forfeiture provisions apply if the employee enters into competition with the company or is terminated for cause? How broadly or narrowly should the plan define what qualifies as cause for termination?
• When should the value of the phantom stock units be paid out in cash (e.g., periodically every three to five years, upon termination of employment, only upon a future change in control, or, perhaps, other events)?
• Should the payment be made in a lump sum or in installments over a period of years? If payments should be made in installments, over how many years?
• During the installment payout period, should earnings be credited on the balance at a specified interest rate? If so, at what rate? Should the phantom stock units pending payment continue to participate in the growth in value of the company?
• Does the phantom stock plan comply with section 409A?  The plan must be designed and documented to conform to section 409A. This may restrict some of the flexibility of the plan design.

Various equity compensation methods, including phantom stock units, can provide great incentive to the employees receiving them and the employer providing them by cultivating increased engagement that can boost company performance. The attributes of phantom stock units should be carefully considered to determine whether it is the  right incentive plan  to meet a company’s needs.

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Carried Interest Calculator

What is carried interest the carried interest definition, how to calculate the carried interest the carried interest calculator, what is the carried interest loophole.

With this carried interest calculator, we aim to help you to calculate the carry distribution and carried interest of an investment fund . The carried interest is the share of the profit that investors pay to their portfolio manager. Hence, it is essential to understand the carried interest calculation.

We have prepared this document to help you understand what carried interest is and how to calculate carried interest . Besides, we will also explain the definition of the carried interest tax loophole.

Carried interest is the share of an investment fund's profits that is used to pay the general partners or portfolio managers . The carried interest can also be seen as the performance fees of the investment fund.

Most investment funds charge annual fees that help the fund cover its operational expenses. The carried interest, on the other hand, acts as the primary source of income of the portfolio managers . Because the better the fund performs, the higher the carry distributions, the carried interest also acts as the tool to align the interests of the investors and the portfolio managers . You can look at our investment calculator to understand more about this.

Now, let's look at how carried interest works in practice.

To understand how to calculate carried interest, let's take Fund Alpha as an example. It has the following information:

• Initial fund value: $10,000,000 ;
• Final fund value: $20,000,000 ;
• Hold period: 5 years ;
• Hurdle rate: 5% ; and
• Carried interest: 20% .

The carried interest calculator is based on 4 steps:

Calculate the fund return

The fund return is the performance of the investment fund. We can calculate fund return using the formula below:

fund return = final fund value / initial fund value - 1

For our carried interest example, the fund return is equivalent to $20,000,000 / $10,000,000 - 1 = 100% . You can also calculate this using our rate of return calculator .

Determine the hurdle rate

The hurdle rate is the minimum fund return that an investment fund must achieve to receive its carry distribution. The hurdle rate for Fund Alpha is 5% .

Determine the carried interest

The carried interest is the percentage of the total fund return that the investment fund claims as its performance fee. The carried interest for Fund Alpha is 20% .

Determine the hold period

The hold period is how long the fund is going to last. In our example, the hold period is 5 years . You can use time duration calculator to speed up this calculation.

Calculate the carried interest and carry distribution

The last step is to calculate the carry distribution using the formula below:

carry distribution = (final fund value - initial fund value * (1 + hurdle rate) ^ hold period) * carried interest

If the carry distribution is negative, the investment fund performance is lower than the hurdle rate and so the portfolio managers will not get any carry distributions.

The carry distribution for Fund Alpha is ($20,000,000 - $10,000,000 * (1 + 5%) ^ 5) * 20% = $1,447,436.87 .

That ends our carried interest example of Fund Alpha. You should now be able to answer the question " How does carried interest work? ". If you need to make more quick and reliable estimations, you can always use our carried interest calculator.

For advanced option, you can also choose to have the GP catch-up option turned on. Once the fund's return surpasses the hurdle rate, the GP catch-up provision allows the general partner to receive a greater share of the profits until they "catch up" to a predetermined percentage.

The carried interest loophole definition, also known as the carried interest tax loophole, says that it's a regulation that allows the portfolio managers to treat the carry distributions they earn as capital gains instead of income .

This means that the portfolio managers only need to pay the capital gains tax on their carry distribution, which is usually much lower than income tax.

It is important to note that this calculator only focuses on one type of carry allocation, which is the European method. This means the general partner receives a percentage of the profits after the investors have received a preferred return on their investment. There are various other carry allocation methods out there such as the American method and the whole-fund method.

What is a private equity?

Private equity is described as an investment that invests only in companies that are not listed in the stock market. It is considered as an alternative investment.

What is a hedge fund?

Hedge funds are investment pools that are actively managed by portfolio managers . They use complex strategies and aim to achieve returns that are higher than the market.

Will there be carry distributions if the fund return is lower than the hurdle rate?

No , if the fund return is lower than the hurdle rate, there will not be any carry distributions. It happens when calculated carry distributions are negative.

How do I start investing actively?

To achieve success by investing actively, you need to:

• Make sure you have the time to monitor the market constantly.
• Make sure you have the relevant knowledge and skills to invest.
• Lastly, make sure you are enjoying it!

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Phantom Stock Plan: What It Is, How It Works, 2 Types

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

Investopedia / Jessica Olah

What Is a Phantom Stock Plan?

A phantom stock plan is an employee benefit plan that gives selected employees (senior management) many of the benefits of stock ownership without actually giving them any company stock. This type of plan is sometimes referred to as shadow stock.

Rather than getting physical stock, the employee receives mock stock. Even though it's not real, the phantom stock follows the price movement of the company's actual stock, paying out any resulting profits.

Key Takeaways

• A phantom stock plan, or 'shadow stock' is a form of compensation offered to upper management that confers the benefits of owning company stock without the actual ownership or transfer of any shares.
• By simulating stock ownership, without actually providing it, management ensures that equity does not become diluted for other shareholders.
• Large cash payments to employees, however, must be taxed as ordinary income rather than capital gains to the recipient and may disrupt the firm's cash flow in some cases. 

How Phantom Stock Plans Work

There are two main types of phantom stock plans. "Appreciation only" plans do not include the value of the actual underlying shares themselves, and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted. "Full value" plans pay both the value of the underlying stock as well as any appreciation.

Both types of plans resemble traditional nonqualified plans in many respects, as they can be discriminatory in nature and are also typically subject to a substantial risk of  forfeiture  that ends when the benefit is actually paid to the employee, at which time the employee recognizes income for the amount paid and the employer can take a  deduction .

Phantom stock may be hypothetical, however, it still can pay out dividends and it experiences price changes just like its real counterpart. After a period of time, the cash value of the phantom stock is distributed to the participating employees.

Phantom stock, also known as synthetic equity, has no inherent requirements or restrictions regarding its use, allowing the organization to use it however it chooses. Phantom stock can also be changed at the leadership's discretion.

Phantom stock qualifies as a deferred compensation plan. A phantom stock program must meet the requirements set forth by the Internal Revenue Service (IRS) code 409(a). The plan must be properly vetted by an attorney, with all of the pertinent details specified in writing.

Phantom stock plans have a lot in common with traditional nonqualified stock plans.

Using Phantom Stock as an Organizational Benefit

Some organizations may use phantom stock as an incentive to upper management. Phantom stock ties a financial gain directly to a company performance metric. It can also be used selectively as a reward or a bonus to employees who meet certain criteria. Phantom stock can be provided to every employee, either across the board or distributed variably depending on performance, seniority, or other factors.

Phantom stock also provides organizations with certain restrictions in place to provide incentives tied to stock value. This can apply to a limited liability corporation (LLC) , a sole proprietor or S-companies restricted by the 100-owner rule.

The two types of phantom stock plans are "appreciation only," which doesn't include the value of the underlying shares, just the increase in stock over the amount of time the shares are held; and "full value," which pays the underlying value and the amount the stock increased while it was held.

Stock Appreciation Rights

Stock appreciation rights (SARs) are similar to a phantom stock-based program. SARs are a form of bonus compensation given to employees that is equal to the appreciation of company stock over an established time period. Similar to  employee stock options (ESO) , SARs are beneficial to the employee when company stock prices rise; the difference with SARs is that employees do not have to pay the  exercise price , but receive the sum of the increase in stock or cash.

Most commonly made available to upper management, SARs can function as part of a retirement plan. It provides increased incentives as the value of the company increases. This can also help ensure employee retention, especially in times of internal volatility, such as an ownership change or a personal emergency.

It provides a level of reassurance to employees since phantom stock programs are generally backed in cash. This can, in turn, result in higher selling prices for a business if a prospective buyer perceives the upper management team as being stable.

Internal Revenue Service. " Publication 5528 (6-2021): Nonqualified Deferred Compensation Audit Technique Guide ."

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Phantom Stock

The ideal plan for growing private companies.

“I have a key employee who’s asking for some stock in the company or else he may move on—should I give it to him?” This is a question with which many owners of closely held businesses wrestle. It is multi-layered in its implications; however, the answer is really pretty simple: “No. But you should be glad he’s asking for it! This is a great opportunity.”

The question the key employee poses reveals both good news and bad news to an owner. The good news? One of the talented producers in the company recognizes that the business has a compelling and profitable future. He believes in the future so much that he wants a piece of it. And he’s confident enough to believe he deserves it. This is why the question represents such a great opportunity. The bad news? Sharing equity in a private company is a pain. And it’s often one of the most inefficient ways to share value—from both the owner’s and employee’s perspective.

The scenario is understandable. Top performers expect to be paid well; and if they help create economic value, they deserve some of what they’ve created.

Instinctively, owners assume that employees with equity will be better employees. If employees have stock perhaps they will think and behave like owners. Maybe they will have greater incentive to manage expenses, service customers, innovate, work hard and even invest their own money in the business.

These are correct instincts and reactions. It’s obviously desirable to engender an ownership stake, or at least an ownership mentality, among employees. However, the means to achieving those attractive outcomes shouldn’t create more problems than it solves, and too often that’s what happens when closely held business owners go down the path of equity sharing.

Why Not Stock or Options?

Granting stock or even stock options will not usually address all of the issues a business owner needs to consider when creating a value sharing arrangement for key contributors. Here’s why.

Let’s take a look at three different ways to get stock into the hands of Sally, the leader of your national sales team, and the potential consequences of each approach.

• You can simply give Sally some stock. More formally, this is called a Restricted Stock Grant (or one of its variations). Congratulations, you have a new partner-shareholder. She’ll be entitled to take a look at the books. She may want to discuss the new compensation program—hers and yours! She’ll be entitled to her share of profit distributions. And so on. You get the idea. Of course, you’ll control the majority of the shares and the final decisions. But the nuisance factor may become intense. If you’re lucky, Sally won’t be interested in those details. She’ll trust you and be truly grateful for the award—so she won’t want to cause problems. That’s good. But we have to consider the tax consequences. Your award of stock to Sally results in an immediate tax cost for her. Let’s say your accountant tells you your stock is worth $10 per share. If you give her 5,000 shares that’s $50,000 of value. Sally will need to pay taxes on that value. As far as the IRS is concerned, it’s as if you gave her $50,000 of cash. Now, assuming you placed restrictions (like a vesting schedule) on the shares (which you should do), she could defer the income taxes until she vests. In that case, however, if your share price goes up (which you’re both hoping for) she’ll wind up paying taxes on the higher amount. Sally will love the idea of getting stock, but she may not love the idea of coming up with the money to pay the taxes. There are more potential problems ahead. What if things don’t work out with Sally? If you let her go (or if she chooses to move on) what will become of her shares? Will you buy them back? Or will she just retain them? You’ll really like the latter solution when you discover that Sally went to work for a competitor. By the way, if you do buy them back how will the value be determined? And don’t expect a tax deduction for the redemption. You’ll buy them back with after-tax dollars. There’s more, but the point’s made. Making employees shareholders opens up a Pandora’s Box of potential headaches.
• Sally could buy Now she’s putting her own money into the deal. Investing her own capital will tie Sally more closely to the success of the company. Hopefully so. It’s not the worst of ideas. But, you still have many of the same problems described above. The open books. The discussion about your compensation. The little chat about the size of dividends. Redemption issues. Buy-and-sell agreements. Termination-of-employment loose ends. And does Sally even have the cash to buy in? If she was going to be concerned about the taxes on a grant, how is she going to come up with the full amount needed to purchase the shares? Maybe you’ll consider lending her the money. Think about that one. You’ll loan her the money that she can give back to you (to buy the stock) so that you can have all the headaches described above? Some employers envision allowing her to use her share of company dividends to repay the loan. How is this any different than giving her stock in the first place—you’re paying yourself back for helping her buy some of your stock by reducing the dividends you would otherwise have been entitled to? That’s quite a partnership!
• Public companies use stock options . Why shouldn’t you? This would enable Sally to acquire some stock at a fair price and get capital gain taxation if you sell the company some day. Maybe. Maybe not. First of all we still have a cash-flow concern. Sally will need to come up with enough cash to exercise her option after the vesting period has passed. Let’s say the stock is worth $10 today (same as above) and you give her 5,000 options to buy the stock at that price. Her three-year vesting period passes and Sally scrapes together the $50,000 to exercise her options. Let’s assume the company share price has grown to $18 in the meantime. She now has $40,000 of new equity value (($18-$10) X 5,000). There are two different types of options—nonqualified and qualified (or incentive). There’s not enough space here to cover the differences in taxes except to say that incentive options, generally, produce a better tax result for Sally and a worse tax result for you. Meanwhile, Sally may now be in a position for capital gain taxation under a future transaction (i.e., sale of the company or IPO) assuming the event occurs at least a year from the date of the exercise of the options. However, what if neither event ever occurs? You’re back to our original problems of redemptions, dividends, etc. Typically, closely-held businesses seldom produce the “future transaction” that the employee was relying upon. As a result the majority owner and the owner-employee face the grind of negotiating a “fair” price for the stock at the time of a future separation of service. How well do you think you’ll enjoy that future conversation with Sally’s attorney?

The bottom line: the financial results of stock or stock option awards can appear to justify the effort—under the perfect circumstances. But reality is never as simple as you expect it to be. The majority of private company owners will regret the move to stock awards for employees. The perceived value of employee ownership is, nine times out of ten, not nearly worth the price. [1]

[1]  The author acknowledges the primary exception to the rule: if your company is on a clear path to an IPO, stock options offer an excellent and efficient way to reward employees.

The Better Approach

Each of the ideas for Sally outlined above has merit. Granting stock is relatively simple and clear-cut. It provides instant recognition and value. It’s great, particularly, for someone who’s been with you for awhile and has made a contribution to your past success. But, the concept carries the baggage described above.

Having Sally buy stock also is intriguing. It deepens her commitment and aligns her with both short-term and long-term goals of the company. But again, there’s baggage.

Stock options are attractive because they’re win-win. Sally only wins if shareholders see their stock value go up. Sally is tied to future growth of the company. But, again, the baggage issue looms large.

What if we could replicate any or all of these approaches without making Sally an actual owner? Is it possible to generate the ownership value and mentality without the baggage? In a word, yes. We can do it with phantom stock.

Phantom Stock Defined

A phantom stock plan is a contractual agreement wherein a company promises to make cash payments to employees upon the achievement of certain conditions. What’s the purpose? Just as with stock awards, the purpose of a phantom stock plan is to generate an ownership mentality and reward key employees for helping to grow the business value.

However, phantom stock has one big advantage—there is no sharing of actual equity with the employees. No requirement to open the books. No ownership rights. No need to pay dividends (although some plans do). The existing owners stay in control of 100% of the stock or interest in the company.

At the same time, phantom stock can create comparable or even identical value as actual stock. Here are the key things that happen when you create a plan on behalf of employees.

• First, you must establish a way to value the phantom shares. In essence, you’re trying to identify the value of the company. You can obtain a formal appraisal or you can establish the value by a formula. The latter will work best in most situations. Perhaps the formula will reflect a multiple of EBITDA or Net Income. Any reasonable formula can work. To be safe, use a formula that is going to be less than the actual fair market value you might sell the company for some day. You don’t want the employees’ phantom shares to be valued higher than your own.
• Full value grant . We could give Sally some shares that are valued, in full, at $10 per unit. We’re going to specify some conditions and restrictions (see #4 below). Nonetheless, we’re committing the full $10 in value times the number of shares we decide to give her. If we give her 5,000 shares she’ll start with a true value of $50,000 (subject to vesting and other restrictions). At some future date she’ll redeem those awards for real cash. Assuming EBITDA grows to $18,000,000 on her redemption date, Sally will receive a check for $90,000. What about Sally’s taxes? Well, remember that with actual stock awards Sally would pay taxes when she received the grant or when the vesting lapsed. With phantom awards, Sally pays no taxes until she actually receives her award value (e.g., the $90k). In this way, she never has to pay income taxes until she’s in receipt of the actual cash. It’s true that had she received actual stock (and paid the taxes up front) she might have saved some taxes in the long run. However, with phantom stock your tax deduction (i.e., the company’s) is higher than it would have been with actual stock. In the first case (actual stock), your deduction was for $50,000, thus a tax benefit of $20,000 (assuming 40% bracket). With the phantom stock example, you get to deduct the full $90,000, resulting in a tax benefit of $36,000. If you’re feeling guilty about Sally’s taxes go ahead and give her more shares, enough to result in your “after-tax cost” being the same.
• Sell phantom shares . This is commonly referred to as a Deferred Stock Unit plan—a form of deferred compensation. Here’s how it would work. Sally would be given the opportunity to defer some of her cash compensation (e.g., salary or bonus) into units of phantom stock. Said differently, Sally would “convert” some of her future pay to phantom stock. An example: Assume Sally makes $200,000 in annual salary. She might defer up to 25% (let’s say) of her salary into the plan. Assuming she does so she would acquire a deferred compensation interest that would have $50,000 worth of starting value. In other words, she would have 5,000 units of phantom stock (at $10/share) credited to her deferred comp account. Technically, you’re not selling shares to her. She’s not acquiring an ownership right in exchange for writing you a check. She’s deferring some of her income into an unsecured account that is measured by the growth of the phantom share price. But it has the same essential effect as selling Sally phantom shares. She is voluntarily foregoing wages in order to ‘invest’ in the company ! That’s a pretty serious commitment. Plus, it’s much better for Sally tax-wise than buying actual stock. Why? Because she gets to do it with pre-tax dollars . Tax-wise for you it’s not perfect, but it’s not so bad. You (or the company) will forego the current tax deduction on the income Sally chooses to defer. However, it’s a delayed deduction, not a lost deduction. Instead, of getting the deduction today of $50,000 (wages) you’ll get the future deduction on $90,000 (assuming our EBITDA growth example given above).
• Phantom Stock Options . This one is a favorite of many private business owners. Stock options (real ones) are attractive because they’re “win-win.” Employees only win if the other shareholders win (by seeing their stock price go up by a value that exceeds the amount by which they were diluted). In a public company environment there are markets that help to handle the exercise of the option. However, in a private company no such market exists. Instead, the employee and the company sponsor have to work out the cash flow mechanics of the exercise. And there’s no “cashless exercise” arrangement that permits the employee to get a reduced number of shares by surrendering a portion of his options to cover the strike price. So let’s use phantom options. Easy. Recall that phantom stock is a cash compensation arrangement. Assume we give Sally 5,000 phantom options with a starting value of $10. What will she really have at that point? Nothing—because the options must go up in value before she realizes any gain. But later, when the phantom share price reaches $18 and it’s time for redemption, Sally is simply handed a check for $40,000 (($18-$10) X 5000). No muss, no fuss. Sally doesn’t need to scrape together the $50,000 to exercise the options. She simply receives a nice payment that reflects a reward for her contribution to growth in company EBITDA.  Sally has tight alignment with the shareholders without the pain and complication of dealing with a stock transaction. (And you have a happy employee without the headaches of another shareholder.) By the way, what’s described here as a phantom stock option is also known as a Stock Appreciation Rights. However, some find the term phantom stock option more appealing and descriptive.
• So you’ve selected a plan type for Sally—full value grants, deferred stock units, or phantom stock options. Or maybe you’ve done a combination of two or more—which may be the right thing for your company. What’s next? Now you need to fine tune the plan provisions. Select a vesting schedule for full value and option awards. Determine the year in which they’ll be paid out. (It doesn’t necessarily have to coincide with the vesting period.) And over what period of time do you want to pay them out? In a lump sum? Or over 3 or 4 or 5 years? Then there are possible scenarios to define and refine: change-in-control, separation of service, disability of a participant, death, termination (for cause or not for cause), and so forth. The plan will need to be pulled together into a document that outlines what will occur under each of these circumstances. You’re going to want some help with these issues. Seek advice from someone who’s had experience dealing with these plans. He or she can help you see the pros and cons of these important decisions.
• The last thing to do (other than actually enrolling Sally in the plan) is to determine how many shares you’re going to give her. (We’re assuming, at this point, you’re doing full value shares or phantom options.) We mentioned earlier that the number of shares you establish in the plan wasn’t crucial…at least then. Now it becomes important. You don’t want to award too few, or too many. So how do you decide? It’s best not to get hung up on the number of shares you award. Focus instead on the potential future value of the shares as a percentage of the growth in the company. This will usually require some spreadsheet modeling. First, project the possible future value of the company over some period of time, given your favorite growth assumptions. Now carve out a percentage (start with 15%) of the growth (not the total value) that you’d consider sharing with your leaders. Then, allocate that to the positions or people you’d consider for participation. Now, calculate the number of grants that will produce the targeted values. In other words, the number of grants is simply a device for generating the dollar value you feel is appropriate for the people who are helping you build the company. This approach to grants achieves the following results:
• Guidelines for grants are established within a pre-approved budget, thus simplifying the annual award process;
• Shareholders are assured that value dilution is being managed within reasonable limits;
• Employees can receive a forecast of value that demonstrates potential personal earnings tied to company growth.

Best Practices

As with any rewards strategy, there are plans that work well and others that fail.  To ensure your approach to Phantom Stock has a greater chance of success, here are some “do’s and don’ts” to consider.

• Don’t do one-time grants. Schedule and award grants annually. Make each grant a celebration. One-time grants always lead to regrets (e.g., “I shouldn’t have given him so many.”)
• If you’re not sure which type to use, go with phantom options. There’s less risk. No increase in value results in no payments to employees. Even if your share price goes down in some years employees can still come out ok (as long as you’re doing annual grants—see #1).
• That said, consider some full value grants for the key long-term employees who’ve been with you “through thick-and-thin.” This will give them some starting credit for prior contributions. Perhaps you’ll just do this in the first plan year, and then include them in your annual option awards. (This could be done for as few as one employee.)
• Start with a small group and expand participation as time goes by. It’s always easier to add participants than to subtract.
• Schedule payouts every five to six years. (Sooner is ok, but longer is not.) Unlike regular stock options and restricted stock, employees cannot (with some exceptions) choose when they’ll “exercise” or “redeem” their shares. You, the plan sponsor, decide. The temptation will be to push the payment date out too long. This has two negative results: (a) the value may compound for a long time resulting in very large payouts, and (b) employees will have no way to access their money unless they quit—not the ideal scenario.
• Don’t make your formula (for share price calculation) too complicated. We’ve seen plans where the company officers don’t even understand the formula (or can’t remember why some things were included). Keep it simple. “Hey gang, if we grow profits we all make money!”
• Don’t ignore the rules. Most phantom stock plans will be subject to ERISA (the Fed’s 1974 rules on pensions) and Internal Revenue Code Section 409A. Sorry. There are rules. Fail to know and follow them at your own peril. 
• Don’t try this at home. Get advice. It’s risky to decide upon the best choices for a phantom stock plan without the guidance of someone who’s done it before, a lot. You may intend to give away 10% of the growth of your company to your employees and you wind up giving away 30% via bad design and operation. This is important. Get help.
• That said, don’t use your attorney as your principal advisor. Your lawyer will be needed in the process—towards the end—to make sure the documents are in order. But, your attorney will not be experienced at the realities of plan operation. Find someone who’s lived with, slept with and eaten with phantom stock over the years. Let them put the structure on your important decisions. Then use your attorney to “cross the t’s and dot the i’s.”
• Manage the plan effectively. Don’t start the plan and forget about it. Keep it fresh. Be flexible. Communicate it. Give the employees statements that show their value. This is a big investment. Use it wisely.

Final Thoughts

This article has been an introduction to the processes you can follow to properly structure a phantom stock plan. Hopefully you’ve learned something of value. These plans can be, without a doubt, one of the most important steps you ever take in assembling the team of people who will take your company to new heights. However, there’s something more important that getting the right structure. You need to create the right mindset.

If you create a “perfect” plan but don’t establish the right mindset your plan will flop. You’ll wonder what went wrong with the plan. But it won’t be the plan’s fault. It will be yours. Ultimately, it’s your job to see that the employees not only understand the plan but that they are inspired by it.

Mindset relates to the perception of the plan in the minds of participants. When you make Sally a participant in this plan she should feel like she was just made a partner in the company. She should understand that her financial future is tied to yours (and vice versa). She should realize that you trust her to help produce the results that will create value for both of you.

Always position the plan in a positive light. Explore and discover ways to make your plan one of the highlights of your relationship with your key people. You’re investing in them. Make sure they know how much you value their efforts and how much you trust them to generate great results. Your phantom stock plan is a symbol of your commitment to a partnership relationship. They aren’t getting actual stock but they don’t really want those headaches anyway. They want to know that they have a chance to participate in the value they help create. A phantom stock plan, properly designed, can do just that because it sends the right message about the future:

We’re building a great company.

We’ve got the right people.

We’re united as partners in our financial success.

Let’s go make it happen.

Are You Ready for a Plan? If you lead a business and are struggling with developing an effective long-term compensation approach, it might be the right time to have a conversation with a VisionLink consultant.  To speak with one of our experts about the rewards issues you are facing, call us at 1-888-703-0080. 

About the Author Tom Miller President, The VisionLink Advisory Group Tom Miller is the founder and president of The VisionLink Advisory Group. He has been consulting with businesses for over 39 years on a range of compensation and executive benefit issues. Tom is a frequent speaker with business groups throughout the country and has authored numerous articles on topics related to compensation, benefits and related issues. He is VisionLink’s chief strategist and innovator. An inveterate entrepreneur, Tom has founded and operated two compensation consulting businesses as well as a benefits administration company and a registered investment advisory firm. His current company, The VisionLink Advisory Group (“VisionLink”), has served more than 500 companies across North America and Great Britain. VisionLink provides guidance and support on all forms of employee and executive compensation including salaries, short- and long-term incentives, and equity plans. In 2016, Tom established another company, BonusRight.com, a cutting-edge “software-as-a-service” incentive plan design platform. BonusRight is the first online tool supporting Tom’s mission to transform the way businesses share wealth with their employees. Tom’s passion lies in converting the visions of business owners into fuel for growth by linking employee compensation to the achievement of challenging goals. Tom can be reached at [email protected] or 949-265-5700.

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Phantom Equity: How Is It Different From True Equity

Equity is now a commonplace form of compensation, and it is vital in ensuring employee retention. However, the particulars of equity distribution plans can vary in how and when shares are allocated.

True equity always entails the actual transfer of stock ownership to an employee. Contrastingly, phantom equity is the flip side of such true equity distributions. We detail exactly what phantom equity is, how it works, and why companies choose to employ it as a compensatory tool.

What Is Phantom Equity and How Is It Different From True Equity?

As we hinted above, phantom equity is the ‘shadow’ side of true equity. This means that no stock is distributed in phantom equity distribution plans. 

Select employees (usually high-level) receive ‘mock stock.’ This entails receiving the benefits of stock ownership but no real company stock. Phantom stock is essentially a simulation of stock distribution that protects equity from further dilution but allows employees to gain from company share growth financially.

Phantom stock units mimic the price movements of real stock units and will pay out any resulting profits in the same way real stock would.

You may also be interested in: How Transparency in Cap Tables Can Benefit Your Startup

How Does Phantom Equity Work?

Now that we understand that phantom equity doesn’t involve issuing real stock let’s delve into how phantom equity distribution plans work.

Even though the phantom stock is an abstract concept, it still holds financial value like its real counterpart. This cash value will be paid out to qualifying employees once the requisite waiting period is over (usually two to five years). Phantom stocks can be awarded in two ways, which we detail below:

Appreciation only plan

Appreciation-only stocks bar recipients from receiving the full value of a phantom stock when it is cashed out. Instead, recipients receive only the ‘profit’ or appreciation value of the stock. This is essentially the difference between the stock’s current value and the value of the stock when granted.

For instance, let’s say that Jane Doe was granted 1000 phantom shares in July 2020, when they were worth $40. To receive the cash value of these shares, Jane must remain at the company for three years.

Assuming that Jane stays with the company until July 2023, when the shares are worth $60 each, Jane will receive $20,000 ($20 appreciation earned per share, for 1000 shares).

Full value plan

Full value phantom share plans payout recipients the entire worth of the shares at their current price. This means initial phantom share value plus any stock appreciation.

For instance, let’s say that John Doe was granted 1000 phantom shares in July 2020, when they were worth $40. To receive the cash value of these shares, John must remain at the company for three years. Assuming that John stays with the company until July 2023, when the shares are worth $60 each, John will receive $60,000 ($60 per share, for 1000 shares).

Advantages and Disadvantages

Phantom equity plans have proven very advantageous to businesses that wish to incentivize employees to stay with the company without transferring any more ownership away from founders.

This allows retention of power since employees hold no voting rights. As a result, phantom stocks afford companies a greater level of flexibility than true equity distribution plans, but that’s not to say there are no disadvantages to it.

In fact, companies can incur significant costs in implementing phantom equity distribution plans. Higher outgoing cash flows are due to conducting necessary external equity valuations and the cash payout for phantom stock. 

To avoid cash depletion, companies can circumvent this problem with a ‘conversion clause’ that converts phantom stock to real stock at payout.

Which Companies Should Consider a Phantom Equity Plan?

Deciding on an equity distribution plan is one of any business’s core decisions. There are many things to consider, but phantom equity comes with a few extra considerations, which we detail below:

• Growth: is the company expected to grow? Phantom equity sharing plans only perform well in steadily growing businesses.
• Profit-sharing: assuming the company’s growth is steady, is it feasible to share 5%-15% of those profits with employees?
• Value: even if it is possible to share profits from growth with employees, is the dollar value of that share meaningful enough to keep employees around?
• Key employees: assuming good growth and meaningful profit sharing are in place, it is equally important to count and consider any employees indispensable to the very growth businesses depend on.

A summative view

The Bottom Line

Whether you choose phantom equity or true equity takes your fancy, and equity management will always be necessary for growing businesses.

Having a secure, centralized, and customizable platform from which company owners can easily manage everything equity is a necessity. trica equity’s management software does precisely this. Try it out and book a demo today. 

ESOP & CAP Table Management simplified

Get started for free.

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The Carry: Private Equity Insights (October 2023)

Welcome to The Carry: Private Equity Insights for October 2023.

The Carry is our Private Equity Insights newsletter designed to keep you up-to-date with the latest trends and issues relevant to private equity.

In this update we put a spotlight on our Public M&A Report, a Takeovers Panel case, PIPE deals in Australia, upcoming employment reforms and IPO exits by PE vendors.

HSF Public M&A Report released: FY23 in review

In its fifteenth edition, HSF’s Australian Public M&A Report 2023 report released this week examines the 56 control transactions involving Australian targets listed on the ASX that were conducted by way of takeover bid or scheme of arrangement in the 2023 financial year.

View our full report

51+ problems and Chapter 6 is one: the Takeovers Panel considers the application of Chapter 6 to proprietary companies

In this article, we consider a recent Panel decision that signals it may treat proprietary companies differently (when compared to listed public companies) for the purposes of Australia’s takeovers laws.

Private Investment in public equity – PIPE deals in Australia

The current economic conditions have made PIPE (private investment in public equity) deals a more compelling option. We examine the reasons why and outline the key considerations for potential investors and issuers, including the common forms of instrument, terms and approvals required.

Closing Loopholes - Employment law reforms: What it means for your portfolio businesses

Significant employment reforms are coming that may have material consequences for portfolio companies. In this article, we provide a summary of key changes for your awareness.

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IPO exits by PE vendors

Global geo-political conditions, rising inflation and interest rates and other economic factors have contributed to a significant downturn in Australian IPO activity since 2021. However, the global IPO market is already staging a comeback. In this article, we explore past IPOs of companies backed by PE vendors and highlight essential considerations for PE vendors when planning their exits through an IPO.

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