You’ve probably heard of Synthetic Equity, Phantom Stock, and Stock Appreciation Rights for employees, but which one is right for your Company?
Short answer: it depends! These types of arrangements are done through a contract among the parties and one would need to look at the specific contract to see the specific terms and conditions of the synthetic equity, phantom stock, and stock appreciation rights. Generally though, these types of plans are given to employees to give them an approximation of equity in a Company, but not actually give them equity in the Company to disturb the management or ownership structure. It is not real ownership, but the parties act as if the holder has real ownership in the Company. These plans are not right for every Company, but can promote employee retention and motivation to grow the Company’s value when providing actual equity is disfavored.
Traditionally, Companies were formed as corporations. The founders received stock from the corporation representing ownership–Common Stock–which came with voting and cash dividend rights. In this model, everyone has the same rights, which was shared depending on your ownership percentage. Eventually, Companies wanted to be able to give other pieces of the Company away–perhaps stock without voting rights, or stock with extra rights to distributions. Non-Voting Stock and Preferred Stock were created to provide alternative rights from the Common Stock. The issuance of Non-Voting Stock gives Common Stock owners the ability to raise money or capital in the Company, but not give away any real control over the Company. For a corporation, all types of stock must be described in the certificate of incorporation or articles of incorporation on file with the state where the Company is organized. With this information, investors can determine what types of stock are issued by the Company, what rights each type of stock has, and how many shares of each type the Company can issue (this can be helpful to see how much an investor can be diluted by the issuance of additional stock).
An alternative to the corporate structure, LLCs were created to provide maximum flexibility. LLCs are governed by an agreement among their members, members who own a “membership interest” in the LLC. The Operating Agreement governs the management and financial aspects of the LLC, and can provide for various types of membership interests (including non-voting and those with preferred distributions). Generally speaking, the members can organize an LLC any way they desire, they are not as limited as a corporation is. Should someone receive an interest in an LLC without being admitted to the LLC, that person would hold an economic interest in the LLC, but not actually be a member and a party to the Operating Agreement.
For both corporations and LLCs, a popular way to incentivize employees is to provide a stock option or restricted stock. For a corporation, these can be fairly easy to implement, but will chip away at the equity and control the current owners ultimately hold. Implementation can be ongoing and maintenance can be very costly. When a corporation has a handful of employees to share in equity, these plans can be very effective, but when the numbers of employees, stock option grants, and associated vesting schedules grow, the plans can become very expensive. For an LLC, options or restricted membership interests grants are near impossible. More typical is for an LLC to provide “profits interests” to employees, but those plans can be extremely complicated and costly for a small business along with providing negative tax treatment for the employees receiving such interests.
Outside of the cost and complexity of a traditional equity incentive program, Companies may be barred from providing actual ownership in the Company. For an “S-Corp”, companies are capped at 100 equity owners. Even a mid-sized Company may reach that cap quickly with a stock option plan. Additionally, Women-Owned, 8(a), Service-Disabled Veteran-Owned, or other Companies participating in the Federal Government’s set aside contracting programs, must closely monitor their ownership in order to remain in compliance with the regulations. Providing employee equity plans, even if the employees would not have voting or other rights that could interfere with the eligible individual, would shift ownership percentages.
In order to avoid some of these issues, corporations and LLCs alike turn to synthetic equity, phantom stock, or stock appreciation rights. Synthetic equity is a term that refers to all manner of equity that is not actually equity. Phantom stock usually refers to a contractual arrangement whereby the Company acts as if the holder owns a certain amount of stock in the Company. The holder can receive bonuses as a “distribution” of profits in the Company or share in the profits at the sale or change of control of the Company (in an M&A context). The bonus amount would be tied to the equity in the Company–acting as if the holder had X% ownership in the Company.
Stock appreciation rights are similar to phantom stock, but typically refer to the right to receive a bonus at a sale or change of control in an amount that would mirror the increase in the value of the Company’s stock from the date of the SAR grant to the sale. Both types of synthetic equity can best vesting and would likely be forfeited should the employee leave the Company.
Providing any type of phantom equity will incur an expense for the Company and some accounting/tax issues, but the fees should be lower than the maintenance and on-going expenses for stock options. Additionally, in a corporate context, the phantom stock holder would not have any right to management (unless of course that was included in the contract regarding rights). Contrary to some beliefs, even non-voting stock holders (actual equity owners) get a right to weigh in on fundamental corporate decisions.
All of that said, Companies can obtain much of the same result with the issuance of restricted stock as a signing bonus, issuing bonuses on current profits or providing a “retention” type bonus to be paid out at a sale. Frequently synthetic equity and even stock options or employee stock ownership plans provide complex answers to problems that can be solved simpler. Regardless, Companies have many options when it comes to incentivizing employees.