Shadow Shares: A Hidden Asset Class
In the world of startups, attracting and retaining talented employees is crucial. One way these businesses achieve this is through equity compensation, and one such form is the Phantom Stock Plan.
Phantom stock, also known as shadow stock, is a type of deferred compensation offered by start-up companies to their key employees or independent contractors. Unlike traditional equity, it offers the benefits of stock ownership without giving employees actual shares, thus avoiding dilution of company equity.
The payout under a phantom stock plan is tied to the market value of the company's stock at the moment of vesting. There are two main kinds of phantom stock plans: "appreciation only" plans and "full value" plans, with the former only paying out if the shares increase in value after the phantom stock has been granted. These plans may provide for dividends or not.
For startups, the pros include flexible structuring, tax advantages for the employer, and no dilution of equity. Employers do not need to allocate actual shares and can modify plan parameters as needed. From the employee perspective, phantom stock provides financial upside tied to company performance without complicating ownership or receiving K-1 tax forms from multi-state businesses.
However, there are cons to consider. For startups, the main challenge is cash flow, as payouts under phantom stock plans are cash expenses that the company must reserve for in the future, potentially impacting liquidity. Additionally, certain plan features like accelerated vesting can introduce tax and financial complexity, and may reduce employee retention incentives.
From the employee perspective, the downside is primarily taxation treated as ordinary income on cash payouts rather than capital gains, which can result in a higher tax burden. Unlike true equity, phantom stock does not provide voting rights or dividends, and payments are only made if certain conditions or liquidity events occur.
Here's a summary of the pros and cons for both startups and employees:
| Aspect | Startup Pros | Startup Cons | Employee Pros | Employee Cons | |----------------------|------------------------------------------|----------------------------------|--------------------------------------------|------------------------------------------| | Equity Ownership | No dilution of equity | Must fund future cash payouts | Benefits from company value upside | No actual shares or voting rights | | Taxation | Tax benefits and timing flexibility | Cash payments are taxable expenses| No complicated multi-state K-1 income | Payouts taxed as ordinary income (higher rate) | | Plan Flexibility | Highly customizable and can include vesting| Complex financial and legal compliance | Incentive aligns with company success | Payments depend on milestones or liquidity events | | Cash Flow Impact | N/A | Potential disruption to cash flow| N/A | N/A |
In essence, phantom stock is an appealing tool for startups wanting to motivate teams without diluting equity but requires careful cash flow and tax planning. Employees gain incentive upside with simpler tax filings but face ordinary income taxes on payouts and lack actual equity rights.
By granting employees an ownership stake in the company, startups can align the interests of employees with those of the company and its investors. However, it's essential to consider the potential cash flow and tax implications before implementing a phantom stock plan.
[1] Startup Phantom Stock Plans: Pros and Cons for Startups and Employees (2021), www.startupnation.com [2] Phantom Stock Plans: What Every Startup Founder Needs to Know (2020), www.forbes.com [3] Phantom Stock vs. Stock Options: What's the Difference? (2020), www.investopedia.com [4] Understanding Phantom Stock: A Guide for Startup Founders (2019), www.entrepreneur.com [5] The Pros and Cons of Phantom Stock for Startups (2018), www.inc.com
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