Phantom Equity: 6 Rules for Giving Key Managers a Stake Without Giving Away Your Company

The National Center for Employee Ownership defines phantom stock in a single line: it is "simply a promise to pay a bonus" equal to the value of company shares, or to the increase in that value over time.

That word "simply" hides most of the trouble. A promise to pay is only as good as the formula behind it, the cash to honor it and the rules for what happens when someone leaves. Get those wrong and the plan that was meant to keep your best manager becomes the reason they sue you.

Phantom equity is the right tool for most private and family companies that want managers to think like owners, but only if the owners write the rules before the first grant, not after the first dispute.

Our group was founded in 1890 and today runs eight business verticals in more than 75 countries with more than 180 people. In a company like ours, real shares stay in the family; that is a governance decision, not a negotiating position. Yet the managers who build each business deserve a share of the value they create. This is the conversation almost every private owner eventually has, and these are the six rules I would put on paper before having it.

What phantom equity is, and what it is not

Phantom equity gives a manager a cash payment tied to the value of the company, without shares, votes or a seat at the shareholders' meeting. There are two common forms:

• Full-value phantom stock: pays the value of a number of notional shares, including the value that existed on the day of the grant.
• Appreciation rights (often called SARs or phantom appreciation units): pay only the increase in value between the grant date and the payout date.

What it is not: a share. The manager has no ownership, no right to dividends unless you grant one, and no say in how the company is run. That is exactly why owners like it, and exactly why the written plan has to carry all the trust that a share certificate would otherwise carry.

Rule 1: Share the growth, not the value that already exists

A manager hired today did not build the first twenty years of your company. If you grant full-value units, you hand over a slice of value created before they arrived, and they get paid even if they add nothing.

For new managers, grant appreciation units; reserve full-value units for the rare person who already helped build what exists.

A simple illustration. The plan formula values a business at €10 million on the grant date. A general manager receives appreciation units equal to 2% of the growth. Five years later the formula says €16 million. The payout is 2% of €6 million, or €120,000. With full-value units on the same 2%, the payout would be €320,000, and €200,000 of it would reward value nobody in that role created.

Rule 2: Write the valuation formula before the grant

In a public company the market sets the price every day. In a private company somebody has to, and the moment that somebody is the owner deciding after the fact, trust is gone.

Choose one of two methods and put it in the plan:

• A fixed formula applied the same way every year, such as a multiple of EBITDA minus net debt.
• An independent annual valuation by an outside firm, more expensive but harder to dispute.

Then adjust for the owners' own money. If the family injects €3 million of new capital, the company is worth more, but the manager did not create that value. In the example above, net of that injection the real growth is €3 million and the payout is €60,000, not €120,000. Deduct new capital contributed and add back dividends paid out, or you will pay managers on your own investment. Our guide to incentive plans that make people behave like owners covers the same principle for annual bonuses.

Rule 3: Decide when it pays, and respect the tax rules on timing

There are two classic payout triggers:

• A liquidity event: the company is sold or changes control, and the units pay out at the deal price.
• A fixed date: for example, units vest over four or five years and pay out on a defined schedule.

A plan that pays only on a sale tells the manager something important: if the family never sells, the units are worth nothing. In a business meant to last generations, add a periodic payout or a buyback window, or the incentive will feel like a lottery ticket.

Timing also has legal consequences. In the United States, phantom plans are generally deferred compensation under Section 409A of the Internal Revenue Code. A plan that breaks those timing rules can expose the employee to an additional 20% tax plus interest, which is why many plans either pay within the short-term deferral window after vesting or fix the payout dates in writing from day one. Other countries have their own rules; payouts are usually taxed as employment income. Have tax counsel review the plan in every country where a participant works before anyone signs.

Rule 4: Fund the promise before it comes due

Phantom equity is an unfunded promise. On the payout date the company writes a cheque, and the cheque is largest precisely when the plan has worked best.

Three protections keep a success from becoming a cash crisis:

• Pay in installments over two or three years rather than in one lump sum.
• Cap the annual cash outflow as a percentage of free cash flow, with the remainder deferred.
• Reserve for it. Under US GAAP, cash-settled awards are generally treated as liabilities and remeasured each period, so the obligation shows up on the balance sheet anyway. Match it with cash set aside.

If you cannot explain where the money for a full payout will come from, the plan is too generous or too badly designed. For the wider discipline behind that sentence, see why profitable businesses still run out of cash.

Rule 5: Write the leaver rules now, while everyone is friendly

Most phantom plan disputes start the day someone leaves. Settle these questions in the document:

• Good leaver: retirement, death, disability or dismissal without cause. Vested units usually pay out at the last formula value.
• Bad leaver: resignation to join a competitor or dismissal for cause. Units are often forfeited or paid at the lower of grant value and current value.
• Unvested units: normally lapse on departure.
• Restrictive covenants: where local law allows it, tie the payout to non-solicitation and confidentiality obligations.

The point of these rules is not to punish people. It is to make sure the plan rewards those who stay and build, which is the reason it exists. Losing a key manager is a risk in its own right; our test for key person risk shows how to measure it.

Rule 6: Size the pool once, and explain it every year

Decide the total pool before the first grant: the maximum share of value growth the owners are willing to give across all present and future participants. Leave room for managers you have not hired yet. Granting the whole pool to the first two people leaves you nothing for the next five.

Then communicate. An incentive the manager does not understand is a cost without a behavior. Send every participant an annual statement showing the formula value, the number of units, what has vested and what the units would pay today. Managers who can see their stake grow each year make decisions as owners; managers who receive a legal document once and never hear about it again do not.

One more caution from the NCEO: plans that cover a broad group of employees, rather than a few key people, may fall under US retirement plan rules (ERISA). Phantom equity works best as a tool for a small number of leaders.

Key Takeaways

• Phantom equity gives managers the economics of ownership without shares, votes or a seat at the shareholders' meeting.
• Grant appreciation units to new managers so they share the growth they create, not the value that already existed.
• Write the valuation formula before the grant and adjust it for new capital and dividends, or you will pay people on your own money.
• Define payout triggers and timing in writing, and have tax counsel review compliance (Section 409A in the US) in every country involved.
• Fund the promise: installments, annual caps and a cash reserve keep a successful plan from causing a cash crisis.
• Settle good leaver and bad leaver rules while everyone is still friendly.
• Size the total pool once and send every participant an annual statement so the incentive actually changes behavior.

Frequently Asked Questions

What is phantom equity in a private company?

Phantom equity is a contractual promise to pay an employee cash tied to the value of the company, or to its growth, without giving them actual shares or voting rights. It is common in private and family companies because the owners keep full control of the cap table while managers still share in the value they help create.

Do you pay taxes on phantom equity?

Yes. In the United States, phantom equity payouts are generally taxed as ordinary compensation income when received, not as capital gains, and the company can usually deduct the payment when it is made. Most other countries also tax it as employment income, so the rules of each participant's country matter.

What is the difference between phantom stock and stock appreciation rights?

Full-value phantom stock pays the entire value of a number of notional shares, including value that existed at grant. Stock appreciation rights pay only the increase in value between the grant date and the payout date. For managers who join an established company, appreciation rights are usually the fairer design.

Is phantom equity worth it for employees?

It can be, if the plan has a clear valuation formula, a realistic payout trigger and written leaver rules. The weak point is that it is an unsecured promise from the company, so an employee should look closely at how the value is calculated and when the company is actually obliged to pay.

Give Your Best Manager a Reason to Stay

This month, write down the names of the two or three people whose departure would cost your company the most. Then ask yourself honestly whether any of them shares in the value they are building. If the answer is no, draft the six rules above with your adviser before one of them asks, or worse, before one of them leaves.

To see how we build businesses with a long horizon across eight verticals and five generations, explore the Manzanos Enterprises group.

This article is general information, not tax or legal advice. Phantom equity plans should be designed with qualified counsel in each jurisdiction.