THINKING LIKE AN OWNER THE POWER BEHIND EQUITY‑BASED INCENTIVE COMPENSATION BY PETER LANGDON, KOLEY JESSEN INCREASINGLY, EMPLOYERS HAVE BEGUN TO CONSIDER AND implement alternative compensation structures as tools to attract, motivate, retain, and reward key employees. Two of the primary alternative compensation arrangements take the form of equity-based incentive compensation, specifically phantom equity and equity appreciation rights. These alternative compensation arrangements are attractive because they incentivize workers to think like an owner (without issuing actual equity), the employer has significant design flexibility, and there is typically no cost to the employee. This article provides a general overview of phantom equity and equity appreciation rights as well as certain design considerations to take into account in structuring these arrangements. Phantom equity (also referred to as phantom stock for corporations or phantom units for limited liability companies) is a contractual right to a payment at some point in the future based on the full underlying equity value of a company, i.e., phantom equity mirrors the underlying equity value of the sponsoring employer. For example, assume Bob is granted one share of phantom equity in ABC Corporation on Jan. 1, 2025. On Jan. 1, 2025, the fair market value of one share of ABC Corporation’s stock is worth $100. As a result, Bob has been granted a contractual right to payment in the amount of $100. Assume further that on Jan. 1, 2026, one share of ABC Corporation’s stock is worth $200. Bob’s benefit in the phantom stock has now increased to $200. As can be seen, Bob’s benefit in the phantom stock will appreciate in value as ABC Corporation’s underlying stock appreciates in value. Such a benefit incentivizes Bob to maximize the value of ABC Corporation’s underlying stock, which incentivizes Bob to think like an owner of ABC Corporation. Similarly, equity appreciation rights (also referred to as stock appreciation rights for corporations or unit appreciation rights for limited liability companies) are a contractual right to payment at some point in the future based on the appreciation in value of a company’s underlying equity. This is distinct from phantom equity, where phantom equity mirrors the entire value of the equity of a company. With respect to equity appreciation rights, a recipient has a contractual right to payment based on the appreciation in value of a company’s underlying equity from the date of grant. To continue our prior example, assume Bob is granted one equity appreciation right in ABC Corporation on Jan. 1, 2025. On Jan. 1, 2025, the fair market value of one share of ABC Corporation’s stock is worth $100. Upon the grant of the equity appreciation right, Bob is not entitled to any benefit because ABC Corporation’s underlying stock has not yet appreciated in value following the grant date. However, on Jan. 1, 2026, one share of ABC Corporation’s stock is worth $200. As a result, Bob’s benefit under the equity appreciation right equals $100. On Jan. 1, 2026, one share of ABC Corporation’s underlying stock equals $200, which is an increase of $100 from the date of grant of the equity appreciation right. Similar to phantom equity, equity appreciation rights incentivize Bob to maximize the value of ABC Corporation’s underlying stock, although at a lesser benefit than phantom equity. Phantom equity and equity appreciation rights have distinct nuances with respect to each type of arrangement. However, both structures share general similarities with respect to design considerations. The three primary design considerations include: (i) vesting; (ii) payment triggers; and (iii) payment timing. Similar to qualified plans (as well as other compensatory employee benefits), a vesting schedule can be attached to phantom equity and equity appreciation rights. Typical vesting schedules include cliff vesting or pro rata vesting over a three- or five-year period. However, performance-based vesting could also apply, either as standalone vesting or coupled with time-based vesting to create double-trigger vesting. It should be noted that the vesting schedule should be drafted to be consistent with any forfeiture provisions in the plan documents. The second primary design consideration is to select the payment triggers as to when the benefit of the phantom equity or the equity appreciation rights will be paid. Generally, there is significant flexibility in setting the payment triggers. However, to the extent the phantom equity or the equity appreciation rights are subject to Internal Revenue Code Section 409A as non-qualified deferred compensation, then limitations will apply as to what events may constitute a payment trigger. Generally, the following items can be used as payment triggers: (i) death; (ii) disability; (iii) separation from service; (iv) a change in control (sale of the company); (v) a specified date; or (vi) an unforeseeable emergency. Not all of the foregoing payment triggers must be used and, in fact, employers typically do not select all of the foregoing items as payment triggers. Notably, in designing the payment triggers under a phantom equity or equity appreciation rights arrangement, termination for cause (as defined in the underlying documents) should be treated as a forfeiture event. Additionally, employers should consider whether COUNSELOR’S CORNER 12 Nebraska CPA
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