Business owners often desire to incentivize key employees by providing them with an equity stake in the business. These majority owners believe that issuing equity ownership to key employees will instil in them pride of ownership in the firm, create a stronger focus on business goals, and enable the company to achieve higher levels of profitability. This strategy for enhancing profits, however, is not without threats to the company’s future corporate governance and litigation risk.
One way for majority owners to strike a balance between achieving the benefits of issuing equity ownership to key employees while limiting the risks associated with stock option grants is through the issuance of phantom stock or its kissing cousin, stock appreciation rights (known as SARs). The definition of both is set forth below. Further, and as explained below, key employees often find phantom stock plans and SARs attractive, as well, when they are structured to provide significant financial benefits that are equal to, or perhaps even more favorable than, stock option grants.
Phantom Stock and SARs Defined
Phantom stock is not actually stock, and is, instead, a contract right. Specifically, phantom stock is a commitment by the company to pay a bonus to the holder of the right that is equal to the value of the company’s stock or the increase in the stock’s value over a specified time period. An SAR is very similar to stock, and reflects a promise to pay the holder of the right the cash equivalent of the increase in the value of a specific number of shares over a defined time period.
Benefits of Phantom Stock and SARs from Majority Perspective
In simplest terms, phantom stock and SARs provide a compensation plan that is directly tied to the company’s financial success. These plans, in effect, provide a cash bonus to employees at a defined future point in time. Often the distributions under these plans are tied to the proceeds that are generated when the company is sold, but they can also be more limited and more frequent. For example, the payments to holders of phantom stock and SARs can be tied the dividends issued to shareholders or they could be triggered by events such a hitting revenue or profitability targets, of the occurrence of an IPO or simply by the passage of time, typically a period of 3 or 5 years. The plans always require the holder to be employed by the company. Therefore, these plans promote continued loyalty and longevity of key employees, as well as incentivizing them to achieve outstanding financial results.
Another added benefit of these plans from the perspective of majority owners is that they provide the holders of the plans with contact rights, not with shares or stock or units in the business. Therefore, the holders of phantom stock rights and SARs do not have the rights that are provided by statutes or in corporate formation documents to equity participants. In particular, the holders of phantom stock and SAR rights: (1) do not have any voting rights and therefore cannot vote for directors/managers or on any issues that affect the operations of the business, (2) they cannot call for meetings of the members or shareholders, (3) they have no right to demand access to the company’s financial books and accounting records, and (4) they have no right to bring claims alleging breaches of fiduciary duties because they are not owed any fiduciary duties by the officers and directors of the company.
In contrast to holders of phantom stock and SAR rights, equity owners, even those who hold a minority of the company’s shares or units, have legal and equitable rights that give them the power to cause substantial difficulties and disruption, both economic and practical, for those in control of the business. By way of example, minority owners can bring lawsuits claiming breach of fiduciary duties or demanding appointment of receivers; they can demand and obtain access to the company’s financial books and records; and they can require board or shareholder meetings to be held and votes to be taken on the agenda items they present.
In summary, the issuance of phantom stock and SARs to key employees can provide them with significant financial incentives without affording them the rights (and the power) of equity owners, as detailed above.
Benefits of Phantom Stock and SARs from the Minority Perspective
Should minority owners reject the grant of phantom stock and SARs and, instead, demand that they be given ownership of a minority equity interest? Not necessarily. Phantom stock plans and SARs can also provide significant and readily measurable financial benefits to key employees.
The first benefit is that phantom stock and SARs are non-taxable plans until the cash is paid to the employees in the future. This should be contrasted with some types of stock option plans which, when the grant of the option is based on past services performed, may be immediately taxable to the employee upon the grant of the option.
Second, phantom stock plans and SARs provide the employee with a contract right. If the company fails to honor this right and fails to pay the amount due to the employee under the terms of the contract, this would breach the contract. In Texas, a breach of contract claim authorizes recovery of legal fees by the prevailing party, which allows the employee to recover the amount due to him/her from the company under the plan, as well as all of the legal fees the employee incurred in pursuing the claim.
Third, and perhaps most importantly, the majority owner of a private company who issues stock to a few employees may not provide the new minority stockholders with a purchase price that assures the employee of receiving fair value upon leaving the business. In this regard, the departing employee may learn at the time of his resignation that the value of his/her ownership interest is subject to substantial minority discounts. Under phantom stock and SAR plans, however, the cash benefit to be paid to employees is typically well-defined and it is not subject to any type of valuation discount. [As noted earlier, however, the holder must still be employed by the company to receive the cash benefit at the time it becomes due.)
The majority owner who issues stock in his/her company to a group of valued employees may learn first-hand the truth of the adage that no good deed goes unpunished. Over time, these minority owners may grow unruly and vigorously exercise their rights as shareholders in ways the majority owner never anticipated. One way for majority owners to achieve most, if not all, of the desired benefits of providing financial incentives to key employees that flow from equity ownership, but without creating a new group of potentially adverse minority owners, is to use phantom stock and SARs strategically and with a clear explanation of their financial benefits.
Key management employees who are presented with proposed phantom stock or SARs should not reject them out of hand and insist on receiving equity stock grants. While phantom stock and SARs provide contract rights rather than equity participation in the company, when these plans are structured fairly, they can provide employees with significant financial benefits that are as attractive, if not more compelling, than stock option grants that provide a minority ownership interest in the company.