I use phantom shares in my companies, and I love them. They provide a way for me to incent my employees as if they were owners without the headaches of issuing shares, evaluating the shares, buying back the shares, dealing with shareholder meetings, etc. For the owner of a company, they are awesome.
A structure I have used in the past is to have two agreements with key employees:
Distribution Sharing - This says that whenever the owners takes a profit distribution, a portion of that distribution is reserved to be divided up among those with phantom shares according to how many phantom shares they have vested.
Sale of Company Sharing - This says that if the company is sold, a portion of the proceeds of the sale are reserved to be divided up among those with phantom shares.
I find that this provides the employees with something that looks and feels like ownership (from a financial point of view), but reduces my management headaches substantially.
However, you should know that these agreements are not the same as equity and don't come with the same rights as equity. For example:
- You do not get a seat at the table at shareholders' meetings, and you do not get a vote on the board of directors and other decisions. Note that each shareholders' agreement states what rights a shareholder has, so you should review the existing shareholders' agreement to find out what you are missing out on.
- If you were to die, your phantom shares would not pass on to your family, so the value of your pseudo-equity would evaporate
- In a "closely held company", it's common to want to keep all the company shares among the original founders to prevent a case where someone dies and his wife now has a vote in the business even though she was not a founder. There is often a clause in the shareholders agreement that allows the company or other existing shareholders the right to buy the shares if a shareholder dies or leaves the company. You would not be able to participate in the benefit of being able to acquire additional shares this way, since you are not a real shareholder.
- Eventually, if the company were to sell, the money that you do get would be taxed as normal income (the highest tax rate). If you were a real shareholder, the proceeds would be taxed as a long term capital gain (the lowest tax rate).
- It depends on the wording of the deal, but it's common that if you were to leave the company, you would forfeit your phantom shares and get nothing. If you had real shares, the company would have to purchase them from you.