Although the name ‘phantom stock’ might suggest something mysterious, it is actually a very real and effective tool used by private companies to attract and keep top talent without giving them legal ownership in the company. In this paper, we’ll explain how phantom stock and other synthetic equity plans work, the benefits they offer to private businesses, and how they fit into executive compensation strategies.
What are Phantom Stock and Synthetic Equity Plans?
Phantom stock is one example of a broader category of equity-based incentive compensation known as synthetic equity. Synthetic equity describes a variety of equity-based incentive compensation plans that are designed as non-qualified deferred compensation plans, meaning they do not involve actual legal ownership of company equity. Common forms of synthetic equity are phantom stock and stock appreciation rights (SARs).
While both types of plans reward participants for growth in stock value, SARs plans typically have greater incentive impact because the payout is based entirely on appreciation. Because of this, SARs tend to be more popular than phantom stock (but we couldn’t resist the great Halloween theme for this article).
Why Choose Synthetic Equity?
In the competition for top executive talent, public and private equity-backed companies have a powerful advantage in the form of stock options and stock grants. For closely-held companies with no intention of selling, synthetic equity is a tool to level the playing field.
How Does It Work?
Synthetic equity plans can be structured in several ways, but the two most common forms are:
- Stock Appreciation Rights (SARs): These rights give the holder the ability to receive a cash payment equal to the increase in value of the company’s stock over a set period of time, usually 3-7 years. The employee benefits only from the appreciation of the stock value, not the full value of the shares themselves.
- Full-Value Phantom Stock: This form grants the employee a cash payment equivalent to the full value of the stock, including any appreciation from the time the stock was awarded.
The vesting period for synthetic equity is typically tied to company milestones, performance metrics, or a fixed number of years. This long-term structure is designed to align incentives around long-term value creation.
Benefits to the Company and Employees
Synthetic equity creates a win-win scenario for both the company and the employee:
- Company Perspective: Businesses retain full ownership control while incentivizing employees to increase the company’s value. The payouts are typically tax-deductible for the company and are only paid if certain performance metrics are met.
- Employee Perspective: Employees gain financial rewards tied to the company’s success without needing to purchase or manage actual shares. This alignment between personal success and long-term value creation can be a powerful incentive. Moreover, because the payout is in cash rather than stock, employees don’t need to worry about liquidity events to realize their compensation.
The Tax, Legal, and Practical Considerations
Unlike stock options, which may allow the employee to benefit from favorable capital gains tax treatment, synthetic equity payouts are taxed as ordinary income on the employee’s tax return when they are paid. Additionally, since companies using synthetic equity are private and don’t have a public market or liquidity event, the company itself must provide the cash for the payouts.
It’s important for companies to consult legal and tax professionals when designing a synthetic equity plan. These plans are subject to various employment and tax laws, and missteps in structuring or administering the plan can lead to unintended financial and legal consequences.
When Should You Consider Synthetic Equity?
Not every company needs a synthetic equity plan. They are typically most effective for middle market and upper-middle-market companies that are competing with public companies or private equity-backed firms for executive talent. If your company is growing rapidly and looking to bring on high-level talent while preserving ownership, synthetic equity may be the right tool for you.
How Adamy Can Help
If you are considering implementing a synthetic equity plan at your company, consult with legal, tax, and valuation professionals to ensure the plan is structured correctly and aligned with your company’s long-term goals. The experts at Adamy Valuation are here to help you and your advisors develop and administer the right plan to support your growth objectives.
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