Don t Fear the Phantom Stock

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1 Don t Fear the Phantom Stock In a prior article, we discussed the benefits of issuing stock options as part of an employee compensation package and outlined common pitfalls for entrepreneurs to avoid when implementing a stock option plan. A stock option plan is a valuable compensation tool because it ties the employees compensation to the company s success. However, entrepreneurs should know that alternate compensation plans are available to accomplish this goal. One such plan is a phantom stock plan and the closely related Stock Appreciation Rights (SARs). This article aims to explain phantom stock plans and highlight a few of the advantages of to this approach to employee compensation. Phantom stock is a compensation plan that bestows upon the holder the right to receive a cash payment at a specified future point in time usually in conjunction with a specified future event or milestone. The amount of the cash payment is linked to the market value of a predetermined number of shares of the company s stock. There are two main types of phantom stock plans: Appreciation Only Plans pay an amount equal to the value of the growth (if any) of the company s share price over a predetermined time period. Full Value Plans include the underlying value of the stock, and thus pay out considerably more to the employee on a per-share/unit basis. Phantom stock is similar in many ways to a cash bonus deferred until the future. However, typically the payout is much bigger than an annual bonus, and the award is usually contingent upon the phantom stockholder s continued employment with the company. Occasionally the plan will have a conversion feature that issues actual stock in the company in lieu of the cash payout, if the employer so chooses. Stock Appreciation Rights (SARs) operate much like phantom stock plans with a few key differences. Unlike full value phantom stock plans, SARs do not offer employees the value of the underlying stock in the company. The employee only receives cash equal to the increase in the stock price from the date of the grant to the date of the exercise. If the stock price does not increase, the employee receives nothing. In addition, although both phantom stock and SARs typically have a vesting schedule attached, SARs recipients can usually exercise their rights whenever they choose after the schedule is complete whereas phantom stock holders typically receive their payout dependent upon the company meeting certain contingencies or milestones defined by the plan. Five Advantages of a Phantom Stock Plan All the financial benefits of ownership for the employee without all the risks

2 Structure can motivate employees to accomplish company specific goals and Employers share the economic value of the company without sharing ownership control Less administration than a traditional stock option plan Tax and accounting implications 1) All the financial benefits of ownership for the employee without all the risks Phantom stock plans are also called mirror stock or shadow stock. From the employee s perspective, the potential financial reward of participating in a well-designed phantom stock plan will mimic the payoff of holding actual equity or options. Just like actual shareholders, holders of phantom stock have more than just a job and a paycheck to keep them focused on the company s future success, especially if payout terms are tied to long-term company performance. The greatest benefit of phantom stock from the holder s perspective is many of the risks and liabilities ordinarily incurred by those with direct, legal equity ownership are avoided with this pseudo version of company stock: First and foremost, the employee is not required to infuse cash into the business to purchase stock or exercise options. Since they do not actually have any ownership interests, holders are not exposed for corporate governance issues. Similarly, they are not required to personally guarantee company debt. Phantom stock plans offer only upside opportunity. 2) Structure can motivate employees to accomplish company specific goals Most businesses today are not on a path to go public. Employees granted stock or stock options lack a liquid marketplace to sell their shares, which takes some of the appeal out of a traditional employee stock option plan. Phantom stock plans have the flexibility to define the contingencies that trigger a payout. Phantom shareholders are not dependent upon an IPO to see a reward, and the contingencies can be defined in such a way to motivate phantom shareholders to meet key company goals. 3) Employers share the economic value of the company without sharing ownership control Phantom shares are not subject to any of the statutory shareholder rights set forth under corporate law. The rights of phantom shareholders are limited to those rights defined in the phantom stock plan. While the plan can dictate that holders phantom stock receive voting rights, typically they do not. Thus, the full authority for company decision-making remains with the actual shareholders, which typically include the company s founders. Additional shareholders add complexity to the decision making process, which can prevent the company from acting quickly to capture key opportunities and react appropriately during times of hardship. 4) Less administration than a traditional stock option plan The issuance of phantom stock is considered a non-qualified benefit. As such, much of the paperwork,

3 restrictive rules and reporting requirements affiliated with traditional qualified benefit plans can be avoided. Thus, implementing a phantom stock plan should cost less in legal and accounting fees than implementing more traditional plans. Internal Revenue Code section 409A governs a variety of deferred compensation plans, including phantom stock, and sets restrictions with regard to payment and timing. As a form of non-qualified deferred compensation, the liability associated with a phantom stock plan must be accounted for on the company s balance sheet to recognize its obligation to the plan s participants. Oxford Valuation Partners has the expertise to help you If you need help with your stock plan contact us on info@oxfordvp.com or for a free consultation 5) Tax and accounting implications When actual stock is issued in exchange for services the recipient must recognize taxable income, just like W-2 wages. Employees granted stock or stock options are often disillusioned when they learn that they must either pay the fair market value of their shares or face taxable income. Unlike actual stock, phantom stock is non-taxable until the cash is paid. At that point, the payment generates ordinary income for the holder of phantom stock while simultaneously generating a deduction for the company. Disclosure The information provided here is for educational purposes only and is not intended as tax advice. Oxford Valuation Partners does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Oxford Valuation Partners assumes no responsibility for the tax consequences to any investor of any transaction. Think you know options? Think again!

4 An employee stock option is a contract between a company and its employee that gives the employee the right to purchase a specified number of shares of stock in the company at specified strike price by a specific date. The employee is under no obligation to purchase all or part of the number of shares granted in the option. Typically, but not always, the number of shares granted vest over time. Companies establish employee stock option programs as part of an overall employee compensation plan for several key reasons. Option programs can boost employee morale and help attract talented, skilled workers who are motivated to help the company improve and succeed. Employees holding options to purchase shares feel more like owners or partners in the business and are invested in the company s success. In addition to being a benefit for employees, stock option plans are cost-effective for companies with the only significant costs to the company being the lost opportunities to sell some stock at market value in the future (since employees usually buy at a discounted rate) and the expense of administering the plan. While stock options are an excellent choice for companies wishing to offer employees a costeffective benefit tied to the company s future success, entrepreneurial businesses must be cautious to avoid the following pitfalls when using stock options as a form of compensation: 1. Setting the option strike price too low or too high. Under Section 409A of the Internal Revenue Code (IRC), a company must ensure that any stock option granted as compensation has an exercise price equal to (or greater than) the fair market value of the underlying stock as of the grant date. If the option strike price is set too low, the options will be considered deferred compensation, the recipient will face significant adverse tax consequences, and the company will have tax-withholding responsibilities. While there is no regulatory penalty for setting an option strike price too high, the option is not as valuable to the holder as one with an appropriate strike price. A company can establish a defensible fair market value of the underlying stock by obtaining an independent appraisal from well-qualified experts. 1. Forgetting to issue options on time. Stock options offer employees the opportunity to benefit from the increase in the company s value over time. As a company meets operational milestones, the value of the company will increase, and the value of the underlying shares of stock of the option will also

5 increase. It s easy for management to get caught up in the daily responsibilities of running and growing a business thereby forgetting to take the necessary legal steps to grant options in a timely fashion. However, the issuance of stock options to key employees should be done as soon as possible, when the value of the company is as low as possible, if they are to provide the most value to the employees. 2. Establishing a large option pool that dilutes shareholders When establishing an employee option pool, companies planning to seek equity investors should consider how investors calculate price per share. Venture capitalists calculate the price per share of a company by dividing the total pre-money value of the company by the fully diluted number of shares outstanding. For the purposes of this calculation, fully diluted shares include not only issued and outstanding shares but also the number of shares currently reserved for an employee option pool as well as any increase in the size (or the establishment) of the pool required by the investors for future issuances. Investors typically require an option pool of approximately 15-20% of the post-money, fully diluted capitalization of the company. Obviously, existing shareholders (including the founders) are substantially diluted by this approach. The only way to avoid unnecessary dilution is to keep the option pool as small as is feasible while still attracting and keeping the talent needed to grow a business. 3. Understanding the differences between ISOs and NSOs Incentive Stock Options (ISOs) are regulated by IRC Section 422, which lays out the requirements for an equity instrument to qualify as an ISO. ISOs are only available for employees and must be granted pursuant to a shareholder plan. The exercise price of an ISO may not be lower than 100% of the fair market value of the underlying stock at the time of the grant. Non-statutory Stock Options (NSOs) have fewer regulations and restrictions than ISOs. NSO s can be offered to advisors, service providers, and others affiliated with by not employed by a company. However, ISOs uniquely offer the possibility of being taxed under long-term capital gains, while NSOs are taxed under both ordinary income and capital gains. That said, if employees don t follow all the holding rules, then the favorable tax treatment of ISOs no longer stands. 4. Restricted Stock vs. Options Restricted stock can be a good alternative to options as a means of employee compensation in early stage companies for several reasons. Unlike options, restricted stock is not subject to Section 409A regulations. Restricted stock may better accomplish the goal of motivating employees to behave in the best interest of the business since the employees are actually receiving shares of common stock of the company. Under IRC Section 83(b), employees holding restricted stock will be able to obtain capital gains treatment, and the holding period begins upon the date of grant, provided the employee files an 83(b) election. The disadvantage of restricted stock is that upon the filing of an 83(b) election (or upon vesting, if no such election is filed), the employee is considered to have income equal to the then fair market value of the stock. Thus, if the stock has a high value, the employee will have significant income and must possess the necessary cash to pay the applicable taxes. Thus,

6 restricted stock issuances are not appealing unless the value of the stock is sufficiently low that tax impact is minimal as is generally the case immediately following the company s incorporation. 5. Options for LLCs? Limited Liability Companies (LLCs) have grown in popularity as a vehicle through which entrepreneurial companies operate their business. An LLC shares many corporate characteristics, but most are taxed as partnerships. Thus, the LLC structure has clear benefits, but also faces significant challenges in the area of equity compensation. Within an LLC, ownership is expressed by membership interests rather than stock. As a result, LLCs cannot create employee stock ownership plans (ESOPs), issue stock options, provide restricted stock, or otherwise give employees actual shares or rights to shares. However, like corporations many LLCs want to reward employees with an equity stake in the company. The most commonly recommended approach to sharing equity in an LLC is to share profits interests. A profits interest is comparable to a stock appreciation right. It is not literally a profit share, but rather a share of the increase in the value of the LLC over a stated period of time. Vesting requirements can be attached to this interest. Options to purchase profits interests can also be granted. Entrepreneurs should be aware that while LLCs are flexible entities that provide tax efficiencies not available in corporations, they tend to be more expensive to form and administer than corporations, especially given the unique requirements surrounding employee compensation. Disclosure The information provided here is for educational purposes only and is not intended as tax advice. Oxford Valuation Partners does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Oxford Valuation Partners assumes no responsibility for the tax consequences to any investor of any transaction.