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Phantom Stock Agreements as a Low-Risk Incentive for Employee Retention

The biggest complaint I hear from small business clients is the constant struggle to find and keep good employees. This is a common complaint across almost every industry in New Hampshire.

Once they do find a good employee, the small business owner must then continuously induce the key employees to stay long term. This is particularly true with senior managers or top-performing salespeople.

The solution that many small business owners come up with is to give that key employee ownership equity in the business. Equity could be stock in a corporation, membership in an LLC, or partnership in a general or limited partnership. Giving the key employee equity may seem like a good idea, and might be in certain cases, but it is fraught with potential danger. For example, what happens if you must terminate that employee, or if the employee quits? If the employee equity was not structured properly, then you may end up paying to get the equity back from the former employee whom you gave the equity for free.

Another choice might be stock options. This works for larger businesses, but stock option plans may be too complicated and too expensive to set up for a small business owner with only a handful of employees.

A lesser-known option is a “phantom stock” agreement. A phantom stock agreement is a contractual arrangement between the business and its key employee, usually a senior manager. The agreement allows the employee to receive equivalent benefits of equity ownership without actually owning the equity. This provides financial benefits to the employee equivalent to being an owner, but without the business giving up any actual ownership or control.

Although it is commonly referred to as phantom stock or shadow stock, it does not need to be based on actual stock. The agreement could be based on membership in an LLC or equity ownership in any other kind of business. Also, because it is contractual in nature, it may include any benefits or restrictions that the business and the employee agree to. Grantors of shadow or phantom stock rarely, if ever, grant the recipient the full benefits of true ownership, especially with regard to voting rights.

As an example of benefits, the phantom stock agreement may provide that the employee receives a bonus equivalent to the annual dividends or profits the employee would have received if they owned the same amount of real stock. Similarly, in the event of a buyout event, the phantom stock agreement may also provide that the employee receives the same amount of proceeds from the buyout as an equivalent stockholder of real stock. The value of the phantom stock tracks with the value of a corresponding amount of real stock in the business.

The phantom stock agreement may also include certain restrictions on how and when the employee receives such payments. In the event that the employee is terminated for any reason, the phantom stock agreement is also terminated along with all rights and benefits that go along with it. There is no need to redeem or repurchase the phantom stock because there is no stock.

Phantom stock agreements are not appropriate for all businesses, nor are they appropriate for all employees within a business. For some small businesses with key senior employees, however, it might be the perfect solution to a sticky problem. If you’re considering giving an employee equity in your business through phantom stocks or any other arrangement, consult with an experienced business law attorney to ensure your business’s interests are protected in the long term.

Christopher E. Ratté is a Partner at the law firm Shaheen & Gordon, P.A., and has been serving the needs of small business clients in New Hampshire for more than 25 years.