Retaining the Stars: How Phantom Stock Agreements Can Help MSP Owners Keep Their Best Employees

In today’s cutthroat job market, keeping your top talent is no walk in the park. The typical millennial will hop between seven different companies by the time they hit 35, and the tech sector is a battlefield when it comes to snagging and holding onto employees. For Managed Service Providers (MSPs), this means you need to create an environment so irresistible that your stars wouldn’t dream of leaving.  Enter phantom stock agreements – your secret weapon for retaining key employees. These agreements offer a slew of benefits that align your employees’ interests with those of the company, minus the headaches and risks of actual stock ownership.

What is Phantom Stock?

Phantom stock (sometimes referred to as equity participation, ghost shares or shadow stock) is like giving your employees a taste of stock ownership without actually handing over any shares. Instead, they get contract rights based on the value of hypothetical shares. You can make this applicable to LLCs taxed as disregarded entities and not just corporations. You can even limit participation to future value beyond the current value at the time of the program. These rights are typically unfunded and unsecured obligations of the company, meaning no actual stock changes hands. As long as its income compliance with section 409A of the Internal Revenue Service Code, including the requirements of the substantial risk of forfeiture (if you leave, you lose the benefits of the program), there is no immediate tax consequence to any party.

How Phantom Stock Agreements Work

Phantom stock agreements are designed to mimic real stock ownership. Employees are granted phantom shares that vest over time, just like real stock options. Once vested, employees receive cash payments based on the value of the phantom shares, which can be tied to the company’s performance or other metrics.

Key components of phantom stock agreements include:

• Vesting: Phantom shares typically vest over a set period, incentivizing employees to stick around. This means that employees earn the right to the phantom shares gradually, encouraging them to stay with the company for the long haul.
• Forfeiture: To dodge taxes and encourage the right behavior, phantom shares may be forfeited if certain conditions aren’t met. This ensures that employees meet specific performance or tenure requirements to benefit from the phantom stock.
• Acceleration Events: Certain events, like a sale, merger, change in control, death, disability, or retirement, can trigger accelerated vesting of phantom shares. This means that participants receive their benefits upon triggering any of these events.
• Mimicking Dividends: You have the option to mimic dividends in the same way employees would receive dividends as an owner. However, keep in mind that this comes with slightly higher taxes to the participants. This feature allows employees to feel more like actual shareholders, receiving periodic payments based on the company’s performance.
• Tax Benefits: An outright grant of stock entails income taxes to the employee at the time of grant. With phantom stock, this tax burden is delayed until the phantom shares are paid out. This can be a significant advantage for employees, as they don’t have to pay taxes upfront nor do they have to shell out any money to buy into the company.
• Equity in Appreciated Value: You can grant employees equity in the appreciated value of the company, meaning the value of the company at the time of grant is excluded from the program. Only the upside is being divided, which can be a significant motivator for employees. This means that employees benefit from the company’s growth without being taxed on the initial value of the company at the time of the grant.

Benefits of Phantom Stock Agreements

Phantom stock agreements offer several advantages for both MSP owners and employees:

1. Alignment of Interests: By tying the value of phantom shares to the company’s performance, employees are motivated to contribute to the company’s success. This alignment ensures that employees work towards the same goals as the company, driving overall performance.
2. Retention: The vesting schedule encourages employees to stay with the company for the long haul. This long-term incentive helps reduce turnover and retain top talent.
3. Flexibility: Phantom stock agreements can be customized to meet the specific needs of the company and its employees. This flexibility allows MSP owners to tailor the agreements to their unique business goals and employee expectations.
4. Simplicity: Unlike real stock options, phantom stock agreements don’t involve actual stock transfers, making them easier to manage. This simplicity reduces administrative burdens and legal complexities.

Conclusion

In the high-stakes world of MSPs, retaining top talent is crucial for success. Phantom stock agreements offer a powerful tool for aligning the interests of employees with those of the company, providing financial incentives that encourage long-term commitment. By implementing these agreements, MSP owners can create a more stable and motivated workforce, ensuring that their stars continue to shine.