At some point as a business owner, you’ll think about incentivizing your key team members, and you’ll likely hear about the concept of ‘phantom equity.’
(Side note: A more descriptive term would be the ‘mutually contractual golden handcuff that gets us rowing in the same direction’, but phantom equity rolls off the tongue easier. Either way, if you need a refresher on what phantom equity is, click here.)
If you are at the point where you are thinking about golden handcuffs for your management team, let’s rule in / out when phantom equity can make sense. First, the ‘rule out.’
It’s been our experience that phantom equity does not work well (meaning it’s perceived as more of a ‘slight’ than an ‘incentive’) when real live equity ownership is more the industry norm. CPA firms, law firms, medical practices, and generally heavy white collar, rite of passage, chasing-the-carrot types of industries are not appropriate for phantom equity. That’s because, even if it results in the same financial result for the recipient, the psychological reaction is likely to be ‘guess I’ll never be an owner around here and I’m really not appreciated.’ So, in these types of industries, you need to be figuring out real equity plans.
While phantom equity is a good gateway into real equity, if your ultimate succession plan is an internal buyout by your team (not an ESOP), then at some point you are going to have to create a real equity plan. This is because your team will be buying your equity and will thus be equity owners. In our opinion, that phantom equity step just adds an unnecessary complication.
If you are not these first two examples, great news! Phantom equity is right for you. It’s been our experience that from the company performance / incentive perspective, there IS NO DIFFERENCE in end results between equity and phantom equity, so phantom equity is the superior choice given all the pros and flexibility it offers (e.g., no buy in, no K-1s, no buy out if someone is terminated for cause, limited legal disputes…basically, all the headaches that can come with real equity plans).
That said, be very careful. If you do not have a plan to get the ‘key team member’ paid in a reasonable time frame, one could question its value as an incentive. Imagine working for ‘the man’ and ‘the man’ said to you, “Hey, Timmy, you’re really valuable, and someday, I might sell this company and reward you, and here’s what you’ll get.” If there’s no timeframe around that, Timmy’s not going to get excited about waiting around until he’s 60 or more for a payout! (FYI: A legal phantom equity plan must have a time expiration on it anyway, even if it’s just renewed later.) Instead, the best plans are also coupled with a shared vision like, “We are going to grow to a $20m valuation in the next four years, and at that point, we’ll sell, and this will be your share.” Now that’s something Timmy can get behind!
Hope this helps. Don’t forget, to check out the BGW Vault. In addition to tax strategy, we cover topics on succession planning, value creation, cash flow, and more. Access it now!
