Phantom Equity (“PE”) is a contractual agreement for a type of deferred compensation between a company and key employees, advisors, and/or contractors. Startups can offer PE to valuable employees, so they have skin-in-the-game, and thus, feel an urgency to help the startup become as successful as possible in the shortest amount of time.
PE is essentially a bonus payment that kicks in when a pre-determined trigger event happens. Some examples of a triggering event are:
- Initial Public Offering (IPO)
- Acquisition of 51% or more of the company
- Capital infusion of X dollars (Series A, B, C, etc.)
- Sale of intellectual property (such as a patent)
Why Use Phantom Equity?
When startups are strapped for cash, they often find themselves having to make hard choices trying to bring new people into the fold. In the case of a C-Corporation, the founders will have equity ownership in the form of stock. In the case of an LLC, the principals’ ownership comes in the form of membership interests.
If startup plans to build a product or service, they will probably need to give advisors, consultants, and important employees equity in the company. But what happens when you want to bring someone on board but either can’t or don’t want to provide them with stock? That’s where PE comes in. While it isn’t as well known as stock equity, Phantom Equity is a great and equally effective alternative.
How Does PE work?
Generally, there are two parts: (1) a PE plan with the same terms and conditions for everyone; and (2) a PE award agreement that each key employee signs with specific terms. The employees’ shares of PE would be based on their contribution to the startup. The more value they bring, the more shares of PE they receive.
The payout would be based on either a percentage of the trigger event proceeds or a certain dollar threshold. So, it could be 20% of a patent sale (gross or net) or 10% of a Seed or Series A financing. The percentage set aside for the PE plan would be divided based on the amount of PE shares an employee has.
For example: Company XYZ has 3 employees with PE; the Manager of Business Development (100,000 shares), the Head of Human Resources (50,000 shares), and the Lead Software Developer (50,000 shares). The company gets a $10M Series A financing round (trigger event), with 10% NET proceeds set aside for the PE pool (assuming the startup does not have any debts or liabilities). Business Dev. Manager would get $500K, Head of HR would get $250K and Lead Software Developer would get $250K.
What Are The Benefits Of PE For Startups?
There are several benefits for startups offering PE which are:
- Transferability restrictions and revocation for poor performance.
- Gives the Startup founders more stock equity to offer Venture Capital firms and other financiers in the future.
- PE holders are not granted voting rights which keeps control of the company vested in the Startup Founders.
- PE does not need to be registered with the SEC because it is not stock. Additionally, PE is generally easier to give out than stock because there is no franchise tax involved.
- PE gives employees a sense of urgency for success, encourages a team mindset with a common goal for the startup. It can help lead a company to hyper-growth.
What Are Some Drawbacks?
- The PE holder does not have an “accession” to wealth at the issuance of the PE; thus, no taxable income. The PE holder is subject to regular income tax as opposed to capital gains tax once they receive the compensation.
- A PE plan could be considered a retirement plan and open you up to ERISA issues if not structured properly.
- PE is subject to IRC Section 409(a) in conjunction with different State laws enhancing Section 409(a) (which means you should work with a tax attorney in conjunction with your corporate attorney).
Phantom Equity is a great alternative to traditional stock equity. PE is a tool for startups to bring great talent into the fold, without giving up an ownership interest in your company. If you’re interested in learning more about Phantom Equity, contact Brown & Blaier, PC (and an accountant) today!