Phantom Equity - An Idea for Motivating a Key Employee
Updated: May 17, 2020
How do you keep a key employee interested and engaged? You might give him equity in the business - an ownership position - like stock in a corporation or membership interests in an LLC. Stock options are trendy.
But equity ownership means more than just a right to share in the profits. It also means voting rights (and maybe the ability to veto corporate action). Giving a key employee such a potentially powerful voice in the company's decisions might not be a good idea for the company.
In addition, giving an employee equity creates separation issues if the employee quits or is fired. Typically, in those circumstances, the company will need to buy back the equity or let the ex-employee remain an equity owner.
Giving a key employee the right to participate in the company's profits, without giving him any other rights, might be the answer. This benefit usually is called "phantom stock."
What it is: The key employee gets the right to receive a certain percentage of the company's profits each time profits are distributed to the equity owners. In addition, the key employee might get the right to receive a certain percentage of the sales proceeds the company receives if it is sold (i.e., the purchase price from an asset sale, stock sale, or merger). The phantom stock rights typically terminate if the employee quits or is fired.
How you do it: The company and the key employee enter into a contract that defines the phantom stock rights.
So the next time you are thinking about giving a key employee an equity position in your company, pause, take a deep breath, and think about whether offering phantom stock will accomplish your objectives while avoiding some of the risks of giving equity to an employee.