When startups and young companies 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. If the startup plans on raising money, they will most likely need to give investors, advisors, and important employees an equity interest in the company. But what happens when you want to bring an employee or contractor on board but either can't or don't want to provide them with stock?
A little known, but great alternative is something called Phantom Equity, which we will discuss in more depth in this blog post.
What is Phantom Equity?
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 (a sense of ownership) and thus, 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)
How does PE work?
Generally, the PE plan would be applied universally (a pool with the same terms and conditions for everyone) which each key employee signs onto. The employees' shares of PE would be based on their contribution to the startup (i.e. the more important work you do, the more shares of PE you receive). The PE payout pool would be based on either a percentage of the trigger event proceeds or a certain dollar threshold. So, it may be 20% of the patent sale (gross or net), or $10M of the $100M Series A financing. The percentage set aside for PE the pool would be divided based on the amount of PE shares the employee owns.
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 doesn't 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 a lot of benefits for Startups offering PE shares over equity to key employees. Some of the notable benefits are:
- Unlike stock equity, PE shares can be controlled and drafted to restrict or limit transferability for employees who leave the company before the trigger event, in addition to giving startup founders the flexibility to cancel or revoke the shares of PE.
- Gives the Startup founders more stock equity to offer Venture Capital firms and other financiers in the future.
- PE holders aren't 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 and is generally easier to give out than stock because there's no franchise tax involved.
- PE gives employees a sense of urgency for success, encourages a team mindset with a common goal for the startup, and thus, lead a company to hyper-growth.
Some of the drawbacks of PE are:
- While the PE holder doesn't have an “accession to wealth” at issuance of the PE, and therefore no taxable income, the PE holder is subject to regular income tax as opposed to capital gains tax once they receive the compensation.
- If not structured properly a PE plan could be considered a retirement plan and open you up to ERISA issues.
- 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 lawyer)
To sum up; Phantom Equity is a great alternative to traditional stock equity and 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 us (and a tax attorney or accountant) today!