It’s a common enough entrepreneurial scenario. You shed blood, sweat, and tears to get your company off the ground. Now it’s up, running, and doing well. But many of your employees weren’t there for the start-up phase, so to them it’s just a job. What you really want now is a company in which all the employees are engaged and committed—a company where they think and act like owners.

So you take the first steps. You work with your people to clarify the key economic metric for the year: average customer tab, revenue per billable hour, units shipped, whatever it might be. You develop a scoreboard to show how everyone influences that metric, and you put in an incentive plan funded by improvement in the key number. You track your progress weekly, and people seem pretty involved.

That’s great. It’s good for a year, two years, even three. But if you are building a company for the long haul—and if you want your employees both to stick around and to stay every bit as engaged and committed as they are now—you realize you have to think about equity.

That’s a sticking point for a lot of entrepreneurs. Some just don’t want to give up their ownership, perhaps thinking that some day they might pass the company on to a son or daughter. Others are sympathetic to employee stock ownership plans (ESOPs), but aren’t ready or able to pay the significant legal fees and other costs.

What’s the answer? Phantom equity—sometimes called synthetic equity—may be a good choice.

Phantom equity is essentially a deferred compensation agreement between the company and the employee. Employees who hold phantom equity do have a claim on the economic value and growth of the company. The value of their phantom shares reflects the value of actual shares.

Unlike an ESOP, however, phantom equity doesn’t involve any transfer of ownership or control.

Phantom equity is different in other ways from an ESOP. Setting up a phantom program requires no big legal fees. There are no detailed government regulations to watch out for, including the requirement that you treat all employees the same. By the same token, there are no tax advantages.

But phantom equity does have significant benefits. You can pay bonuses in the form of phantom equity—a boon to fast-growing companies that need all their cash to finance expansion. The phantom shares can be fully vested immediately, or else vest over a period of time—your choice. Just as with an ESOP, employees who receive phantom equity develop a stake, sometimes a sizable one, in the growth and profitability of the company.

Phantom equity allows employees to learn the “magic of the multiple”: the fact that the value of the company is likely to be four or six or ten times its earnings. As you track profitability, you can also use a simple formula to track the value of the shares—one that approximates the appraised value. That helps employees understand how they drive the value of the company, and thus of their phantom shares.

If the business does well, moreover, the shares will multiply in value. That’s what drives engagement and commitment over the long haul.

Though there are many options for phantom equity plans, there are some particulars that you should probably be aware of.

First, suppose you decide to sell the company. Like an ordinary share, every phantom equity share will be valued at the transaction price. That, after all, is what the company is worth at the moment of sale.

Second, suppose an employee with vested shares leaves the company. Departing employees will need to be paid cash compensation for the value of their equity. You may want to spell out in the phantom-equity agreement that the company has the option of paying the departing employee in cash or in a loan, typically over a three-year period (with interest at prime), to avoid a sudden cash drain.

Third, when cash is eventually paid to employees. it is taxable as gross wages and will appear on the employee’s W-2 form, filed with the IRS. Employees should understand this tax liability in advance. Withholding rules may apply.

Complex? Certainly there are things to consider. But phantom equity is considerably less complex than an ESOP. Several companies we know of have phantom equity plans in place, and the agreements often take up less than a page. After the initial hurdle, people find them pretty easy to understand and administer. They also find that employees love watching that equity stake grow. Of course phantom equity can also complement a future ESOP.

One final tip: Some companies insist that employees must attend the weekly open-book staff meeting to quality for phantom equity or any other bonus. The requirement reinforces the idea that this extra compensation is an opportunity, not a right—and that it depends upon the continued profitable growth of the business.

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By Bill Fotsch and John Case ·