The Music of the Night . . . Phantom Plans for Early Stage Companies

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By Kevin Selzer

Early stage companies that are strapped for cash often turn to long-term incentive compensation plans to attract and retain key employees and service providers. Many of these companies opt to put in place arrangements that grant actual equity interests (e.g., stock options or, in partnership-taxed entity, profits interests).  While these arrangements may be a good match for certain companies and situations, I find that phantom plans often fit better with early stage company/ownership goals.

There are many flavors of phantom plans, but the general idea is that participants receive grants that provide the economics of equity without receiving actual ownership.  A common version of a phantom plan (perhaps the vanilla flavor) is a plan that pays participants out a percentage of net proceeds (in cash) received by the owners upon a sale of the company.  This plan design aligns participant interests with the interests of the owners, provides valuable retention and is comparatively simple to implement.  While certain tax efficiencies may be lost with a phantom plan, many early stage companies prefer the simplicity – as the phantom plans avoid some of the downsides of granting actual equity such as, loss of employee status (in partnership-taxed entities), financial disclosure obligations, periodic third-party valuations, and having to put other ownership transfer/repurchase type provisions in place (e.g., a shareholders agreement).

Phantom plans are simply promises to pay compensation in the future.  However, companies that go the phantom plan route need to step carefully to comply with tax rules, and in particular, Code Section 409A.  Complicated phantom plan designs can quickly push into compliance gray areas and are often difficult for participants to understand. In early stage companies, simple plan design is king. A short checklist for companies considering designing a phantom plan:

  • determine how to align company liquidity with settlement of the phantom interests
  • determine how settlement value is determined (e.g., percentage of sale proceeds, equivalent to the value of actual ownership, etc.)
  • develop a communication strategy to maximize incentive and retentive effects of the plan
  • ensure the plan is designed to comply with applicable law