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What is Phantom Equity in a Business Sale?

Sounds spooky, but you'll know soon how beneficial this is!
phantom equity when selling a business

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Phantom equity might sound like a spooky term, but it’s quite practical. When selling a business, it’s essential to understand this concept, especially if you’re an employee, manager, or business owner. 

So, what exactly is phantom equity, and why does it matter in a business sale? Let’s break it down in simple terms.

Quick Key Takeaways

  1. Definition:
    • Phantom equity is a compensation plan where employees receive cash payouts based on the company's valuation, mimicking real equity without actual ownership.
  2. Benefits:
    • No Ownership Dilution: It doesn’t dilute shareholders' ownership since it’s not actual stock.
    • Employee Motivation: Aligns employees' interests with company success, encouraging better performance.
    • Retention: Helps retain key talent by promising future financial rewards.
  3. Drawbacks:
    • Cash Flow Impact: Companies need sufficient cash for payouts, which can strain finances.
    • Complex Setup: Requires careful planning and ongoing management to implement effectively.
    • Expectation Management: If company performance falters, employees might feel demotivated or disappointed.
  4. Tax Implications:
    • Companies can deduct payouts as compensation expenses, reducing taxable income.
    • Employees report payouts as ordinary income, subject to income and payroll taxes.
  5. Types:
    • Appreciation-Only Phantom Equity: Payouts are based on the increase in company value.
    • Full-Value Phantom Equity: Entitles employees to the full value of designated shares.

Understanding Phantom Equity

Phantom equity, also known as shadow stock or phantom stock, is a type of compensation plan. It gives selected employees or managers the right to receive a cash payment based on the company’s future valuation.

Unlike actual stock, phantom equity doesn’t provide ownership but mimics the value of real equity. This makes it attractive for companies looking to reward key players without diluting ownership.

Phantom equity is essentially a promise. It’s a promise that if the company grows and becomes more valuable, the people holding phantom equity will share in that increased value.

This setup aligns employees’ interests with those of the company’s owners, as everyone benefits from the company’s success.

How Does Phantom Equity Work?

Phantom equity plans typically include specific conditions. These conditions often revolve around company performance, employee tenure, or the occurrence of a particular event, like the sale of the business. Here’s a simple breakdown of how it works:

  1. Granting Phantom Equity: The company grants phantom equity to selected employees or managers. This grant outlines how much phantom equity each person gets and the terms under which they will benefit.
  2. Vesting Period: Like many stock options, phantom equity often comes with a vesting period. This period means the employees must stay with the company for a certain amount of time before they fully earn the phantom equity.
  3. Triggering Event: A triggering event is usually required for the phantom equity to pay out. This event could be the sale of the business, reaching a specific financial milestone, or an employee meeting performance targets.
  4. Payout: Once the triggering event occurs, the company calculates the value of the phantom equity. The payout is then made in cash, reflecting the current valuation of the company.

Phantom equity becomes particularly relevant during a business sale. When a company is sold, the value of the business is determined, and those holding phantom equity get paid based on this value.

This arrangement can motivate employees to work towards making the company more valuable, knowing they will directly benefit from its sale.

Two Types of Phantom Equity Plans

Phantom equity typically comes in two main forms: Appreciation-Only Phantom Equity and Full-Value Phantom Equity.

  1. Appreciation-Only Phantom Equity: This type grants employees the right to receive a cash payout based on the increase in the company’s value from the time the equity is granted to the time it is exercised. For example, if the company’s value rises from $1 million to $2 million, the employees benefit from the $1 million increase.
  2. Full-Value Phantom Equity: This variant entitles employees to the full value of a certain number of shares at a future date or event, like a business sale. It mimics owning actual stock, as employees benefit from the entire value of the shares, not just the appreciation.

Both types align employee interests with the company’s growth, but the choice depends on specific business goals and financial strategies.

How to Determine Phantom Equity

Creating an effective phantom equity plan involves several key steps:

  1. Define Objectives: Determine what the company hopes to achieve with the phantom equity plan. Is it to retain top talent, motivate employees, or both?
  2. Select Participants: Identify which employees or managers will receive phantom equity. Typically, these are key players whose contributions significantly impact the company’s success.
  3. Determine Vesting and Payout Conditions: Set clear vesting schedules and payout conditions. Ensure these align with the company’s goals and are attainable for participants.
  4. Valuation Method: Decide how the company’s value will be determined at the time of payout. This could involve an independent valuation or a predefined formula.
  5. Communication: Clearly communicate the details of the phantom equity plan to participants. Make sure they understand how it works, what they need to do to earn it, and how it will benefit them.
  6. Legal and Tax Considerations: Consult with legal and tax professionals to ensure the phantom equity plan complies with all relevant laws and regulations. Proper structuring can help minimize tax liabilities for both the company and participants.

Phantom Equity Formula

While there isn’t a one-size-fits-all formula for determining phantom equity, a commonly used approach involves calculating the payout based on the company’s valuation at the time of the triggering event. Here’s a simplified formula that can be adapted to various situations:

Payout = (Company’s Final Valuation – Company’s Initial Valuation) / Number of Phantom Shares x Employee’s Phantom Shares

Variables:

  • Company’s Final Valuation: The value of the company at the time of the triggering event (e.g., business sale).
  • Company’s Initial Valuation: The value of the company when the phantom equity was granted.
  • Number of Phantom Shares: Total number of phantom shares granted to all employees.
  • Employee’s Phantom Shares: Number of phantom shares allocated to a specific employee.

Example Calculation:

Assume a company granted 100,000 phantom shares with an initial valuation of $1 million. After five years, the company is sold for $3 million. An employee holds 1,000 phantom shares. The payout would be:

Payout = ( ( $3,000,000 – $1,000,000 ) / 100,000 ) × 1,000 = $20 × 1,000 = $20,000

Tax Implications of Phantom Equity

Phantom stock unit payouts are subject to taxation at ordinary income tax rates, which are typically higher than capital gains tax rates. This taxation occurs when the employee receives the payout, making it part of their regular income. This contrasts with most traditional forms of corporate equity, as well as LLC equity such as profits interest plans.

With these other forms of equity, if managed properly, the recipient can often benefit from the lower capital gains tax rates instead of the higher ordinary income tax rates.

Ordinary income tax rates can significantly impact the net payout an employee receives from phantom stock units. In contrast, capital gains tax rates, usually applied to long-term investments, are more favorable and can result in substantial tax savings.

Phantom Equity vs. Stock Options: Which is Better?

It’s also helpful to compare phantom equity with traditional stock options to understand the differences and similarities:

  1. Ownership: Phantom equity doesn’t grant actual ownership, while stock options do. With stock options, employees eventually own shares in the company.
  2. Dilution: Phantom equity doesn’t dilute ownership, while issuing new stock options can dilute existing shareholders’ ownership.
  3. Payout Method: Phantom equity typically results in cash payouts, while stock options involve employees buying shares at a predetermined price.
  4. Valuation Impact: The value of phantom equity is based on the company’s valuation, while stock options depend on the stock price.

The Difference Between Phantom Equity and Rollover Equity

You’ve probably heard of rollover equity, but they’re quite different in terms of principle.

Phantom equity gives employees or executives a share of the company’s profits without giving them actual stock.

On the other hand, rollover equity lets current shareholders keep some of their equity after the company is sold. This helps keep everyone’s interests aligned and ensures that both sellers and new owners stay committed to the company’s success.

Conclusion

Phantom equity can be a powerful tool for aligning employees’ interests with those of the company, motivating key players, and retaining top talent. While it doesn’t grant actual ownership, it provides a way for employees to share in the company’s success, especially during a business sale.

Understanding how phantom equity works, its benefits and drawbacks, and the key considerations for structuring a plan can help business owners make informed decisions. With the right approach, phantom equity can contribute to the company’s growth and success, benefiting both the business and its employees.

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