The competitive job market has made startups and businesses continually seek innovative ways to attract and retain top talent. Equity compensation often serves as a powerful incentive, giving employees a stake in the company's success.
However, traditional equity plans like stock options or restricted stock can be impractical in certain situations, such as issuing equity to non-employees in some countries, aligning with specific company strategies, or navigating the complexities of cross-border regulations.
This is where phantom stock plans come in. It’s a type of equity-based compensation that provides employees, senior management, and even service providers with the financial benefits of ownership without granting actual shares. These plans offer a way to reward and align stakeholders with the company’s performance while avoiding ownership dilution.
Despite their appeal, phantom stocks come with notable disadvantages and risks. From taxation challenges and motivational misalignments to administrative complexities, these downsides can impact both employers and employees.
This article will discuss some risks and challenges of phantom stock plans to help stakeholders weigh their options and make informed decisions.
Key takeaways
- Phantom stock plans simulate the benefits of owning company shares without granting actual ownership, ensuring existing shareholders don’t lose equity.
- Employees face potentially unfavorable tax treatment, as payouts are taxed as ordinary income rather than capital gains, reducing their net benefit.
- Employers must fund large cash payouts when phantom stock is redeemed, creating potential challenges for cash flow management.
- The lack of ownership and voting rights in phantom stock plans can reduce their ability to inspire long-term commitment and alignment with company goals.
- Designing and managing phantom stock plans involves significant legal and administrative effort, including compliance with tax regulations.
What is phantom stock?
Phantom shares describe a hypothetical form of stock that mirrors the value of actual company shares without granting real ownership. The term "phantom" aptly conveys that these shares don’t physically exist, yet they behave like actual stock in terms of value appreciation (or depreciation). They are also called phantom shares, shadow stock, ghost shares, virtual shares, or phantom equity.
Phantom stock plans are a modern yet increasingly popular approach to equity-based compensation. They offer a flexible and cost-effective alternative to traditional schemes such as stock options or restricted shares.
At its core, a phantom stock plan is a contractual agreement between a company and an employee or service provider. Under the plan, the company commits to paying the recipient a cash sum equivalent to the value of its real stock at a predetermined future date. While these plans don’t involve actual stock ownership, they are tied to the company’s stock performance, enabling recipients to benefit from the growth in the company’s value.
For instance, if the company's stock price rises, the holder of the phantom stock reaps the financial rewards (usually in cash), similar to how a shareholder benefits from capital gains. However, unlike traditional equity options, phantom stocks do not grant voting rights or true ownership.
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
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Types of phantom stocks
Phantom stock plans typically fall into two categories:
- Appreciation only
- Full value
1. Appreciation only phantom stocks
In an appreciation only plan, employees are rewarded based solely on the increase in the company’s stock value over time. If the stock price rises, the employee receives a cash payment based on the growth. The employee, however, earns nothing if the stock price remains static or depreciates.
For instance, imagine a phantom stock issued at a starting price of ₦1,000 per share. At the time of redemption, the company’s stock price has risen to ₦3,000. The cash payout per phantom stock would be the difference between the redemption price and the starting price:
₦3,000 − ₦1,000 = ₦2,000 per share.
If an employee holds 100 phantom stocks, their total payout would amount to:
100 × ₦2,000 = $2,000
Use case: This plan is particularly attractive to employers as it avoids paying out when the stock price underperforms, limiting potential financial liabilities.
2. Full-value phantom stock plans
In a full-value plan, employees are entitled to the entire value of the company’s stock at redemption, including any growth in its price. Unlike appreciation-only plans, full-value plans guarantee a payout even if the stock price declines or remains static, as employees receive the current value of the phantom stock regardless of performance.
For example, if the phantom stock starts at ₦1,000 and the stock price rises to ₦3,000, the employee receives the full redemption value of:
₦3,000 × number of shares
If the share price falls to ₦500, the payout would still reflect the full depreciated value, ensuring employees receive some benefit:
₦500 x number of shares
Comparison example: Appreciation only vs full value
Let’s consider an employee who is issued 200 phantom stocks at a starting price of ₦1,500. At a later redemption date:
1. If the stock price increases to ₦1,800:
Appreciation only: The payout is the difference between the starting and appreciated price: (₦1,800 − ₦1,500) × 200 = ₦60,000.
Full value plan: The payout reflects the full value of the stock, including appreciation: ₦1,800 × 200 = ₦360,000.
2. If the stock price decreases to ₦1,000:
Appreciation only: No payout, as there is no increase in stock value.
Full value plan: The payout is equal to the depreciated value of the stock: ₦1,000 × 200 = ₦200,000.
Key considerations
- Appreciation-only plans align payouts with the company’s success, reducing risk for employers while potentially motivating employees to drive performance.
- Full-value plans offer more security to employees by ensuring payouts even during downturns, which may foster loyalty but increase the employer’s financial liability.
How does a phantom stock plan work?
Here’s how it works, step by step:
Step 1: Create phantom stock
The company establishes a pool of phantom stock units, each reflecting the value of a single real share. These phantom shares don’t represent ownership but are tied directly to the company's stock price.
Step 2: Set the vesting schedule
A vesting schedule is set, detailing the duration employees must remain with the company to become eligible for payouts. For example, a three-year vesting schedule might require employees to stay employed through this period to earn their phantom shares.
Step 3: Determine trigger events
Employers often designate trigger events — milestones that must be achieved before payouts occur. Common triggers include a company sale, achieving specific financial targets, or other liquidity events.
Step 4: Calculate payout
When the vesting period concludes, and any trigger events are met, the phantom stock’s value is calculated based on the performance of the company’s real stock price. Employees receive a cash payment equivalent to the value of their vested phantom shares.
Who qualifies for phantom stock plans?
While employees are the primary beneficiaries of phantom stock plans, these schemes are versatile and can be extended to a broader group of individuals connected to the company.
Here’s a breakdown of who might qualify:
1. Employees
Phantom stock plans are commonly designed for employees, particularly those in senior roles or top-performing positions. These individuals are seen as critical to the company’s success and are often rewarded to incentivize long-term commitment and performance.
2. Directors
Board members or company directors may also be eligible for phantom stock. Though not full-time employees, these individuals often play pivotal roles in guiding the company's strategy and performance.
3. Contractors and consultants
Phantom stock can be offered to third-party professionals, such as contractors or consultants, who contribute significantly to the company’s growth or success.
4. Service providers
In some cases, companies may grant phantom stock to key service providers whose work aligns closely with the business's strategic objectives.
Disadvantages of phantom stocks
While phantom stock plans may seem appealing as a flexible and cash-based incentive, they come with significant drawbacks.
Below are the main disadvantages to consider when evaluating such plans.
1. They don’t offer ownership and voting rights
Unlike traditional equity, phantom stocks do not provide actual ownership in the company.
Employees holding phantom shares:
- Lack voting rights and, therefore, cannot influence company decisions.
- Don’t typically receive dividends (but can, depending on the plan), limiting their financial benefits compared to real shareholders.
- May feel less invested in the company’s long-term success, as there’s no tangible ownership.
This lack of equity appeal can make phantom stocks less attractive in industries where genuine equity compensation is the norm, reducing their effectiveness as a talent attraction tool.
2. They have unfavorable tax implications
Regular stocks undergo capital gains treatment, under which employees are only required to pay a tax on the profit they make from selling the stock. Phantom stock payouts are taxed as ordinary income, often at higher rates than capital gains.
This significantly diminishes employees' net value, especially compared to other equity compensation forms like stock options or RSUs, which can qualify for lower long-term capital gains tax rates. Employers may also face additional payroll tax obligations.
3. They lack liquidity and marketability
Phantom stocks are inherently non-transferable and can’t be sold or traded, unlike real shares. Employees must wait for a predefined liquidity event, such as a company sale or IPO, to receive their payout.
This lack of liquidity creates uncertainty as employees:
- Have no control over when they can access the financial benefits.
- Risk losing potential rewards if the company’s performance or liquidity fails to meet expectations.
4. They cause cash flow strain for employers
Phantom stock plans require companies to pay large sums in cash upon vesting or at trigger events. For companies with tight budgets or inconsistent cash flow, this can create significant financial strain.
5. They involve administrative complexities
Managing phantom stock plans involves substantial administrative effort, including:
- Drafting detailed legal agreements to define the terms of the plan.
- Regularly valuing phantom shares to ensure accurate payouts.
- Ensuring compliance with complex tax laws, which can vary depending on the jurisdiction.
These burdens can make phantom stock plans time-consuming and costly to maintain, particularly for small businesses that lack dedicated legal or HR teams.
6. They impact employee motivation
While phantom stocks are designed to incentivize employees, they often lack the same emotional and financial appeal as true equity. Employees may view phantom stocks as a bonus rather than a long-term investment in the company's success. This perception can diminish the motivational impact.
Benefits of phantom stocks
Despite their limitations, phantom stocks remain a popular choice among startups and growing companies as an alternative or complement to traditional equity compensation.
Below are the key advantages:
1. They don’t dilute ownership
For founders and existing shareholders, the non-dilutive nature of phantom stocks is a major benefit. Unlike traditional equity compensation, phantom stocks do not impact the cap table.
Companies can reward employees without reducing the value of existing equity holdings, and shareholders can retain their proportional ownership and voting rights.
2. They are accessible
Employees participating in phantom stock plans don’t need to invest any personal funds, unlike stock options that often require upfront purchases.
This makes phantom stocks accessible to a wider range of employees, including those who may not have the resources to buy shares. Additionally, they are simpler to understand and engage with, as they operate like a cash bonus tied to company performance.
3. They are flexible
Phantom stock plans offer significant flexibility in their design, allowing companies to tailor them to their needs.
- Companies can choose between appreciation-only or full-value plans.
- Vesting conditions can be tied to time, performance, or specific milestones.
- Plans can be adapted to fit varying employee levels and strategic goals.
This versatility makes phantom stocks a suitable option for companies across industries and growth stages.
4. They have potential tax advantages
If structured correctly, phantom stock plans may provide tax benefits in the following ways:
- Companies can deduct phantom stock payouts as an expense, reducing their taxable income.
- Employees typically defer taxation until the payout is received, aligning with their cash flow.
Pro tip: Consult tax and legal professionals when structuring a phantom stock plan to optimize these benefits and ensure compliance.
Appreciation-only phantom stock vs. stock appreciation rights (SARS)
Appreciation-only phantom stock and stock appreciation rights (SARs) are often considered for rewarding employees with compensation tied to a company’s performance without granting actual equity. While both share similarities, they have distinct differences in structure, payout mechanisms, and overall purpose.
Appreciation only phantom stock
An appreciation-only phantom stock plan offers employees the promise of future cash compensation based on the increase in the company’s stock value over time. Employees are not granted actual shares but instead receive a hypothetical or "phantom" stake in the company, tied exclusively to stock price growth.
Stock appreciation rights (SARs)
SARs function similarly to appreciation-only phantom stock by focusing on stock value growth. Employees holding SARs have the right to receive the monetary equivalent of the increase in stock price over a specific period. However, SARs are often structured more flexibly than phantom stock plans.
For example, SAR holders can typically exercise their rights once vested rather than waiting for a triggering event like a company sale. Upon exercising SARs, employees receive the gain in stock value, often paid in cash or actual shares, depending on the plan structure. SARs are tied solely to the appreciation value and do not mimic ownership in the same way as phantom stock.
Key similarities
- Deferred compensation: Appreciation-only phantom stock and SARs are considered deferred compensation, with payouts taxed as ordinary income upon redemption.
- Performance-based: Both reward employees based on the company's stock performance, aligning employee interests with company success.
Key differences
Appreciation-only phantom stock | Stock appreciation rights (SARs) | |
Payout triggers | Typically tied to company milestones (e.g., sale or liquidity event). | Can often be exercised anytime after vesting. |
Ownership-like features | May be structured to include dividends or mimic equity ownership. | No ownership features like dividends or voting rights. |
Complexity | Can involve additional elements like dividends. | Simpler structure, limited to appreciation value. |
Which plan is right for your company?
The choice between appreciation-only phantom stock and SARs often depends on the company’s goals. Appreciation-only phantom stock plans are ideal for creating a sense of equity-like ownership without actual dilution, while SARs are straightforward tools to reward employees for company growth without considerations like dividends.
Phantom shares vs equity: key differences
Phantom shares are a flexible and less complex alternative to equity, making them appealing to companies that want to reward employees without sharing ownership. Equity, on the other hand, provides tangible ownership benefits and is often preferred in competitive markets to attract top talent.
Here’s a detailed comparison of phantom shares and equity to clarify their distinctions:
Phantom shares | Equity | |
Ownership and voting rights | No ownership or voting rights (employees don’t participate in corporate decision-making). | Provides actual ownership, voting rights, and potential for dividends. |
Payout structure | Tied to company valuation or stock price, with no direct liquidity or long-term benefits. | Offers dividends, potential IPO or acquisition gains, and liquidity through share sales. |
Dilution impact | Non-dilutive — does not affect company ownership or the cap table. | Dilutive — adds new shareholders, reducing the ownership percentage of existing stakeholders. |
Administrative complexity | Easier to implement with fewer regulatory hurdles compared to equity issuance. | Involves complex legal and regulatory requirements for issuance and management. |
Best use case | Suitable for private companies, family-owned businesses, or firms prioritizing control retention. | Ideal for startups, public companies, or businesses offering direct ownership to employees. |
FAQs about phantom stock
How are phantom stocks taxed?
Phantom stock payouts are taxed as ordinary income when received, often resulting in higher tax rates compared to capital gains. Employees are required to pay taxes on the full value of the payout, similar to a bonus or salary.
What happens to phantom stock when you leave a company?
When an employee leaves, the treatment of phantom stock depends on the terms of the agreement. Some plans may allow partial payouts, while others may require forfeiture of unvested units.
What happens to phantom stock when a company goes public?
In the event of an IPO, phantom stock plans are often converted into cash payouts or equity grants. The specifics depend on the company’s agreements and legal obligations.
What are the risks of phantom shares?
The main risks include higher tax rates, lack of ownership benefits, and potential misalignment with employee motivations. Employers face administrative challenges and cash flow demands for payouts.
Are phantom stocks the same as stock options or RSUs?
No, phantom stocks differ from stock options and RSUs as they do not involve issuing actual shares. Instead, they mimic the financial benefits of equity without transferring ownership.
Can phantom stocks be used for startups?
Yes, phantom stocks are ideal for startups seeking a cost-effective way to provide equity-like rewards without diluting ownership or affecting the cap table.
How are the payouts for phantom stocks calculated?
Payouts are generally determined by multiplying the number of phantom stock units by the increase in company share value (if it’s an appreciation-only plan) or the current share price (if it’s a full-value plan).
Is phantom stock legal?
Yes, phantom stock plans are legal and widely used as compensation strategies. However, plans must comply with the country's applicable tax and securities laws.
Conclusion
Phantom stocks present a unique way to incentivize employees without diluting company ownership. However, they come with significant disadvantages, including tax implications, lack of ownership rights, and potential administrative burdens. Businesses and employees should carefully weigh these pros and cons before incorporating phantom stocks into compensation packages.
Consulting legal and financial experts can help ensure these plans align with long-term goals and economic realities.
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