A company can reward and provide incentive to employees with awards or grants of company ownership or equity. Two alternatives include actual equity or “phantom equity”. Phantom equity is an equity-based contract which mimics equity ownership and provides similar economic payments related to company operations and any exit event such as a company sale. Various advantages and disadvantages (or challenges) exist for each alternative. Also, for each alternative, various features can be used to best maximize the reward or incentive for a particular employee and protect the company and existing owners.
Actual Equity or Ownership
Some Advantages
- Employee owns an actual legal interest in the company (whether shares or units), so the award might have a better psychological benefit or impact for them and in turn the company.
- Existing ownership structure and documents (including buy-sell agreements) (if any) could be used but might need to be changed.
Some Disadvantages (Challenges)
- Company would need to implement a buy-sell agreement (if one does not already exist) in order to put in place restrictions on transfer of ownership and buy-out rights upon certain events related to the employee such as death, disability, bankruptcy, creditor actions, divorce and separation of employment. These are needed for various reasons including in order to control who has ownership and safeguard against unintentional owners. If the company has an existing buy-sell agreement, it might need to be changed or supplemented to apply to scenarios which were not initially expected.
- Unless the company grants the ownership in connection with its initial formation when there is zero or very little value to the company, the employee will have tax consequences based on the current value of the company. Thus, the employee will need to come out of pocket to pay taxes. The IRS views equity grants as being made in exchange for the employee providing services, so the employee will recognize ordinary income reported on their W2 to the extent the value of the equity received exceeds what the employee pays for it. Usually, the company does not require the employee to make any payment for an equity grant.
- Documents will likely be more substantial increasing the company’s cost. Depending on the facts, additional accounting or tax costs might be incurred.
“Phantom Equity” or Equity-Based Right
Some Advantages
- Company avoids risk of unintentional owners because the award is a contract right which is non-assignable and cannot be attached by third parties like creditors instead of actual ownership.
- Company need not incur additional expenses to create a buy-sell agreement (if one does not already exist) or to modify any existing buy-sell agreement to add further protection related to employee ownership.
- Employee will not incur any front-end tax consequences related to the award.
- Company has flexibility to choose whether the economic benefits to the employee will apply only to an exit event or sale of the company or will also apply to operational results such as owner annual or quarterly distributions (if any).
- Company has flexibility to apply economic benefits to the employee with respect to an exit event or sale of the company only if the employee remains employed at the time of such event. Company can also choose whether to make any payment to an employee if employment ends prior to an exit event or sale of the company.
- Payments to the employee will be tax deductible by the company.
- Can be easier to customize for each employee in the individual document for the employee.
- Documents will generally be simpler and less costly.
Some Disadvantages (Challenges)
- Employee might have a lesser psychological boost related to the award because it is a contract right instead of actual ownership.
- All payments received by the employee will be taxed at ordinary income tax rates instead of any payments related to an exit event or sale of the company possibly being taxed at capital gains rates. But capital gains rates might not apply with an exit event based upon the structure of the sale. Other adjustments could be made to minimize any difference in tax rates.
Some Features
- Vesting can be used to reward but maximize retention and continuation of services of the employee.
- Vesting can be based upon (i) length of continued employment, (ii) thresholds, milestones or metrics related to the employee’s individual performance, (iii) thresholds, milestones or metrics related to the company’s overall performance, and (iv) any combination of any of the foregoing.
- If not already existing, the company can further protect the company by conditioning any award on the employee agreeing to certain protective covenants such as confidentiality, work product, non-disparagement, non-solicitation of personnel, non-solicitation of customers and/or non-competition.
- If the company awards actual equity and vesting applies, the employee can make a timely Section 83(b) election with the IRS with the goal of minimizing the income taxes which might otherwise apply.
- Company’s payments can be varied including on an installment basis.
If done properly, equity or equity-based awards can foster retention and additional alignment of goals and actions. A company has several tools to use to reward and provide incentive to employees. These tools can also be used with non-employees such as contractors, consultants, directors or even third parties with whom the company has a contract or some business arrangement.
Many factors can impact the choice and structure of equity or equity-based awards to employees or others including whether the company is a limited liability company or a corporation, as well as the tax status of the company such as a C corporation, an S corporation or another pass through for tax purposes such as a partnership.
There is no “one size fits all” related to equity or equity-based awards to employees or others, so working with an attorney experienced in these areas is very important to ensure the company makes choices which are best for the company as well as the particular employee or other person in order to maximize the intended results.
BFV’s corporate attorneys assist businesses and their owners in all phases of their operations, including start-up and structuring, such as C and S corporations and limited liability companies; raising capital and funding, including private placements, venture capital and bank loans; negotiating and implementing contracts, such as employment agreements, incentive arrangements, buy-sell agreements, distribution agreements and confidentiality, non-solicitation and noncompete agreements; business and asset acquisitions and divestitures, including asset and stock transactions and taxable and tax-deferred mergers and reorganizations; joint ventures; and facilitating exit strategies. Please contact us for assistance.
David concentrates his practice in corporate law and mergers and acquisition and other related areas to serve his clients. He represents privately-held businesses and entrepreneurs, as well as senior executives and organizational leaders at privately-held and publicly-traded businesses.
