Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Phantom Stock for Pre-IPO Liquidity
Transcript
- Lucas: So Databricks is currently valued at one hundred and eighty-eight billion dollars, but until very recently, employees with vested equity couldn't really touch any of that wealth without selling shares on a secondary market that barely existed. Luna: And that's a pretty common pain point for late-stage startups. The valuation is huge on paper, but the cash is locked up. Lucas: Exactly. And what Databricks did about six weeks ago was a phantom stock tender offer. They essentially created a synthetic equity instrument that tracks the value of the real stock, pays out in cash based on the company's valuation growth, but doesn't actually issue any new shares. Luna: So it's a way to give employees liquidity without diluting existing shareholders. I've seen this used before — Palantir did something similar before its direct listing back in 2020. Lucas: Right. And Airbnb also had a phantom stock plan for certain international employees who couldn't participate in the standard equity program due to local tax laws. The key difference here is that Databricks used it as a broad-based liquidity event, not just a niche fix. Luna: How does the math work? If the company is worth one hundred and eighty-eight billion, and an employee has phantom shares equivalent to, say, ten thousand real shares, do they just get paid the difference between the grant price and the current price? Lucas: Pretty much. The company sets a strike price — usually the 409A valuation at grant — and then when the phantom stock vests or a liquidity event happens, the employee gets the appreciation in cash. So if the strike was one hundred dollars and the current fair market value is two hundred, they get one hundred dollars per phantom share. Luna: No actual stock changes hands. That's clever for companies that want to avoid shareholder caps or keep the cap table simple. Lucas: Exactly. And it's particularly attractive for pre ipo companies that don't want to trigger a 409A valuation adjustment or deal with the complexity of a secondary sale. The downside is it's a cash expense for the company, so it only works if the business has strong cash flow or a willing credit line. Luna: Databricks definitely has that. But for earlier-stage startups, phantom stock might be a stretch. Lucas: Yeah, it's really a late-stage tool. But let's talk about the tax angle — because that's where a lot of founders get tripped up. Luna: I assume it's taxed as ordinary income, not capital gains. Lucas: Exactly right. The payout is treated as compensation income, so it's subject to income tax and payroll taxes. That can be a nasty surprise if employees aren't prepared. But some companies structure it so that the company withholds a portion of the cash to cover taxes, just like a regular bonus. Luna: So it's not as tax-efficient as selling actual stock, which would get long-term capital gains treatment if held over a year. Lucas: Right. But for many employees, the ability to get cash today outweighs the tax hit. Especially when you consider that the alternative — waiting for an IPO — could take years, and there's no guarantee the stock price holds up. Luna: Speaking of holding up, I noticed in today's market that high-growth names are taking a hit. Shopify is down about one percent over the past five days, and Roblox is off more than six percent. Lucas: Yeah, that's a rough week for Roblox. And it's a reminder that even after a company goes public, the exit isn't always a home run. Phantom stock at least lets employees diversify earlier. Luna: Honestly, if this episode helped you understand phantom stock a little better, that's exactly the kind of practical knowledge we try to deliver every week. And if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. Keeps us ad-free and independent. Lucas: Yeah, listener support is what lets us dig into these niche structures without chasing clicks. Appreciate anyone who chips in. Luna: Alright. So back to the mechanics — one thing I want to clarify: how does the vesting schedule work for phantom stock? Is it the same as the actual equity? Lucas: Typically, yes. The phantom stock vests on the same schedule as the real stock — usually four years with a one-year cliff. But the liquidity event can be triggered earlier by the company at its discretion. Luna: And the company decides when to allow cash-outs, right? It's not automatic. Lucas: Correct. The board approves a tender offer window — maybe a thirty-day period — and employees can elect to cash out some or all of their vested phantom shares. Databricks did that, and I think they allowed up to twenty percent of vested shares per employee. Luna: That's a nice balance. Enough to make a difference, but not so much that the company bleeds cash. Lucas: Exactly. And it sends a strong signal to the market that the company is employee-friendly. That matters when you're competing for top engineering talent against companies like Apple and NVIDIA. Luna: Apple is up more than five percent in the past five days, by the way. So they're doing fine. Lucas: Yeah, Apple is a beast. But for a pre ipo startup, phantom stock can be a powerful retention tool. It gives employees a reason to stay and build value, knowing they'll get a cash payout before the IPO. Luna: Any other recent examples besides Databricks? I know Stripe has done something similar. Lucas: Stripe had a phantom stock plan for its international employees back in 2021. And more quietly, companies like Canva and Epic Games have used variations. It's becoming more common as startups stay private longer. Luna: The average time to IPO is now around eleven years, I think. Lucas: At least. And with the IPO market still choppy — just look at the NASDAQ this year — many companies are happy to stay private and use tools like phantom stock to keep their teams whole. Luna: So if I'm a founder listening, what's the first step to setting something like this up? Lucas: Talk to your compensation consultant and your tax attorney. You need to make sure the phantom stock plan is compliant with Section 409A of the Internal Revenue Code, because nonqualified deferred compensation plans have strict rules. Luna: And the board has to approve it, obviously. Lucas: Right. But if you can get that done, it's a relatively low-cost way to provide liquidity without diluting your existing investors. And it keeps your cap table clean for the eventual IPO. Luna: One last question: does phantom stock affect the company's valuation at all? I mean, it's a liability, right? Lucas: It does show up as a liability on the balance sheet. But because it's tied to the equity value, it's usually not a big deal for late-stage companies. Investors understand it's part of the compensation package. Luna: Good to know. I think phantom stock is one of those tools that more founders should know about. It's not sexy, but it solves a real problem. Lucas: Absolutely. And with companies like Databricks and Stripe paving the way, I expect we'll see a lot more phantom stock tender offers in the next couple of years. Luna: Thanks for breaking it down, Lucas.