Phantom Stock as Executive Compensation for Family Businesses

By Robert Adelson on 4 September 21   Executive Employment

This article was published in Ivy Exec in September, 2021.

Whether you are a C-level executive, a VP or senior executive, or even a director rising in the company, your executive compensation package should always have two components.

The first component is your cash compensation – fixed: your base salary; and variable: your executive bonus based on performance.

There should also be a second component, your equity in the company. If you perform well and the company prospers, the company grows in value. That will certainly benefit the investors, who put capital into the company. But as part of the management who made that growth possible for the investors, you too should have a stake in that growth. That stake comes from your executive equity which is separate and in addition to your cash compensation.

However, if you work for a family business or are considering an executive job offer from a family business, you are not likely to receive equity as part of your executive compensation. Why? Most family businesses are organized to keep 100% ownership within the family to satisfy their family objectives and avoid having minority shareholders who only want to maximize profits. In this situation, how can you get your stake in company growth?

This article explores three alternatives to executive equity compensation. In particular, phantom stock is a way for family businesses to provide equity-type benefits to their executive-level employees, thereby enhancing their ability to compete for executive talent. For you, it means you can get the benefits of equity compensation without actually receiving equity.

non-family executive working in a family business

Alternatives to Equity Compensation

The first alternative is to offer a non-voting stock plan. This applies only for S corporations, LLCs, and C corporations.  Non-voting stock is usually equal in all economic aspects to voting stock except that there are no voting rights, unless state law requires otherwise.  Holders of non-voting stock gets the same dividends and distributions of voting stock holders. They share proportionately in the proceeds of the sale of the business should it occur. Non-voting equity compensation therefore provides for all the same potential capital appreciation of voting shares and on top of that, allows you to take advantage of the record low 15% tax rate on capital gains and dividends. However, without voting rights, you won’t have a say in the company’s operations and strategic choices.

On the other hand, many family businesses are reluctant to issue non-voting stock outside the family. They recognize that shareholders can have certain intrinsic rights, and even non-voting stockholders, could potentially litigate over decisions made that do not maximize profits.

The second alternative is to offer a non-qualified deferred compensation plan. This type of plan is designed to secure your payout in future. Taxation is deferred via a ‘rabbi trust’, so called because it was first used for a rabbi. The deferred compensation provided by a rabbi trust does not rise and fall with the value of the company stock, hence it is not tied to the performance or growth of the company. It is also subject to the creditors of the family business.

Phantom Stock

The third alternative is phantom stock. It enables family businesses to face the competition for talent by offering the non-family executive a form of equity compensation that does not transfer ownership.

The phantom stock is a variation of the rabbi trust that gives the look, feel and appreciation opportunity of real stock.  Under the phantom stock plan, the company sets a share value benchmark (the phantom strike price) at the time the stock is issued to you. The plan usually includes a vesting and redemption schedule as well as a method for future stock valuation. If the family business grows and increases in value, and then you redeem your shares (units in the phantom stock plan), you will get an amount equal to the value appreciation. In other words, you will be paid the difference between the share value on the phantom stock redemption date and the original phantom strike price. This payout would be similar to what you would get if you had real stock options.

For offers from small public companies and private companies, phantom stock may actually be better for you than real stock because you may not be able to find buyers for the stock of these types of companies. On the other hand, phantom stock provides liquidity because the company, in essence, buys you out.

Substitute Options, RSUs, Capital Gains

There can be a lot of flexibility in the structuring of phantom stock.  One approach pegs a strike price at current per share value.  If that strike price went down, the phantom units would be under water and worth nothing similar to options. Another approach is to structure the phantom stock as phantom RSUs so that instead of delivering the spread on the growth of your units, it could be structured to deliver the total value of your units, either before tax or after tax.  In this manner, phantom units, once vested, could never go under water.

The phantom stock plan could also be structured to deliver phantom capital gains and/or phantom dividends. Stock option plans rarely allow you to take advantage of capital gains or dividend tax treatment, so this phantom stock approach could also provide a distinct advantage over real stock.

If you are considering an executive job offer from a family business, you might want to consider introducing a phantom stock plan.  It is a way for the family business to share the rewards of ownership without actually giving you equity. The actual terms can be a substantial piece of your executive compensation package. Therefore, you should consult an experienced executive compensation lawyer to help you achieve the best offer.