shares for people who participate in a company ’ s profit and the proceeds from its sale but have no voice in the company ’ s decisions . This may be a way for the original owners to expand ownership of their company and raise capital without surrendering control .
No income . There could be shareholders who aren ’ t entitled to profit distributions and only participate in the sale of the company . There can also be phantom stock or stock appreciation units that participate in the value of the company but not in the vote or profits .
No value . There can also be a class of contributors who receive a percentage of
the profit of the firm but do not vote and do not receive a percentage of the value if the firm is sold . Sometimes these are called “ income partners ,” but this is essentially a bonus plan if you think about it .
Some of these instruments are worth describing :
Non-voting shares . These can be used with both S corporations and LLCs filing taxes as partnerships ; they simply preserve control of decision-making in the hands of the original shareholders . This is an instrument often used by family businesses .
Phantom shares . These offer the right to a percentage of the proceeds of the company during a sale … if it ’ s sold . For example , I can own the right to 5 % of the proceeds from the sale of the company if
You can think of synthetic equity as something that loses you one or more of the three primary rights of share- holders ( when other rights are emphasized ).
it ’ s sold . If it isn ’ t , my right is not worth much , but if it is , let ’ s say for $ 10 million , then I will receive 5 % of $ 10 million , or $ 500,000 . This instrument is usually used by companies whose sale is somewhat expected — perhaps it is only a matter of time — but the business needs to retain key people until that day comes . This is usually an instrument used in companies where succession is imminent — in other words , the founders are aging .
Stock appreciation rights ( SARs ). These are very similar to phantom shares , but they have a specific date of exercise . For example , stock appreciation rights are granted to me equal to 5 % of the appreciation of the company between now and December 31 , 2027 . If the company appreciates in value from , say , $ 8 million to $ 10 million , then I will receive in cash 5 % of the $ 2 million in appreciation ( from $ 8 million to $ 10 million ) or $ 100,000 . Notice that SARs do not require the company to be sold , so they can be used to share the appreciation of a firm that is not expected to sell . They will , however , require the company to spend quite a bit of cash on the exercise day .
Stock options . These allow someone to purchase shares in the future at a predetermined price ( usually today ’ s price ). This is a valuable right : If the stock appreciates , then the difference between today ’ s price and the future price is pure profit . If the price doesn ’ t increase , the owner of the options can simply forfeit them without exercising . In essence , the owner of the options captures the appreciation in the stock — even if he or she doesn ’ t have the rights of an owner until the exercise date . These options are often used as recruiting instruments to entice professionals to a firm where their efforts will contribute to its increase in value .
Restricted stock units . These are shares not fully owned until a restriction ( usually years of service ) lapses . This allows a company to use the shares for recruiting but lock the recipient into a contract for a time ; if the employee leaves , they would forfeit the shares . Restricted stock unit holders don ’ t usually get dividends while the shares are still subject to vesting . Just like options , RSUs delay the timing of the ownership rights . But unlike options , they have value even if the stock does not appreciate . For example , if I had regular options to purchase 1,000 units at the price of $ 1,000 per share and the price appreciated to $ 1,200 per share , I have a gain of $ 200,000 ( 1,000 x $ 200 appreciation ). If I owned 1,000 RSUs , my gain would be equivalent — 1,000 units would appreciate by $ 200 apiece . However , with regular options , any shares that did not appreciate at all means the $ 1,000 of options would be worthless — no gain to be had . But the restricted stock units are still worth 1,000 x $ 1,000 = $ 1 million .
Notice that synthetic equity can be created by changing the timing of ownership . For example , restricted stock units may make someone an owner , but this ownership can be forfeited if the person leaves before the units vest . And a stock option that delays the buying decision into the future creates a Schrödinger ’ s box of ownership — the person may or may not be an owner . We ’ ll only find out when we open the box on exercise day .
Some ownership may also be earned within a compensation program where the employee is subject to other restrictions — for instance , that they can ’ t leave and solicit clients .
Finally , these days we also see many firms allow their best professionals to buy
16 | FINANCIAL ADVISOR MAGAZINE | OCTOBER 2024 WWW . FA-MAG . COM