To watch the full interview with Chris & Mark as they discuss the most commonly asked questions about phantom stock, click here.
Chris: All right, well thanks so much, Mark, for joining me for this video. Just to kick things off, why don’t you tell the listeners or watchers a little bit about who you are, your background, and your relationship with Reins?
Mark: Sure. I’m certainly glad to be associated with Reins as outside legal counsel. In terms of my expertise, I have over 40 years of experience in executive compensation, focusing on incentive plans, stock plans, and phantom stock plans. I’ve worked with both small and large companies, public and private. For over 20 years, I worked at a law firm with over a thousand lawyers, where I led the executive compensation practice. Additionally, I spent over 10 years teaching at Georgetown Law School on the subject of executive pay, securities issues, and tax, among other topics. So, my background is quite compatible with what Reins is doing, and I’m glad to support the effort.
Chris: You’re a little qualified to speak on the subject, then!
Mark: [laughs] Yes, I feel comfortable with what we’re talking about.
Chris: Great! Why don’t we start with this: What is phantom stock, and how does it work?
Mark: Phantom stock can sound elusive or mysterious, but it’s actually pretty straightforward. The “phantom” part means that it’s an award paid in cash rather than actual stock. Essentially, phantom stock gives an individual the financial upside of stock ownership without the actual ownership rights, like voting or reviewing company records. For closely held or private companies, phantom stock is popular because it serves as a financial incentive without expanding the shareholder base or giving up control of the company.
Chris: Got it. Do you have to share information with phantom stockholders?
Mark: Technically, no, you don’t have to. However, you need a mechanism for valuing the phantom stock, and the more credible that mechanism is, the better the plan works. Typically, phantom stock plans provide an annual valuation, but you wouldn’t necessarily need to share how the valuation was done. Companies usually set up the plan so that any good faith valuation they provide is binding, to avoid disputes. You don’t want to litigate value, so it’s important to have consistent internal records to defend how the value was determined.
Chris: Do phantom stockholders have to purchase it, or can they exercise it at any time?
Mark: No, phantom stockholders don’t purchase phantom stock. Phantom stock is essentially a promise to pay money in the future, so you can’t really purchase a promise. Now, there are two types of phantom stock: a whole value award, which gives the holder the full value of the stock, and an appreciation-only award, which is similar to a stock appreciation right. In the latter case, the holder only benefits from the increase in value after the award is granted. A downside of the appreciation-only award is that if the company’s value doesn’t increase, the award has no value.
Chris: And just to clarify, for both the whole value and the appreciation-only awards, is the payment triggered by a specific event?
Mark: Exactly. The payment could be triggered by a future event like a change in control or the passage of time. The design of the award determines when and how it can be exercised.
Chris: What are the benefits of phantom stock for companies, especially small business owners?
Mark: Small businesses often do a great job with annual bonuses and retirement benefits, but phantom stock fills the mid-term gap. It provides employees with an incentive to stay for several years or until a specific event like a change in control. It offers them a stake in the company’s future without giving them actual ownership.
Chris: Are there any downsides for the company when offering phantom stock?
Mark: The only potential downside is that you’re adding complexity. You need to administer the plan and keep proper records. But if it’s structured properly, a phantom stock plan can be predictable and beneficial. One thing to be mindful of is modeling the plan properly from the start so you understand how it will affect the company over time.
Chris: What are the benefits for employees?
Mark: For employees, phantom stock functions as a deferred bonus. It gives them a financial stake in the company, which accumulates over time. If structured correctly, it can also serve as a way to retain employees by tying payouts to continued employment or performance milestones.
Chris: How does phantom stock compare to other structures like profits interest, stock appreciation rights, or actual equity?
Mark: Phantom stock is much simpler than profits interest or stock appreciation rights, especially for small businesses. Profits interest, for example, is extremely complex, with significant ongoing tax and accounting obligations. By contrast, phantom stock is straightforward—it’s essentially a promise to pay a cash amount based on company performance, without the complications of real equity or profit-sharing plans.
Chris: Is phantom stock taxable?
Mark: Yes, it’s taxed as ordinary income when it’s paid out. Phantom stock offers flexibility, though. You can give employees the option to defer the payout and spread it over several years, which can help with tax planning.
Chris: What happens if an employee who holds phantom stock quits or is terminated?
Mark: That’s completely up to the design of the plan. Some companies require employees to be employed at the time of the triggering event, while others allow vesting over time. You can also tie payouts to non-compete agreements or trade secret protections to protect the business if someone leaves.
Chris: How can phantom stock be used in succession planning?
Mark: Phantom stock is a great first step in succession planning. It allows the business owner to share financial upside with key employees without giving up ownership. It’s a way to see if a person is the right fit for eventual ownership.
Chris: What’s the number one thing small business owners should consider with phantom stock that they might not think about?
Mark: The biggest mistake I see is underappreciating key employees. Phantom stock can be part of a larger strategy to retain and incentivize those people. I also recommend tying it to non-compete or non-disclosure agreements to protect the business.
Chris: Great advice. Thanks so much for the time and insights today, Mark.
Mark: Glad to be here, Chris.
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