WARRANTS / PHANTOM STOCK:
Phantom stock is a contractual agreement between the phantom stock plan participant and the
employer. The agreement gives the participant the right to cash payments at (1) specified times
or (2) specified conditions based on the market value of equivalent shares of the company.
Some organizations may use phantom stock as an incentive to upper management. Phantom
stock ties a financial gain directly to a company performance metric. It can also be used
selectively as a reward or a bonus to employees who meet certain criteria. Phantom stock can be
provided to every employee, either across the board or distributed variably depending on
performance, seniority, or other factors.
Phantom stock also provides organizations with certain restrictions in place to provide incentives
tied to stock value. This can apply to a limited liability corporation (LLC), a sole proprietor or S-
companies restricted by the 100-owner rule.
There are two main types of phantom stock plans. “Appreciation only” plans do not include the
value of the actual underlying shares themselves, and may only pay out the value of any increase
in the company stock price over a certain period of time that begins on the date the plan is
granted. “Full value” plans pay both the value of the underlying stock as well as any
appreciation.
Both types of plans resemble traditional nonqualified plans in many respects, as they can be
discriminatory in nature and are also typically subject to a substantial risk of forfeiture that ends
when the benefit is actually paid to the employee, at which time the employee recognizes income
for the amount paid and the employer can take a deduction.
Phantom stock may be hypothetical; however, it still can pay out dividends and it experiences
price changes just like its real counterpart. After a period of time, the cash value of the phantom
stock is distributed to the participating employees.
Phantom stock, also known as synthetic equity, has no inherent requirements or restrictions
regarding its use, allowing the organization to use it however it chooses. Phantom stock can also
be changed at the leadership’s discretion.
Advantages of Offering Warrants / Phantom Stock:
- Tax Deductible Payments to Warrant Holders upon a sale.
- No concern about minority shareholder rights or minority oppression.
- Easy to grant and easy to take away.
- Subject to less government restriction.
- Can be made non-dilutable (if desired).
Disadvantages of Offering Warrants / Phantom Stock: - Some more sophisticated employees don’t like them because they know that stock
options give them superior rights. - Treated as ordinary income for the employee upon payment.
- Confer less rights to the employee.
- From the employee’s perspective, the Warrants can be made to terminate upon a
separation from employment or upon the occurrence of an event (crimes, termination of
licensure, divorce, etc.).
STOCK OPTIONS (IN THIS EXERCISE I HAVE RECOMMENDED CLASS B
SHARES):
Corporations may be divided into a series of different classes of stock. By default, the class of
shares is called common shares, which are subject to voting rights, dilution, dividends, and
other rights and benefits under the Corporation Act. In this exercise, I am recommending that
TICG only considers Class B Shares, which would be non-voting and not subject to or eligible to
receive dividends. I would also propose a restriction that would make them not subject to transfer
without written authorization from the common (Class A) shareholders.
Stock Options are a form of financial equity compensation that is offered to employees and
executives by their organization. The stock options offered come in the form of regular call
options and allow the employee or executive to purchase their organization’s stocks at a
specified price and time. Before the stock option is finalized, the terms and conditions are
discussed and signed off on in an employee stock option agreement.
In the case of stock options, there are two primary forms:
- Incentive Stock Options (ISOs)
Sometimes referred to as qualified or statutory options, incentive stock options (ISOs) are stock
options that are mainly offered to important employees or upper management. Incentive stock
options are given preferential tax treatment. It is because incentive stock options profits are
treated as long-term capital gain under the Internal Revenue Service (IRS).
- Non-Qualified Stock Options (NSOs)
On a different note, non-qualified stock options (NSOs) are stock options that are offered to all
levels of employment. Non-qualified stock options are not given preferential tax treatment. It is
because non-qualified stock options profits are taxed as ordinary income tax.
Advantages of Offering Employee Stock Options:
Listed below are the primary advantages of offering employee stock options.
- Increases employee retention
- Gives employees “ownership” in the company, allowing them to feel more connected to
the organization as a whole - Potential tax benefits for the employee (long-term capital gains) as opposed to Warrants /
Phantom Stock (which is taxed as ordinary income). - As a whole, offering employee stock options allows the employees to feel more
connected to the business and more motivated to work harder, so the organization does
better.
Main Disadvantages of Offering Employee Stock Options:
Listed below are the primary advantages of offering employee stock options. - Employees now have many more rights as owners of the corporation.
- Minority Shareholder Oppression Lawsuits:
All owners of corporations, partnerships and limited liability companies have certain
fundamental rights. These rights extend to minority shareholders, partners, and limited
liability company members. Legally, those who control a company cannot abuse their
power in ways that fundamentally harm the minority owners’ rights. This includes
engaging in behavior toward minority shareholders that is fraudulent, illegal, oppressive,
or willfully unfair. It also includes conduct that constitutes a breach of fiduciary duties.
Nor can they engage in behavior that harms the corporate entity.
Some of the basic rights typically afforded to all shareholders include:
• The right to attend and vote at shareholder meetings,
• The right to inspect financial records,
• The right to participate in electing directors, and
• The right to participate in the adoption or modification of bylaws.
Why Are Minority Shareholders Oppressed?
The reasons that someone might oppress a minority owner are virtually limitless. As with
many business-related legal conflicts, some of the most common scenarios involve
disagreements about power and money.
A minority shareholder may object to how the company is being managed or how its
finances are handled. Majority stakeholders sometimes retaliate in a way that leads to
minority oppression.
Sometimes, they may attempt to constrain a perceived threat or accusations by minority
owners by denying the minority owner his or her rights.
Other Disadvantages of Offering Employee Stock Options:
- Increased accountability for Class A Shareholders.
- Complicated tax implications for the employees (usually require the employees to engage
a CPA). - Stock options can be difficult to value.
- Individual employees rely on the effort put forward by their peers for organizational
success, which can cause potential conflict. - Stock options can result in high compensation for executives, even if the business is
financially under-achieving. - Over the long run, dilution can be extremely costly to shareholders.
- As a whole, offering employees stock options can cause some negative implications.
Valuation of stock options can be difficult, and executives can financially prosper even
when the organization is not reaching its goals.
THE KEY DIFFERENCES BETWEEN A PHANTOM STOCK PLAN VERSUS A
STOCK OPTION PLAN:
A phantom stock plan and stock option plan both award employees from the share appreciation
of the company’s stock price. On redemption, in a phantom stock plan, the plan participant
receives a cash payment. This is in comparison to a stock option plan, where the plan participant
receives common stock. As a result, a phantom stock plan allows the participant to reap the
benefits of an increasing share price without shareholder dilution.
Warrant Holders (Phantom Stock) do not have rights as shareholders. Instead, Warrant Holders
have the right to collect a receivable upon a sale if all conditions in their Warrant Agreement
have been satisfied and the Warrant Holder is otherwise not in breach of the Warrant Agreement.
Stock Options confer the benefit of ownership to the employee and subject to Corporation and
Class A Shareholders to the rights of the other shareholders (including potential minority
shareholder oppression litigation).
