Getting the Benefits of Equity Compensation from Family Businesses through Phantom Stock

Equity compensation, whether stock, options or RSUs, is a critical means for companies to lure executives like you to join the company. It is also the “golden handcuffs” to retain you for years after hiring.  Equity gives you a stake in the company and lets you share the benefit of that growth. Often the equity stake can exceed the dollars paid in salary and bonus, especially when taxes are taken into account.  That includes the opportunity for capital gains tax treatment rather than ordinary income and the opportunity for income not subject to payroll taxes.

But what if you work for a family business, or you receive a job offer from a family business? Family businesses are generally not in a position to offer a share of their equity in executive compensation. They often try to keep 100% ownership within the family because they have family as well as business objectives and they want to avoid having minority shareholders whose motive would be solely to secure profit and ultimate sale of the business. In this situation, how can you get a share of the rewards from your efforts in growing the company?

This article discusses phantom stock – a technique that enables family businesses to use equity-type benefits to compete for executive talent and allows CEOs and senior executives to get the benefits of equity compensation without actually getting equity.

Alternatives to Equity Compensation

For a family business that cannot offer equity to attract and retain top executive talent, there are three alternatives.

One option is to offer a non-voting stock plan. Non-voting shares are allowable in LLCs, C corporations and S corporations. Normally, non-voting stock is written in a way that makes it equal in all economic aspects to voting stock except that there are no voting rights unless state law requires otherwise.  Non-voting stock gets the same dividends, distributions and would share proportionately in the proceeds of any sale of the company. Thus, non-voting equity compensation provides for potentially all the same capital appreciation of normal shares and allows you, the executive, to take advantage of the record low 15% tax rate on capital gains and dividends. The down side is that you don’t have a say in the company’s operations and strategic choices.

However, many family businesses would not wish to issue non-voting stock outside the family. This is because shareholders have certain intrinsic rights.  There cannot be “oppression” of minority shareholders.  As a result, there exists the potential that minority shareholders, including non-voting stock holders, could launch a shareholder’s derivative suit if issues develop with management such as when decisions were made that did not maximize profits.

Another option is a non-qualified deferred compensation plan, which is designed to secure your payout in future. Taxation is deferred via a “rabbi trust” which is a trust that is set aside for you, the executive, but subject to the creditors of the company. This form of compensation was first used for a rabbi, hence the name. Non-qualified deferred compensation plans can contain provisions whereby you can lose these benefits if you leave the company, or if you violate non-compete agreements, confidentiality or other company restrictions whether during employment or after termination.

The rabbi trust delivers deferred compensation, but it is not tied to the rise and fall of the company as stock is.  So, it may not offer the same potential for appreciation tied to company growth as stock does.

Phantom Stock – A Technique that offers Equity Benefits to Family Business Executives

There is a third alternative that gives the non-family executive a share in the rewards of ownership without actually transferring even one share of family business stock. It allows family businesses to meet the competition by offering their own form of equity — without actually transferring ownership.

The technique is “phantom stock”.   This is a variation of the rabbi trust but different. It is a variation that gives the look, feel and appreciation opportunity of real stock.   Under the phantom stock plan, the company sets a share value benchmark (the phantom strike price) at the time the stock is issued to you. The contract typically includes a vesting and redemption schedule as well as a method for future stock valuation.

Thus, under a phantom stock plan, if the family business prospers, and later you redeem your shares (units in the phantom stock plan), you will get an amount equal to the value appreciation. In other words, you will be paid the difference between the share value on the phantom stock redemption date and the original phantom strike price. This payout would be similar to what you would get if you had normal stock options.

For offers from private companies and small public companies, phantom stock may be better than real stock for you because you may not be able to find buyers for real stock whereas phantom stock provides liquidity – in essence, the company buys you out. 

Hypothetical Example: Recruiting Successor CEO with Phantom Stock

An established family business (Fam Inc.) has outgrown its current management and wants to recruit a successor CEO from outside the family. The top candidate knows the industry, has managed a larger workforce with multiple offices and has the proven ability to take a company to a new level.

The current family CEO, at age 75, is looking toward retirement. The prospective successor CEO, Pete Donovan, is 55 years old. Hiring this key player would bring new vigor to the company. The parties hope to see Fam Inc. grow from its current valuation of $30 million to $100 million or more over the next decade.

But Fam Inc. has a severe handicap in recruitment.  Pete, at age 55, is in the prime of his career.  It is very important that Pete receive a significant equity stake in his next hire – this could be his last chance for a big hit before he retires.  He likes the fit Fam Inc. offers for his skillset and truly believes he’s the right person to see them through to their goal.  But he has other opportunities and insists that if he were to take the position, he must have a significant stake in Fam Inc.’s growth if he succeeds.

Pete suggests that he might take the position if Fam Inc. first developed a Phantom Stock Plan where he would have an equity-type opportunity. Thus, working with Pete, Fam Inc. sets up a Phantom Stock plan that will take effect when Pete joins the company.

Fam Inc. offers Pete Donovan phantom stock that matches his annual salary of $300,000. During each year of a five-year employment contract, Donovan receives phantom stock units at a strike price of $3.00 per unit based on current valuation of the company’s stock with the units vesting annually at 20% (half the vesting based on his remaining with Fam Inc. and half based on achievement of his performance goals). In ten years, when Donovan retires, the company would again be valued and Donovan paid on the growth of his vested units, with a buyout over five years.

Thus, if Donovan stays with Fam Inc.4 1/2 years. In that time, for example, if he achieves half his business targets, he’ll vest 60% of these units (vesting 80% based on four years’ tenure and 40% based on meeting half his targets).  Donovan’s potential equity stake was in units with an aggregate strike of $1.5 million in phantom stock units that would have represented 5% of the equity value of the company.  When he leaves after 4 1/2 years, Donovan is vested 60% which translates into units with an aggregate strike price of $900,000 equal to 3% of the outstanding shares of the company.  Donovan has no voting rights or rights to stock, but — assuming he doesn’t violate company covenants — he will receive a future payout for the units.

Now suppose that due in part to Donovan’s achievements over those 4 1/2 years, Fam Inc. grows from a $30 million company to a $80 million company over the 10 years from his original hire.  Under the plan, Donovan would be paid off at the spread between the $3 original strike price and the $8 current market price then years from his start date.  Thus, the value of his vested units rose from $900,000 to $2,400,000.  With a $5 spread per unit, the payout on Donovan’s vested units would be $1,500,000, which would be paid over five years with interest on the $1,500,000 note at the Wall Street Journal prime rate.

This Fam Inc. / Donovan example works for any family business in any American industry, whether the business valuation is $30 million, $300 million or $3 billion. Although the company must incur the cost of paying out phantom stock, the payment made is fully tax deductible and the company derives a much greater benefit from growth.

If the family business truly needs and values the executive it seeks to recruit, then it may be open to creating a phantom plan just as happened in the example above. You can also suggest that this phantom plan would not be a “one-off.”  The creation of the phantom plan in the Fam Inc. example opened the door for issuance of phantom stock to others that Donovan may recruit to further build the management team.

Phantom Stock: Substitute Options, RSUs, Capital Gains

The Fam Inc. example shows the most common phantom stock plan.  It is a plan designed to deliver you the equity benefits you would receive if you had stock options in Fam Inc.

On the day the phantom stock units were issued, they were worth nothing – the strike price was $3 – if that strike price went down, the phantom units would be under water and worth nothing just like options.

However, the Fam Inc. example is not the only kind of phantom stock plan or phantom stock offering that can be used.  The phantom stock offered to Donovan could instead be structured as phantom RSUs – so that instead of delivering to Donovan the spread on growth of his units, it could be structured to deliver Donovan the total value of his units, either before tax or after tax.  Thus, Donavan’s phantom units once vested could never go under water.

The phantom stock plan could also be structured to deliver phantom dividends and/or phantom capital gains. This too could offer a distinct advantage over real stock.  Stock option plans rarely allows you to take advantage of capital gains or dividend tax treatment.

In conclusion, if you are a CEO, C-suite or senior executive considering taking a position in a family business or the CEO of a family business trying to recruit a top talent, you would do well to consider introducing a phantom stock plan.  Phantom stock provides a way for a business to share the rewards of ownership with you without actually giving you shares. The actual terms and tax benefits can be a key point of negotiation for your executive compensation package. It is wise to consult an experienced executive employment lawyer to achieve the best offer.