Phantom equity plans are a powerful way to align your team with your company's growth. But to make them work effectively, you need to set an initial value. This value acts as a starting point for calculating potential payouts, much like the exercise price in a stock option plan.
What Is Initial Value?
The initial value is the baseline price assigned to phantom shares at the time they are granted. When a payout event occurs—like an acquisition or a liquidity event—the value of the phantom shares is compared to the initial value to determine the gain.
In a way, the initial value functions like the strike price in stock options: it establishes a reference point so participants benefit from the company’s growth rather than just receiving a fixed amount.
Why Is Initial Value Important?
Setting the right initial value is critical for:
Fairness: Ensuring participants earn rewards based on real company growth.
Alignment: Creating incentives that mirror actual shareholder value creation.
Tax & Accounting: Proper valuation can impact tax treatment and financial reporting.
Flexibility: Different approaches allow you to tailor the plan to your company’s goals.
Calculation of Bonus Amount
The bonus amount upon an Exit Event is calculated using the following formula:
Where:
Bonus: The monetary or in-kind amount the company pays to the eligible participant, subject to tax and other deductions.
F (Fund): The total consideration shareholders would have received for their shares dedicated to the plan during the Exit Event.
VPS (Vested Phantom Shares): The total number of the participant’s vested phantom shares at the time of the Exit Event.
TPS (Total Phantom Shares): The total number of phantom shares in the plan at the time of the Exit Event.
IV (Initial Value): The initial value of all the participant’s vested phantom shares before the Exit Event.
Scenarios for Setting Initial Value
There are several ways to determine the initial value of phantom shares:
1. Fair Market Value (FMV)
This is the most common approach. FMV is typically determined through a valuation process (e.g., a 409A valuation for U.S. companies). This ensures that the initial value is based on a professional assessment of the company’s worth at the time of grant.
Important Note: If the initial value is set to FMV, then the value of the award/phantom shares at grant is 0, because FMV = IV. This means FMV - IV is 0, and there is no immediate financial benefit at grant.
Best for: Companies looking for a standard, defensible valuation method.
2. Fair Market Value with a Discount
Some companies choose to apply a discount (e.g., 20-30%) to the FMV when granting phantom shares. This can make the plan more attractive to participants while still maintaining a reasonable link to company value.
Best for: Companies that want to provide an extra incentive while still using FMV as a benchmark.
3. Static Value
A fixed price that does not change over time. This simplifies administration but may not reflect actual company growth.
Best for: Early-stage startups or companies wanting a simple structure.
4. Zero Initial Value
Setting the initial value at zero maximizes potential upside for participants. Every dollar of appreciation translates into a payout.
Best for: Companies looking to create a strong incentive structure for key employees.
Does Initial Value Change Over Time?
A common question is whether the initial value of phantom shares changes with the company’s valuation. The answer is yes—if someone joins the scheme early, their initial value is likely lower than someone who joins later, assuming the company’s value increases over time. This means early participants may benefit more from the company's growth.
Choosing the Right Approach
The best method depends on your company’s stage, goals, and how you want to structure incentives. If you want a strong link to market value, FMV or FMV with a discount may be best. If simplicity or high upside is a priority, a static or zero initial value might work better.
By carefully setting the initial value, you ensure your phantom plan drives engagement, retention, and alignment with your company’s success.