Phantom Equity v. True Equity

By Eric J. Gyllenborg

There is an alternative to companies giving away “true” equity and that alternative is phantom equity. When it comes to equity incentive plans for employees, consultants and directors, you can provide the same economic benefits with phantom equity, without all of the cumbersome entanglements and downsides that come along with “true” equity (for example: voting rights, fiduciary duties, right to receive dividends, rights to inspect the company’s records, dilution of the current equity holders and being wed to a particular person even if they are no longer employed by the company).

First, it makes sense to briefly describe what phantom equity is and how it differs from “true” equity. “True” equity, in this article, means actually owning an equity interest in a company. Such an ownership interest will consist of all the attributes you would typically expect to have if you own an equity interest in a company (for example: voting rights, rights to receive periodic dividends of profits and the like, rights to inspect the books and financials of the company). Such an ownership interest is usually evidenced by the issuance of stock in the company that could either be in the form of an actual stock certificate or in the form of an entry in the company’s stock ledger.

With a phantom equity plan, the recipient receives a phantom unit that is equivalent to (but not an actual) equity interest in the company. Such phantom units can be structured to mimic all of the economic benefits of “true” equity (for example: sharing in profits, sharing in the benefits of increases in the value of the company and/or receiving dividends). On the other hand, a phantom unit plan can also be structured so that the phantom units are in essence the equivalent of a simple cash bonus payment. A phantom unit plan can provide for payouts or other economic benefits to be available to the recipient only after certain events have occurred. For example, particular vesting periods that have been achieved, or a particular time of service that has lapsed, a milestone that has been achieved by the employee, a public offering or merger event, and/or certain financial targets have been attained by the company. Such triggering events will dictate when the phantom equity holder receives the economic benefits of the phantom equity units.

The beauty of a phantom equity plan is how flexible it can be since the rights associated with phantom units are contract rights which allow the plan to be structured in many different ways. All the while, the recipient of a phantom unit will not receive any “true” equity thereby avoiding the negative attributes associated with giving “true” equity to an employee, but still providing that employee with all of the same economic benefits of “true” equity. It is truly a great way to provide an incentive to employees, consultants and directors as it aligns their economic interests with the company’s goal of increasing the revenue and overall value of the company.

It is imperative to note that phantom equity plans are regulated as deferred compensation under the Internal Revenue Code section 409A (I.R.C. § 409A)[1] because they do not qualify as “stock rights.” Therefore, it is important to structure the phantom equity plan in a manner that is compliant with I.R.C. § 409A. As such, it is highly recommended that you work with a lawyer and an accountant who are well-versed in phantom equity plans so that the plan is structured in a way that avoids negative tax consequences for the company and the recipient of the phantom equity units.

Eric J. Gyllenborg is a director at Boston-based law firm Rackemann, Sawyer & Brewster, P.C., handling general corporate, commercial lending, securities, finance, employment and medical and technology transfer matters. He can be reached at EGyllenborg@rackemann.com.

[1] Section 409A of the Internal Revenue Code regulates nonqualified deferred compensation paid by a “service recipient” to a “service provider” by generally imposing a 20% excise tax when certain design or operational rules contained in the section are violated.