It's There But It’s Not: Understanding Phantom Equity for Startups

Casey Fenton

|

November 7, 2023

Imagine you're the founder of a promising tech startup, racing against the clock to bring your groundbreaking product to market. The pressure is palpable, but you're not alone – you have a team of talented and dedicated employees who share your vision. As the company gains traction and its valuation skyrockets, you face a conundrum: how do you keep your team motivated and deeply invested in the company's success without diluting your hard-earned equity? 

This is where the enigmatic concept of phantom equity enters the scene, offering a tantalizing solution that sounds almost too good to be true. In this article on innovation and ownership, we'll uncover the nitty-gritty of phantom equity and explore how it could reshape the landscape of startup compensation strategies.

What is Phantom Equity?

Phantom equity, despite its intriguing name, is a practical concept employed by startups to reward and motivate employees without parting with actual ownership shares. In this compensation strategy, employees are granted a simulated form of ownership—a "phantom" stake—that mirrors the benefits of traditional equity without the tangible transfer of shares.

The term "phantom equity" is derived from the intangible nature of this ownership arrangement. Unlike conventional equity, which involves direct ownership of shares, phantom equity exists virtually, much like a reflection in a mirror. Just as a phantom's presence is felt but not physically grasped, so too is phantom equity experienced without the actual exchange of shares.

Consider a startup using traditional equity that creates a clear picture of who owns what. Phantom equity, however, introduces an alternative approach. It's as if you're tracing the outline of the puzzle pieces, creating a silhouette that captures the essence of ownership without completing the full picture. This innovative method allows startups to reward their team without diluting their ownership structure.

The motivation behind phantom equity is straightforward. Startups face the challenge of attracting and retaining talent while safeguarding their equity for future needs. Phantom equity emerges as a strategic answer, offering a way to entice employees with a share in the company's potential success while preserving actual equity for investors or strategic partnerships. This pragmatic balance between incentives and equity preservation defines the essence of phantom equity.

How Phantom Equity Works

Phantom equity operates on a simple principle: the value of the virtual ownership granted to employees is tied to the company's performance and valuation. As the startup grows and reaches predefined milestones, the phantom equity account accumulates value. This value is determined by the agreed-upon formula, often tied to the company's valuation or financial metrics.

When it's time to cash in, employees receive a payout equivalent to the accumulated phantom equity value. This payout can come in various forms, such as cash or a combination of cash and actual equity. The simplicity and flexibility of this mechanism make phantom equity an appealing option for startups striving to reward and retain their key contributors.

Benefits of Using Phantom Equity as a Startup

Phantom equity emerges as a dynamic tool that startups can wield to their advantage, offering a range of benefits that set it apart from conventional equity structures. By delving into the world of phantom equity, startups can tap into a host of advantages that align with their unique challenges and aspirations.

1. Retention Incentive

In the whirlwind world of startups, retaining top talent is paramount. Phantom equity acts as a powerful magnet, drawing in skilled individuals and encouraging them to remain committed for the long haul. The promise of a potential financial windfall upon the company's success intertwines employees' fates with the startup's journey, creating a shared sense of purpose that fuels dedication and loyalty.

2. Preservation of Equity

Unlike traditional equity grants, where each share dilutes the ownership pool, phantom equity preserves the startup's equity structure. This is particularly crucial during the early stages when preserving equity can impact future fundraising rounds and valuations. Startups can allocate phantom equity without diminishing their ownership percentages, a strategic advantage that supports growth and future negotiations.

3. Alignment of Interests

The phantom equity concept bridges the gap between employee and owner mindsets. When employees are granted phantom equity, their interests mirror those of the company's owners, fostering a culture of collective responsibility. With financial rewards directly tied to the startup's performance, employees become stakeholders in the truest sense, driving them to make decisions and contribute in ways that amplify overall success.

4. Flexible Customization

No two startups are identical, and phantom equity recognizes this diversity. Companies can tailor their phantom equity plans to suit specific roles, contributions, and company milestones. This customization promotes fairness and ensures that rewards are commensurate with individual or team achievements. The flexibility of phantom equity allows startups to be innovative in their approach to compensation.

5. Financial Resource Allocation

Startups often find themselves in a delicate financial balance, juggling operational needs with strategic growth initiatives. By using phantom equity, startups can allocate their financial resources more strategically. Cash that might have been used for traditional equity grants can be redirected toward critical areas such as research, development, and marketing, propelling the startup closer to its goals.

6. Employee Empowerment

Phantom equity empowers employees by instilling a genuine sense of ownership. This empowerment transcends the financial realm, empowering individuals to think and act like true stakeholders. When employees have a stake in the startup's success, they become motivated contributors who take ownership of their roles, resulting in a more engaged and proactive workforce.

7. Attracting Top Talent

In the fiercely competitive startup landscape, attracting top-tier talent can make the difference between success and stagnation. Phantom equity serves as a unique selling point, differentiating the startup from others and appealing to candidates who seek both financial potential and a deeper connection to the company's growth trajectory.

Types of Phantom Equity Plans: Tailoring Ownership Rewards

Just as startups come in diverse forms, so do the mechanisms of phantom equity. This innovative compensation strategy offers several types of plans, each with its unique structure and benefits. By understanding these variations, startups can choose the phantom equity plan that best suits their goals and aligns with their organizational culture.

Appreciation-Only Plan

In this type of phantom equity plan, employees are entitled to a payout based solely on the appreciation of the company's value over a specific period. As the company's valuation climbs, so does the phantom equity's value, creating a direct correlation between growth and rewards.

Performance-Based Plan

This plan intertwines phantom equity with performance metrics, linking rewards to specific accomplishments or milestones. Imagine a ladder of achievements, with each rung representing a milestone. As employees contribute to the startup's progress and ascend this ladder, their phantom equity account swells. This type of plan actively drives employees to excel and aligns their efforts with the startup's objectives.

Exit-Triggered Plan

Phantom equity can also be triggered by specific exit events, such as a merger, acquisition, or initial public offering (IPO). Think of it as a countdown to a grand finale – employees are poised to reap the benefits when the startup achieves a significant milestone. This plan aligns with the startup's overall journey and offers employees a tantalizing reward for their dedication to seeing the company through to its exit.

Hybrid Plans

Just as a palette of colors can be blended to create unique shades, startups can design hybrid phantom equity plans that combine elements from multiple types. These plans offer a higher degree of customization, allowing companies to craft a compensation strategy that precisely reflects their vision and objectives. A hybrid plan might intertwine performance-based incentives with exit triggers, offering a multifaceted reward structure.

Synthetic Equity Units

In this variant of phantom equity, employees receive units that simulate actual equity shares. These units track the company's value and mimic the experience of traditional shareholders, complete with dividends and value fluctuations. While not conferring actual ownership, synthetic equity units provide employees with a taste of the equity ownership experience.

Risks Typically Associated with Phantom Equity and How to Solve Them

While phantom equity shines as a beacon of innovation, it is not without its shadows. As startups venture into the realm of virtual ownership, they must be mindful of potential risks and challenges. By understanding these pitfalls and crafting effective strategies to mitigate them, startups can navigate the complexities of phantom equity with confidence.

1. Misaligned Expectations

The intangible nature of phantom equity can lead to misunderstandings and unrealistic expectations among employees.

Solution: Open and transparent communication is paramount. Clearly outline the mechanics, potential outcomes, and risks of phantom equity to ensure that employees have a realistic understanding of what they can expect.

2. Valuation Volatility

Phantom equity value is intricately tied to the startup's valuation, which can fluctuate significantly over time.

Solution: Establish a consistent and transparent valuation methodology that takes into account the startup's growth trajectory. Consider periodic adjustments to ensure that phantom equity accurately reflects the company's changing circumstances.

3. Tax Implications

The tax treatment of phantom equity can be complex and vary based on jurisdiction and specific plan structures.

Solution: Work closely with legal and tax experts to design a phantom equity plan that minimizes tax complexities for both the company and employees. Provide clear information to participants about the potential tax implications of their phantom equity rewards.

4. Exit Scenarios

The ambiguity surrounding exit triggers and scenarios can lead to confusion and frustration among employees.

Solution: Define clear and specific exit events that trigger the payout of phantom equity. Ensure that employees have a thorough understanding of when and how they can realize the rewards they've earned.

5. Employee Departure

If an employee departs before the phantom equity fully vests or matures, questions arise about whether they should receive any payout.

Solution: Implement vesting schedules that align with the startup's goals and milestones. Consider incorporating forfeiture clauses that specify the conditions under which an employee may forfeit their phantom equity in the event of an early departure.

6. Unrealized Rewards

Some employees may leave the startup before reaping the rewards of their phantom equity due to the vesting timeline or exit conditions.

Solution: Consider implementing early payout options for employees who leave the company before their phantom equity fully vests. This can help retain departing employees' goodwill and preserve their contributions to the startup.

7. Plan Complexity

Overly complex phantom equity plans can confuse participants and hinder the plan's effectiveness.

Solution: Keep the plan structure as straightforward as possible. Avoid unnecessary intricacies that might lead to confusion or administrative burdens. Clear and concise documentation is key to ensuring participants understand the plan.

8. Psychological Impact

The lack of tangible ownership may lead some employees to perceive phantom equity as less valuable than actual equity.

Solution: Educate employees about the potential benefits of phantom equity, such as preservation of ownership and alignment of interests. Highlight the success stories of employees who have realized substantial rewards through phantom equity.

Why Restricted Stock Units May Be A Good Alternative to Phantom Equity

While phantom equity offers an innovative approach to ownership, restricted stock units (RSUs) provide a more traditional yet effective alternative. RSUs grant employees actual shares, albeit subject to certain restrictions and vesting schedules. This approach combines tangible ownership with the motivation and alignment advantages of phantom equity.

RSUs address the perceived lack of tangibility associated with phantom equity, as employees receive real shares that hold value even if the startup fails to meet its milestones. Additionally, RSUs simplify the tax implications by aligning with established equity taxation norms. Despite the dilution risk, RSUs can be structured creatively to minimize the impact on existing shareholders.

Interested in learning more about RSUs and how they turn uncertainties in equity compensation into potential gains for your employees? Book a demo with Upstock today.

Retain your key employees

Ensure your team is awarded based on contributions and results with Upstock’s KPI inegration feature.

Learn More
ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

Previous: ISO vs NSO: Which One Should You Pick for Your Employee Equity Compensation‍ Next: Jumpstarting Success: The Role of RSUs in Startup Companies‍