In the private company context, high-performers, senior executives and other vital employees are a company’s lifeblood. It is therefore critically important to retain these top performers, which often requires that the company’s majority owners provide these key employees with significant financial rewards. Simply paying top performers additional cash compensation or issuing them shares of an illiquid ownership interest may not be the best approach. But issuing units or shares to employees will dilute the company’s ownership and could also expose the company’s majority owners to future claims for breach of their fiduciary duties. 

An alternative means of compensating top performers may be providing them with stock appreciation rights or what is known as phantom stock. This post reviews some of the pluses or minuses involved when majority owners are considering whether to issue these types of non-equity awards to the company’s highly valued employees.

Issuing Equity Grants to Key Employees Can Create Problems

The desire for an alternative to providing key employees with stock or units in the company is spurred by several factors. First, many companies are closely held and/or have elected Subchapter S tax treatment, which restricts the number of owners the company may have. Second, in closely held companies, the existing owners may be reluctant to have their ownership interest diluted by granting stock options to employees or issuing shares of stock or membership units to them. Third, granting equity to employees provides these new owners of the business with significant new rights, which may include, but are not limited to: (a) calling an owners’ meeting and including items on the agenda for discussion, (b) demanding access to the company’s financial books and records, (c) filing claims against the majority owners on a derivative basis for breach of fiduciary duties, and (d) receiving payment for their ownership stake in the event of a sale or IPO.

In short, once employees are issued equity in the company, they become co-owners of the business, and the majority owners need to be prepared to share ownership of the company and other rights of company governance with these new partners. Therefore, the majority owners need to be aware that their new minority partners will be authorized to assert a number of rights and/or claims against the company and its majority owner(s) that may result in conflicts that can disrupt the business. These concerns must be juxtaposed against the need for the majority owner to provide employees with some kind of “skin in the game” to incentivize them to remain top performers.

What Are Phantom Stock and Stock Appreciation Rights?  

Fortunately, the problems for majority owners discussed above that result from the issuance of equity to employees can be avoided through creative business solutions that do not make the employees new business partners. Specifically, the majority owner can issue stock appreciation rights (SARs) or phantom stock units to these key contributors to the business. These rights are sometimes referred to as “synthetic equity” because they provide employees with a contractual “piece of the pie” that does not give them an actual ownership stake in the business. And these synthetic equity grants can be based on actual shares of stock or other units of ownership, such as membership units.

A SAR is a right granted to an employee with respect to one or more shares of stock (or membership units) that entitles the employee to receive a cash payment for each SAR based on the performance of the business. This is akin to a cash bonus that is equal to the excess of the fair market value of a share of stock or unit on the date of exercise over a specified price, usually referred to as the “initial price” or “initial value” of the SAR. In other words, when the price of a share of the company’s stock increases over a set period, the employee receives a cash payment based on a defined formula. SARs are typically subject to a vesting period, often based on the passage of time, but they could be based upon achievement of other metrics.

As a simple example, an employer grants an employee 10,000 SARs with an initial value of $10 per share (which is equal to the fair market value of the company’s stock on the date of the grant). Sometime later the employee “exercises” the SARs, similar to the manner in which an employee would exercise a stock option, the only difference being that the employee is not required to pay any amount up front to acquire the SAR.

At the time the SAR is exercised by the employee, the fair market value of the company’s stock is $20 per share. As a result, upon exercise, the employee receives a cash payment — and thus taxable compensation — in an amount equal to $100,000 (the difference between the current fair market value of $20 per share and the “initial value” of $10 per share, multiplied by the number of SARs granted to the employee, or 10,000). The company will realize a corresponding tax deduction for the payment of this additional compensation. Payment of SARs may be in cash, stock, or both, but they are most often paid in cash, as payment in stock would be dilutive and counter to the notion of “synthetic equity.”

Phantom stock units, like SARs, are also based on the value of underlying stock or membership unit. The difference between phantom stock units and SARs is that rather than receiving a cash payment upon exercise equal to the appreciation in the underlying employer stock, over some “initial value,” the recipient of phantom stock units receives the actual value of the shares of the underlying stock, multiplied by the number of phantom stock units held by the recipient. As with SARs, awards of phantom stock are typically subject to a vesting period.  

As an example, an employee receives 10,000 phantom stock units. The fair market value of the company’s stock at the time the phantom stock units were granted to the employee is generally not as important as it is with respect to SARs, which use an “initial value.” When the phantom stock units are paid, the employee receives the actual fair market value per share of employer stock at that time. Therefore, if the fair market value at the time of payment was $20, the employee would receive $200,000 ($20 per share multiplied by 10,000 phantom stock units).  Unlike SARs, however, the employee received value when the phantom stock units were granted.  In the example above, if the value of the underlying employer stock was $10, the employee has $100,000 of value on the grant date. If this were a SAR with an initial value of $10 per SAR, there is no value of any kind unless and until the value of the underlying stock appreciates above $10.

Federal Income Tax Treatment

There is no tax due when an employee receives a grant of a SAR or phantom stock units; taxes become due only upon exercise and payment. An employee who has vested SARs or phantom stock units is not in “constructive receipt” of income upon vesting, and thus the employee has not received any ordinary income simply by virtue of the vesting and appreciation of the employer’s stock. Rather, the cash payment to which the employee is entitled is included in the employee’s gross income for the year in which the SAR or phantom stock unit is exercised or paid, at which time the employee receives ordinary taxable income that is subject to withholding similar to normal compensation payments. The company also receives a corresponding tax deduction equal to the amount included in the employee’s income when the employee is taxed upon exercise of the SAR or the payment of the phantom stock unit.

Conclusion: Advantages and Disadvantages

The advantage to the employee of receiving a SAR is that it provides him or her with the potential opportunity to receive large payments from the company while avoiding the need to provide any cash outlay that is associated with buying stock options or actual stock in the company. With certain exceptions due to the impact of Code Section 409A, the employee can also control the timing of exercise with respect to a SAR (but cannot do so with respect to phantom stock units due to Code Section 409A requirements). From the company’s perspective, the employee gains parallel shareholder gains. The employee has no gain unless the share value increases. Finally, the holder of a SAR is not considered a shareholder. Thus, performance-based stock compensation can be awarded without increasing the number of shareholders or otherwise diluting existing shareholders.

Like SARs, the advantage of phantom stock is that it provides a means for the employer to compensate an employee with the value of company stock without having to issue actual shares stock. Similar to SARs, the employee has the potential to receive large gains and yet avoids the financing costs of options and stock ownership. Unlike a SAR, however, the employee who receives a phantom stock unit can receive substantial value even if the company’s stock performs poorly. Based on the example above, if the value of company stock decreased from $10 to $5 per share, the employee would still receive a cash payment of $50,000 based on the ownership of the phantom stock. With a SAR, if the value of the company’s stock declines or remains the same, the employee receives nothing. 

There is one additional, significant benefit to majority owners for issuing SARs and phantom stock to key employees rather than providing them with actual equity. These types of synthetic equity provide contractual benefits, and the employee must therefore remain employed by the company to receive them – this is a “must be present to win” component. When actual stock is issued to employees, the company or majority owner has to repurchase the shares when the employee resigns or the employment is terminated, which can lead to conflicts about the value of the stock being redeemed. With SARs and phantom stock, however, these rights are extinguished automatically when the employee departs from the business and, therefore, there is no stock or ownership interest the majority owner or the company needs to repurchase.