Phantom Stock Plan: A guide to phantom stock option & phantom equity

What are phantom stock plans

Phantom stocks, also known as shadow stock, are a form of deferred compensation plan where employees, typically executives, benefit from the value increase of company shares without owning actual stock. This unique arrangement allows businesses to provide stock-like incentives while maintaining full ownership and avoiding shareholder dilution.

How Phantom Stocks Plan work

Phantom shares are contractual agreements between a company and an employee. These “shares” mirror the value of the company stock but do not confer ownership rights. Instead, employees receive cash payouts based on the stock’s value at predetermined times or events.

Example: If an executive is granted 1,000 phantom shares at $50 each, and after a vesting period the share price rises to $75, the employee receives a cash payment of $25,000 based on the appreciation, without actually owning the stock.

Types of Phantom Stock Plans

Appreciation-Only Phantom Equity Plan

In this model, employees are compensated only for the stock’s appreciation over time. For instance, if the stock price increases from $50 to $75, the payout is based on the $25 increase per share.

Full-Value Phantom Stock unit

Full-value plans provide cash payouts equal to the stock’s total market value at the time of vesting. For example, if an executive is granted phantom shares valued at $50, and at redemption, the stock is worth $75, the payout reflects the full $75 per share.

Key Benefits of Phantom Stocks and Phantom Equity

1. No Dilution of Company Ownership

One of the primary advantages of phantom stocks is that they do not dilute company equity. Employees benefit from stock growth without gaining voting rights or ownership.

2. Attractive to Private Companies with no actual equity

Private companies often use phantom stocks as well as restricted stock as a way to attract and retain talent without the complexities and costs associated with issuing real stock.

3. Aligning Executive Interests with Company Growth

Phantom shares incentivize executives to drive company success. Since their payouts are tied to value of the phantom stocks, executives are motivated to increase profitability and market share.

4. Flexibility in Vesting Schedules

Phantom stocks allow for flexible vesting, whether it’s based on performance, time, or milestones. This ensures retention and long-term loyalty.

Considerations and Drawbacks

No Actual Ownership or Voting Rights

While phantom stocks offer financial benefits, employees do not receive actual stock ownership, voting rights, or dividends. This may be a disadvantage for those seeking more control.

Taxation

Phantom share payouts are taxed as ordinary income, which can lead to higher tax obligations compared to capital gains on actual stock. Companies, however, can deduct payouts as compensation expenses.

Potential Liability for Companies

Phantom shares can create uncapped liabilities, especially if the stock value appreciates significantly. Companies often mitigate this risk by capping payouts or setting high issuing prices.

Phantom Stocks vs. Stock Options

While both phantom stocks and stock options provide financial incentives tied to company performance, phantom shares do not involve actual stock ownership. In a stock option plan, employees can purchase stocks at a preset price, while phantom shares offer a cash payout without diluting ownership.

Phantom Stocks Example

Let’s say an employee is granted 500 phantom stocks when the stock price is $50. If the stock rises to $70 after three years, the employee would receive a payout of $10,000 (500 shares x $20 appreciation), based on the company’s increased stock value.

10 critical issues when implementing a phantom stocks plan

1. Plan Objectives

Before implementing a phantom stock plan, it’s essential to clearly define its objectives. Determine what the company hopes to achieve, whether it’s employee retention, incentivizing performance, or aligning employees’ interests with those of shareholders. A well-defined purpose will guide the structure and design of the plan.

2. Eligibility Criteria

Decide who will be eligible to participate in the plan. Most companies offer phantom stock to key executives and employees whose performance directly impacts the company’s success. Setting clear eligibility criteria ensures that the plan targets the right individuals to achieve its objectives.

3. Valuation of Phantom Shares

Since phantom stock represents a promise to pay an employee based on the company’s value, determining the valuation method is critical. Whether you use an internal valuation, an external appraisal, or a formula-based approach, the method should be transparent and fair to both the company and the employees.

4. Grant and Vesting Schedule

Like traditional equity plans, phantom stock plans often include a vesting schedule. Decide when and how employees earn their phantom stock. Options include time-based vesting, performance-based vesting, or a combination of both. Clear vesting terms can help align employee performance with the company’s long-term goals.

5. Payment Triggers

Clearly outline the events that will trigger payments under the plan. Common triggers include the achievement of specific company milestones, employee retirement, or the sale of the company. This clarity helps manage employee expectations and ensures alignment with the company’s financial planning.

6. Payout Structure

Define how and when payments will be made. Payments can be made in cash or deferred over time, depending on the company’s financial position. Establishing a structured payout process is crucial to avoid potential cash flow issues for the business.

7. Tax Implications

Phantom stock plans are subject to complex tax regulations. The company and employees need to understand the tax consequences of both granting and receiving payments. Consulting with tax professionals is essential to optimize the plan and avoid unintended tax burdens.

8. Legal Compliance

Ensure the plan complies with all applicable laws and regulations, including labor laws, securities regulations, and tax codes. Legal review helps prevent disputes and ensures that the plan is enforceable.

9. Employee Communication

Transparent communication about the plan’s structure, benefits, and risks is vital. Misunderstandings can lead to employee dissatisfaction or legal disputes, so clear documentation and regular updates are necessary.

10. Plan Administration

Ongoing administration of a phantom stock plan can be complex, requiring careful record-keeping and periodic valuations. Appointing a dedicated administrator or leveraging specialized software can streamline this process and maintain the plan’s integrity.

Should your business use phantom stocks?

Phantom stocks are ideal for companies looking to reward key employees without diluting ownership. They align employee incentives with company performance, making them a popular choice among private firms and startups.