Phantom Stock – Why Private Cannabis Companies Should Take Note

Privately held cannabis companies might want to give serious consideration to awarding their employees “phantom stock” rather than equity options.

Working so close to Silicon Valley and its “option holder” millionaires, can make it easy for California entrepreneurs to forget the many challenges private companies face when awarding equity options to employees.

Obviously, private companies lack a public market for their shares, making the shares illiquid and difficult to sell. All other things being equal, illiquid shares are less valuable than shares with an active trading market.  Moreover, without a public market setting “fair market value” (FMV) for an option strike price, it is hard for private companies to value their own shares in order to avoid the adverse accounting and tax consequences that can flow from issuing “cheap stock” equity awards. Consider, for example, the 20% and 5% excise taxes imposed under Internal Revenue Code section 409A and its California law counterpart.  Equity plans can also be expensive to establish and both complicated and costly to administer. For example, if a private company isn’t careful, issuing equity to a large number of unsophisticated employees can expose even these companies to public reporting obligations under federal and state securities laws.  There can also be significant information sharing obligations.  Consider, for example, Rule 701 under the U.S. Securities Act of 1933.  It is therefore often thought that companies shouldn’t put long-term equity incentive plans into place without expert (and so expensive) legal and HR advice and consultation.

Equally important, in addition to these very real challenges, we have seen the emotional roller-coaster that many company founders can go through when deciding whether to grant company equity to their employees. Founders often make tremendous personal sacrifices to start their businesses, frequently pouring time, money, sweat, and tears to grow them. Sharing equity to “new hires” can be hard to bear.  And current investors will always watch for undue dilution. Even though sophisticated VC firms will typically accept an equity “pool” for employees and consultants of around 10-20%, angel investors in the cannabis space are often skeptical of the importance of awarding voting equity to rank and file cultivators, manufacturers and distributors, especially when the original founders, who typically hold a sizeable percentage of the company’s equity already, still occupy most of the company’s senior management positions.

Because of these and other similar challenges, it should come as no surprise that, nationally and across industries, privately held companies rarely have long-term equity incentive plans.  For example, a 2007 WorldatWork study surveyed 300 privately held businesses with annual revenues ranging from over $5 billion to under $100 million and found that only one-third of them had long-term incentive plans, and that over half of those that did favored cash-based long-term awards, such as deferred compensation plans, rather than equity awards like options. A more recent study, “Private and public company executive compensation practice: where they merge and diverge“, in 2018 by Willis Towers Watson drew similar conclusions: only 60% of private companies have LTIPs and 80% of those are performance cash plans.

And yet, private companies in the California cannabis industry often find themselves competing for talent against high-tech companies and life science companies in Silicon Valley and So. Cal., industries populated by highly-trained (and well paid) workers. Plus, Californians like to think of themselves as egalitarian, inclusive and progressive. We find Cannabis leadership is often philosophically ready to share equity with their workers as well as keenly aware of the importance of employee retention and in finding ways to align employee and stockholder interests.

With these considerations in mind, California cannabis companies should give serious thought to the unique advantages of phantom stock (also sometimes called simulated stock, shadow stock or synthetic equity).

Phantom stock can be designed as essentially a type of deferred cash bonus, yet one that is tied to appreciation of stock value rather than other metrics such as EBITDA or the achievement of personal milestones.  To implement the incentive program, one or more employees are given a plan document entitling them to a certain number of phantom stock shares (or “units”) at the then current FMV share price. This price can be determined in good faith by the issuer’s Board of Directors using available information, by an outside valuation firm at the issuer’s invitation (i.e., a 409A valuation firm), or when the issuer completes a fundraising round with an arms-length negotiation of pre-money valuation. As with options, phantom stock can have a vesting schedule to encourage employee retention. Companies can also build in special forfeiture provisions, such as if the holder is terminated for cause or breaches company confidentiality rules.  But unlike equity awards convertible into common stock, phantom stock has no ability to convert into voting equity.  After grant, upon the occurrence of one or more predetermined events such as (i) a corporate change or control, (ii) termination of employment, (iii) death or retirement, or (iv) an annual anniversary, the company issuer will either buyback some number of the vested units at their full FMV at the time of the event (a so called “full value” plan) or buyback the units at a price equal to the amount the phantom shares have appreciated in value since the date of the grant. Because the holder does not “exercise the grant,” for example by paying an option strike price in cash, there is no investment decision and therefore no securities law concern. However, as a deferred compensation plan, the issuing company will still need to comply with the requirements of IRC section 409A and gains to the employee will be taxed as ordinary income, not as capital gains.  Lastly, companies concerned about cash flow can give themselves the right to either buyback vested units using shares of stock or through installments over a period of years.  While uncommon, phantom stock plans can also provide for holders to receive dividends.

Bottom line, if handled correctly, phantom stock plans should be easier to implement than an option plan and more flexible, while still allowing the issuing company to attract and retain top talent. This long-term value creation and goal alignment, while avoiding dilution of existing stockholders, can make these equity-like incentives especially attractive to founders of early-stage companies.

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