An Employee Phantom Equity Plan Can Be a Better Way to Incentivize Employees when Raising Funds From Investors

Establishing equity-based incentives for key personnel is an essential requirement for retaining qualified employees.  But  start-up and developing companies must keep in mind that a company’s private equity investors will be keeping an eye on the capital structure and the effect of compensation plans that will affect their investments. The design and legal requirements and tax considerations must be considered, along with the personal interests that employee participants have in the equity process.

While typical employee pools in start-up entities have about ten percent of their shares established as authorized for such compensation plans, there is no fixed rule.  This is because private equity investors and the issuing company’s management ordinarily have mutual interests in designing equity incentives that are aligned with a return on investment for the private equity investors and a meaningful opportunity for the participants to share in value creation. Typically, private equity investors will control the decisions regarding the overall size of the incentive equity pool, and sometimes they will want input on individual grants, and certain terms and conditions of the plan. Issuers need to be mindful of aspects of the issuing company’s organizational and legal structure; and a review of its organizing documents is needed as they may limit the types and amounts of equity available for the incentive plan, and the vesting schedules and limits on distributions and liquidity.

So vesting terms can be seen by investors as the key term of the equity award plan. Vesting is usually time-based, but can be value-based (or a combination of the two), or milestone-driven. Issuing companies need to look at their vesting schedules as tools for providing the employee participants with incentives for remaining with the company, so it is important to consider whether equity awards can be retained after the employment terminates. If management contemplates a future sale of the company, one can expect the buyer to request that management convert (or rollover) a portion of the proceeds from their incentive equity to the post-sale company, thereby aligning management’s interest with the buyer.

Private equity-backed companies are also starting to implement broad-based employee “ownership” programs, sometimes as “phantom” equity pools, often in the form of bonuses dependent on company achievements at the time the private equity investor exits. These “phantom equity” programs are now being widely used when soliciting private equity investors, as they also are acceptable to employees because they provide the employees with the feeling of ownership while, at the same time, these plans serve to avoid the legal and tax implications of granting “real” equity interests to employees.

In designing and negotiating private equity-backed equity incentive programs in the real world, these are among the most critical issues:

• What features of equity incentives should be included to reflect the issuing company’s performance and value?
• What conditions and restrictions are typically placed on incentive equity?
• What is the effect of exit strategy considerations on the vesting schedule for incentive equity?
• What negotiating points typically arise between incentive equity holders and private equity investors?

For a detailed discussion about implementing phantom equity programs in your business structure, contact Dan Brecher at Scarinci Hollenbeck, LLC. Call 201-896-4100 to discuss your organization’s specific considerations.

Results may vary depending on your particular facts and legal circumstances.