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9 frequently asked questions about phantom stock plans
How to pay incentive compensation based on company value.
This article was originally published on Oct. 12, 2020 and has been updated
Phantom stock plans can be a valuable method for companies that seek to tie incentive compensation to increases or decreases in company value without awarding actual shares of company stock. Here are answers to nine frequently asked questions about phantom stock plans and what they could mean for your company.
1. What is a phantom stock plan?
A phantom stock plan is a deferred compensation plan that awards the employee a unit measured by the value of a share of a company’s common stock, or, in the case of a limited liability company, by the value of an LLC unit.
However, unlike actual stock, the award does not confer equity ownership in the company. In other words, no actual stock is ever awarded to the employee under a phantom stock plan. Instead, the employee is granted a number of phantom stock units, and the plan provides that each phantom stock unit is equal in value to one share of common stock.
2. Why might a company want to issue phantom equity instead of actual equity?
Phantom equity does not have some of the drawbacks associated with providing actual equity. Situations in which a company may not want to issue actual equity include:
- A foreign parent may wish to award phantom stock units to executive employees of a U.S. subsidiary to avoid the complications of selling stock on a foreign exchange.
- A U.S. parent may wish to incentivize executive employees of a subsidiary without awarding shares of parent stock to tie their incentive to the subsidiary level value rather than the parent level.
- Equity grants may give rise to voting rights or unforeseen minority rights under state law.
- Additional legal documents and agreements, such as a shareholder’s agreement, may have to be amended or drafted, increasing complexity and legal fees.
- A company may wish that former employees do not own company stock after they separate from service.
3. How does a phantom stock plan work?
A company can grant an employee a designated number of phantom stock units or a percentage interest in the company’s value pursuant to a prescribed valuation method; this can be done once or multiple times. The phantom stock plan should indicate the number of phantom stock units or the participation percentage interest to be granted to the employee.
For example, the company could grant the employee a 5% interest initially and increase the interest to 10% after the employee completes five years of service.
Whether granted up front or over a period of years, the phantom stock units may either be immediately vested or subject to any vesting schedule determined by the company. For example, vesting may be cliff or graded, time-based, or based on the achievement of specified financial performance goals.
In addition, special forfeiture provisions can be included in the phantom stock plan to eliminate the company’s obligation to make payments to an executive upon specified events (e.g., if the employee breaches non-compete restrictions in the plan or the employee’s employment is terminated for cause).
4. How is the value of a phantom stock unit determined?
The value of a phantom stock unit may be measured by the value of a full share of company stock, or it may be based just on the appreciation in value during a specified time frame. (If based only on the appreciation, this is commonly referred to as a stock appreciation right.) The value may be a specified value, determined by an express written formula or determined by a third-party appraisal.
The method used for valuation should take into account adjustments that the parties agree are appropriate. For example, a company could exclude gain or loss attributable to operations or sales of certain divisions of the company. Other adjustments that might be considered include subtractions for capital investments made by the shareholders during the course of the plan, additions for any dividends paid to shareholders during this period, and the amount of accrued deferred compensation attributable to the phantom stock units themselves.
It should be noted that the value of the phantom stock units fluctuates from year to year as the value of the company changes. For example, if the company has a bad year and the value of its stock decreases, the value of the phantom stock also decreases. Thus, regardless of any vesting schedule, there is no locked-in value inherent in the phantom stock.
In addition, companies should be aware that events outside the company’s control also affect its value if a third-party appraisal is used. For example, legislative increases or decreases in corporate tax rates may result in companies having more or less cash flow, accordingly (with all else being equal). Similarly, a major event like the coronavirus pandemic affects market values for many companies. Companies should consider the possibility of such unexpected fluctuations in value, regardless of whether it relies on a third-party valuation.
The phantom stock plan should specify what events should trigger, or give rise to, a valuation (i.e., what events should entitle the employee to receive benefits under the plan) and at what precise point the value of the phantom stock units should be determined.
Typically, the valuation will follow an event that triggers phantom stock unit payouts so that the amount of such payouts can be determined. Companies can choose what the triggers are—examples include a separation from service, a change in control, or a specified future date or fixed payment schedule. In most cases, a valuation is required upon the employee’s termination, death, or disability. In other cases, valuation may be required periodically, such as annually, or on a specific future date.
To the extent possible, any date specified for measuring the value at a triggering event should be based on practicalities consistent with the company’s business practices. For example, once a triggering event has been identified, the company should consider whether the value should be determined on the exact date of the triggering event; or whether it makes more sense to look forward or back to the nearest quarter or year-end, depending on what financial information may be needed to calculate value.
5. How does the executive receive value from the phantom stock?
The number of phantom stock units, vesting schedule, form of payment (i.e., lump sum or installments over a period of years), and triggering payment events are typically set forth in individual grant agreements. Actual payouts of the phantom stock units are usually deferred until a predetermined future date or until the employment relationship is terminated due to retirement, death, or disability.
The phantom stock plan must specify when the phantom stock unit payments should commence and at what point a valuation of the units is generally required, as described above. If payments are to be made in installments, the phantom stock unit plan or grant agreement should also specify whether interest will accrue on the unpaid installments.
When designing these provisions, the company should take into account possible phantom stock valuations and company cash flow. It should be noted that even if payments are made after the grantee terminates service, the nature of the payment is generally still treated as compensation for tax purposes and reported on Form W-2.
6. How is phantom stock treated for income tax purposes?
Phantom stock plans are deferred compensation plans and, as such, must be designed and documented to conform to the requirements of section 409A. For income tax purposes, if the plan is compliant with section 409A, the deferred compensation attributable to the phantom stock will not be subject to income taxation to the employee until it is actually paid to and received by, the employee.
At the time the payment becomes taxable, the company is entitled to a deduction in a corresponding amount (subject to general limitations under section 162 with respect to the amount being reasonable and not excessive). However, unlike actual stock for which the increase in value on a disposition may be eligible for favorable capital gains tax rates, phantom stock unit payouts are taxable to the employee at ordinary income tax rates.
To ensure these tax results occur, companies should ensure that the terms of the phantom stock plan are in compliance with section 409A prior to the plan becoming effective. A violation of the section 409A rules could cause immediate taxation, plus an additional 20% tax, as well as the assessment of penalties all prior to any actual receipt by the employee.
7. What are the payroll tax consequences of phantom stock?
For the Federal Insurance Contributions Act (FICA), deferred compensation is includible as wages in the later of either the year in which the related services are performed, or the year in which the deferred compensation becomes vested.
The vesting and forfeiture provisions contained in the phantom stock plan or individual grant agreement determine whether and when the executive’s rights are vested. As the phantom stock units become vested, the value of the phantom stock units is includible as wages subject to FICA taxes. This is the case even though the amounts are not subject to income tax until actually paid to the employee.
If the employee’s base pay (before adding in the phantom stock unit payment) exceeds the Social Security wage base, no additional Social Security tax would be assessed on the phantom stock payments. However, the company and the employee would each be subject to Medicare payroll tax since the Medicare tax is imposed on total wages, without any wage cap.
8. Can entities taxed as partnerships use phantom stock?
Although partnerships do not have common stock, as noted above, entities taxed as partnerships, including LLCs, can implement plans very similar to phantom stock plans. In the case of a partnership, however, the value of a phantom stock unit is tied to partnership equity value rather than common stock value. All other aspects of the plan would be the same. Because the phantom stock units are not actual equity in the partnership, such a plan should not raise any concerns over partners being considered employees.
9. What should a company consider when designing a phantom stock plan?
Because a phantom stock plan is a nonqualified deferred compensation plan, companies have a lot of flexibility in plan design as long as that flexibility is exercised before the plan becomes effective.
Companies should address the following when formulating aspects of the written plan:
- What are the objectives of the plan?
- What behavior or performance levels is the company trying to incentivize?
- Who will be allowed to participate? (Consider current and future positions)
- What percentage of the company’s value should be dedicated or reserved for this plan?
- Should participants receive the base value of the phantom stock units, or only participate in growth over and above the base value?
- Is the potential payment opportunity under the phantom stock plan in line with the company’s compensation and business objectives in three, five, 10, or 15 years given certain performance assumptions?
- How frequently will phantom stock units be granted (e.g., a single upfront grant or annual grants)?
- When will phantom stock units vest? If phantom stock units are awarded annually, will each new grant be subject to a fresh vesting schedule?
- How will the phantom stock units be valued (i.e., based on a formula or an appraisal)?
- How will the phantom stock units be valued in the event of a merger, consolidation, or a change in control of the company? How should a change in control be defined?
- Will special vesting rules apply in the case of death, disability, or attainment of specified normal retirement age?
- Will any funding mechanism be used to help the company meet “fund” its future obligations to pay the amount owed to recipients?
- Should forfeiture provisions apply if the employee enters into competition with the company or is terminated for cause? How broadly or narrowly should the plan define what qualifies as cause for termination?
- When should the value of the phantom stock units be paid out in cash (e.g., periodically every three to five years, upon termination of employment, only upon a future change in control, or, perhaps, other events)?
- Should the payment be made in a lump sum or in installments over a period of years? If payments should be made in installments, over how many years?
- During the installment payout period, should earnings be credited on the balance at a specified interest rate? If so, at what rate? Should the phantom stock units pending payment continue to participate in the growth in value of the company?
- Does the phantom stock plan comply with section 409A? The plan must be designed and documented to conform to section 409A. This may restrict some of the flexibility of the plan design.
Various equity compensation methods, including phantom stock units, can provide great incentive to the employees receiving them and the employer providing them by cultivating increased engagement that can boost company performance. The attributes of phantom stock units should be carefully considered to determine whether it is the right incentive plan to meet a company’s needs.
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Phantom Stock Plans: How This Alternative to Real Equity Works
What’s a form of equity compensation that’s not actually equity compensation? This may seem like a riddle intended to baffle startup founders, many of whom already have a hard enough time keeping their equity terms straight. But the answer is a type of employee compensation that has become increasingly common in recent years: phantom stock.
Phantom stock plans, otherwise known as shadow stock plans, are a creative way to compensate key employees without granting them actual shares of company stock. Just as a phantom might mirror the outline of an actual figure, phantom stock is a type of employee compensation that tracks the value of actual shares of company stock. Employees who are granted rewards of phantom stock are thus able to benefit from the rise in value of the underlying company stock, without owning any actual stock .
In this guide, we’ll cover everything you need to know about phantom stock plans—including the situations in which they might make more sense than granting actual shares of company stock.
- What is a phantom stock plan
How phantom equity works
The main types of phantom stock, pros and cons of phantom stock plans, how to think about phantom stock as a startup founder, what is a phantom stock plan.
A phantom stock plan is an employee compensation plan in which an employee is offered “phantom shares” that track the value of the company’s actual stock. It’s important to highlight that phantom shares are not actual equity , though their value does rise and fall in accordance with the value of the company’s stock.
Phantom stock plans can be a powerful motivational tool for key employees, including those who already may be highly compensated or top performers. They also have some very attractive benefits for the employer, who typically controls the terms and structure of the plan and may include provisions that incentivize the employee to stay with the company for a longer term. Existing shareholders may also benefit from phantom stock plans, since granting shares of phantom stock does not require the issuance of new shares and thus does not result in the dilution of shareholder equity .
The result may sound like a win-win-win situation for employees, the company, and existing shareholders—and in some cases, it is! But phantom stock has some complexities and potential downsides to understand as well. We’ll get to those in a bit. For now, let’s take a deeper look at how phantom stock works.
The basic idea behind phantom stock is simple: reward a key employee with the financial benefits of stock ownership without giving them actual shares of company stock. The specific number of shares granted to the employee may vary depending on factors like seniority and performance, and in some cases, additional shares may be granted if certain performance goals are met.
Phantom stocks aren’t technically equity, but they do share a few things in common with traditional forms of equity compensation. For example, a 409a valuation may be required to determine the fair market value (FMV) of a share of phantom stock—just as it would be required to determine the price of stock options offered to employees.
As with other types of equity compensation , phantom stock programs also usually include a vesting schedule to encourage employee retention.
How phantom stocks vest
“Vesting” means that the employee doesn’t get all of the phantom stock upfront. Instead, they earn the cash value of their phantom stocks based on a specific delay mechanism—such as time requirement or performance milestone—that’s specified in the terms of the grant.
The full value of the phantom stocks may not vest until the full vesting period is up. In some cases, the employee may see their shares partially vest over the course of the vesting schedule. In other cases, the employee won’t see any cash payment until they’re fully vested—a period that may be up to three, four, or five years.
How company performance affects the value of phantom stocks
Assuming the company is successful and continues to grow, the employee stands to benefit from the appreciation in the company’s stock price.
But here’s a wild thought: what if the company stock price doesn’t appreciate over the full course of the vesting period? What if it actually declines ? Does the employee get anything in this case?
Well, it depends on the terms of the grant and the type of phantom stock the employee is granted. Different types of phantom stock can result in different reward valuations at the end of the vesting period. To illustrate this point, let’s take a look at the two main types of phantom stock.
The two main types of phantom stock are full-value phantom stock and appreciation-only phantom stock.
Full-value phantom stock
As its name indicates, full-value phantom stock grants the full value of the underlying share of stock. At the end of the vesting period, the employee receives not only the value of how much their stock appreciated since the time of the grant, but the full value of the stock.
Here’s an example to make this more clear:
- An employee named Sally is granted 100 shares of full-value phantom stock. At the time of the grant, each of these shares is worth $100.
- Sally’s phantom stocks vest over a period of five years. In the course of that time, the value of one share of company stock rises from $100 to $150.
- When she is fully vested, Sally receives a cash bonus of $15,000 (100 shares x $150).
It’s worth noting that, with full-value phantom stock, the employee will end up with some money even if the price goes down . Let’s look at the example above. If the value of one share of company stock goes down from $100 to $50 in the same time period, Sally will receive a cash bonus of $5,000 (100 shares x $50) when she is fully vested. That’s a lot less than what she’d earn if the value of the stock rises, but it’s still something.
Appreciation-only phantom stock
Unlike full-value phantom stocks, appreciation-only phantom stocks only have value if the underlying stock’s price increases over the term of the vesting period. The employee typically receives a cash payout equal to the appreciation in the stock price from the time of the grant to the end of the vesting period.
If there’s no appreciation in the stock price, it’s possible that the employee won’t receive any cash bonus at all. This is obviously not a great outcome for the employee! If it does end up being the case, the company may provide some other type of cash bonus or incentive as consolation—but this is not guaranteed if it’s not spelled out in the terms of the grant.
Let’s look at an example of how appreciation-only phantom stock works:
- An employee named Steven is granted 100 shares of appreciation-only phantom stock. At the time of the grant, each of these shares is worth $100.
- Steven’s phantom stocks vest over a period of five years. In the course of that time, the value of one share of company stock rises from $100 to $150.
- When he is fully vested, Steven receives a cash bonus of $5,000 (100 shares x $50).
Phantom stock awards can be a solid basis for an employee benefit plan, but they don’t always make the most sense. Before you determine whether a phantom stock program makes sense for your company, here are some advantages and disadvantages to consider.
Advantages of phantom stock plans
- Phantom stock doesn’t dilute shareholder equity. If you’re a founder, you probably care about limiting the dilution of equity ownership across your cap table . Your company’s other shareholders probably care about this a lot, too! Phantom stock can be a great way to give employees exposure to the rise in your stock’s price without granting them equity that would dilute the value of your shares.
- It can help your employees feel bought-in to company success. At many public companies, an employee who wants to own stock must purchase that stock on the open market or in an employee stock purchase plan (ESPP). In the absence of other equity compensation, phantom stock is a way to give employees a “stake” in your company’s future without requiring them to buy their own shares.
- It can supplement other, more restrictive types of equity . It’s not always easy to grant additional equity incentives to top-performing employees. Sometimes the shares just aren’t there, or the regulatory requirements are too onerous. Phantom stocks may offer a more flexible, less restrictive way to reward employees with something close to equity.
Disadvantages of phantom stock plans
- Phantom stock may create outstanding liabilities that affect the value of your company. While phantom stock doesn’t dilute shareholder equity, it can still create outstanding liabilities that decrease the value of your company. This is assuming that the payout is in cash and not shares.
- Taxes may be a pain for employees. The cash payout on a phantom stock plan is taxed at ordinary income tax rates in the year in which the phantom shares vest. Ordinary income rates are typically higher than the long-term capital gains rates an employee might qualify for with other types of equity, so they may be giving up more to the IRS than they otherwise would.
- Less appreciation in the share value means less of a payout. This is basically true with any type of equity, including ordinary stock options. Still, employees with appreciation-only phantom stocks may be extra-bummed if they make it to the end of their vesting period and end up with no reward because the stock’s price didn’t rise. On the other hand, at least the employee doesn’t stand to lose any money from the transaction.
In the right scenario, a phantom stock incentive plan can benefit both the company and the employee. But there are other types of employee compensation you may want to consider as well, whether it’s traditional equity or something like Stock Appreciation Rights (SARs), which work similarly to appreciation-only phantom stock.
How much (and what type) of equity to offer can be a fine line to walk. You need to think about your company’s financials as well as your employees’ motivation and wellbeing. If you’re interested in learning more about equity and your options as a startup founder, schedule a call with a Pulley expert today.
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The Ultimate Guide to Phantom Shares for Startups
Find out what phantom shares are, how they work, and how to create a phantom shares plan
Motivating and inspiring employees can be done in many different ways. But one strategy that is growing in popularity is the use of phantom shares. Also known as virtual stock options, phantom shares promise to deliver the same economic benefits as stock options without granting any actual stock. If you're ready to learn more about phantom shares, keep reading to discover how they work and how they can impact your startup!
What are Phantom Shares?
Phantom shares, also known as phantom stock or virtual stock options, are a popular industry trend among startups. Such a compensation asset aims to reward, keep and inspire employees . Here is how they work:
- Those who get phantom shares do not own a stake in the company. Unlike stock options , recipients of phantom shares do not get a right to buy shares or become shareholders.
- Instead, the idea is to link the value of phantom shares to the actual value of the company's stock. So the compensation from phantom shares is tied to the company’s stock value .
- Phantom shares provide the team with the opportunity to benefit from company growth. It means that when a company's share value increases, the potential compensation also goes up.
- Unlike equity compensation, there's no requirement for startups to set aside actual shares as assets when implementing a phantom stock plan.
- Phantom shares usually get liquid when the company gets acquired or goes public or if the company decides to do a buyback.
- Any gains from the assets must be reported to tax authorities as ordinary income upon vesting .
- The phantom shares plan forms part of your cap table and the vested phantom shares will dilute stakeholders when the company gets acquired or IPOes.
How are Phantom Shares Paid Out?
Phantom shares are usually paid out when the company gets acquired or IPOes . The phantom shares are paid out in cash for their corresponding value. In case of the acquisition, the acquirer must deduct from the total acquisition cost the money to be paid out to employees with phantom shares.
Upon getting acquired, shareholders will only get diluted by the amount of vested phantom shares , also taking into account potential acceleration rights. For example, if a company has a phantom share plan with 10k shares and at the time of the acquisition, only 5k shares have been granted and vested by employees, the rest of the shareholders will only get diluted by the 5k phantom shares which were vested already.
Companies may also buy back some phantom shares from employees at a discount if it was already established in the original contract. Buybacks are an effective way of giving employees liquidity and making space in the cap table without increasing dilution.
How to Create a Phantom Shares Plan?
From the company's point of view, launching an incentive program like a phantom shares plan is usually a task that becomes more complex as the number of investors and employees grows, but the process is usually the same:
1. Design of the phantom shares plan
The first step is for the management and founder team to align on the essential elements of the plan, for example:
- Size of the plan (pool size) : defining the % of shares that you want to allocate is critical. The so-called pool size ranges from 5 to 15% of the total shares available. It is usually closed just before an investment round.
- Vesting period : the period over which the shares will be vested. Usually, the vesting period is 4 years.
- Vesting schedule : Simple structure is the most common (in case of 4 years of vesting, 25% of shares are vested each year). Still, it is possible to grant shares under a different schedule (20% in the first year, 25% in the second, 25% in the third, and 30% in the fourth). Phantom shares can be vested every month, quarterly, or annually.
- Cliff : minimum period an employee needs to work for to start having access to the vested phantom shares. For example, if an employee leaves after 11 months and the cliff is 1 year, no shares will be considered vested. However, when the cliff is reached, then all the ‘vested shares’ become available at that moment (1-year cliff = one year’s worth of phantom shares).
- Full acceleration: when there is a trigger event, all the unvested shares are accelerated and fully vested.
- Partial acceleration: when there is a trigger event, a specified % of unvested phantom shares is accelerated.
- Single trigger, double trigger or x trigger acceleration: this clause specifies the number of conditions (triggers) that need to happen for any acceleration to occur.
- Liquidity event : a triggering event specified in the agreement for the execution of the phantom shares plan. Typical triggers are the moment when the company gets acquired or IPOes.
- Repurchase or buyback : the company may reserve the right to repurchase phantom shares early before the liquidity event, usually at a discount based on the market valuation. This clause is used mainly in successful companies. The primary motivation for such an activity is for investors to acquire more company shares without further diluting the founders.
- Definitions of good and bad leavers : the exit or abandonment clauses define what will happen to the phantom shares (assigned, vested and non-vested). These are determined based on the reason for the end of the employment relationship with the company. Usually, a good leaver covers death, retirement, illness, unfair dismissal and sometimes voluntary leave.
2. Approval of the plan
Once the compensation system is defined, the executive body (usually the council) approves the plan.
3. Launch of the plan
Sending the employee invitation letters, setting up meetings and organizing an information flow to explain the conditions will be a necessary step when launching your phantom shares plan. Communication strategy around employee equity compensation will have to play a big role to ensure the success of the plan.
4. The management of your phantom shares plan
First, your company's lawyers will create and prepare the documents. But once the plan is approved, somebody will have to manage the employee grant letters and vesting calculations, provide ownership visibility, send letters of consolidation when employees leave the company, and keep the phantom shares plan up to date. Capboard automates all these processes and provides the tools to set up the plan, manage it efficiently and give the much-needed visibility for every party involved . Learn more about how you can automate your company's compensation plans .
Advantages of Offering Phantom Shares to Employees
Offering a phantom stock plan to employees is an effective tool startups can use to reward loyalty and incentivize the workforce. It is a good alternative to an employee stock option plan (ESOP) , and here is why.
- This type of incentive compensation program provides employees with a financial benefit based on the company's performance. As a result, it creates a mutually profitable dynamic. But, you don't have to give equity and dilute your stakeholders , which is the case when offering stock options.
- Awarding phantom shares does not require cash outflow right at the moment. That allows you to enjoy the positive impact of such a plan while your company is still developing or fundraising.
- It encourages worker engagement and performance . At the same time, it helps startups retain talented employees that have been integral in helping grow the company. A phantom stock plan can build loyalty within the staff and support rapid expansion. It is especially relevant as the company gains more ground in competitive markets.
- Phantom shares allow employers to align their long-term interests with their employees. It is done by setting up target vesting milestones. That means creating a performance-based compensation system using phantom shares. And such an approach can help you encourage employee performance over the long term .
- Cap table management is easier when having a phantom stock plan and not a stock options plan as phantom shares’ beneficiaries will never become shareholders. Hence, it has no impact on the company’s governance.
Disadvantages of Offering Phantom Shares to Employees
Offering phantom shares to employees can seem like a great idea for startup founders looking for a way to provide compensation. But it's essential to consider the potential drawbacks:
- Employees may not understand the implications of owning nonexistent shares. Something that can put the whole plan at risk of failing and harming the company and the team’s morale.
- Furthermore, real stock options may be more attractive forms of compensation due to their cost structure and increased liquidity.
- It's important to note that employees with phantom shares are not calling the shots . They cannot decide when they will receive the compensation. The phantom shares are redeemed when particular circumstances trigger them. For example, when the company is sold, is part of a merger or goes public. Such triggers need to be specified in the phantom shares agreement.
In the end, phantom shares are just that - phantom or virtual . That means they exist on paper only. No rights to equity are granted, so employees cannot buy any shares. However, employees can keep the vested phantom shares if they leave as good leavers.
Phantom shares vs RSUs vs SARs
Phantom shares, RSUs (Restricted Stock Units), and SARs (Stock Appreciation Rights) are popular methods of offering employee compensation in startups. The three plans share similarities. However, there are significant differences that founders should be aware of.
- Phantom shares are a type of compensation where employees receive notional shares in the company.
- Unlike RSUs, they do not provide ownership rights.
- But they do entitle employees to economic benefits since their value is tied to the company's share value.
RSUs (Restricted Stock Units)
- RSUs give employees a certain number of shares in the company, which they can sell once they vest.
- Once the shares have vested, employees may choose not to sell them at the market price and keep them for potential future profits.
SARs (Stock Appreciation Rights)
- SARs give employees the right to receive an amount equal to the increase in the value of a set number of shares without owning them.
- It means that employees do not have to buy any shares. Instead, they receive a payout equal to the increase in the value of the shares.
- However, they can choose to get the shares for the value of the appreciation.
Employers must be aware of the various tax consequences of each compensation strategy. It is also crucial to remember that each compensation has specific rules and regulations. It is recommended to seek advice from legal and financial professionals before deciding on a compensation strategy.
Tips for Maximizing the Benefits of Offering Phantom Shares
Phantom shares incentivize employees to stay for the long term and perform. They can also provide tangible returns on their hard work. With a well-crafted phantom stock plan, employee compensation can increase significantly. That makes it a win-win situation as the employees and your company benefit from such an arrangement! It's important to make key employees a part of the decision-making. It will allow for maximizing the benefits for both parties. Employee input plays a crucial role in developing an agreement that works for everyone. Here are 6 steps for maximizing the benefits of offering phantom shares.
Offer Phantom Shares at Your Startup with Capboard
Offering phantom shares can be an effective way to inspire employees and create a long-term, results-oriented culture within your startup. Considering the legal and organizational implications of such a plan is crucial before introducing it in your organization. But when done right, you and your team can be greatly rewarded.
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Phantom Stocks Explained
Phantom stock sounds a bit ghostly, but the potential benefits are no hallucination.
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Did you know that some stocks aren’t real?
Most people don’t, but these shadow stocks exist nonetheless—companies even give them to their employees. Don’t worry, these companies aren’t scamming their own workers. In fact, phantom stocks are more valuable than you may think. 👻 💰
To discover exactly how valuable they are, we have to take these stocks out of the shadows for a moment—no matter how hypothetical, phantom stocks can become real very fast.
For instance, for employers—who often struggle to keep key employees at their company for a long time—a bit of extra worker incentive is always welcome. After the Covid-19 pandemic, almost two-thirds of U.S. workers looked for new job opportunities as part of a trend called the “Great Resignation.”
This just goes to show how big the challenge of employee retention is for companies—and why stock-based compensation plans like phantom stocks are an invaluable addition to the mix of employee benefits.
To keep valued employees aboard, companies can compensate them in a variety of ways—phantom stocks being one of those. With many types of stock-based compensation out there, it’s easy to get lost in a sea of financial acronyms and abbreviations.
Nevertheless, an employee needs to know exactly what’s on the table—what’s all the tough negotiating for, otherwise? Likewise, the employer has to put up a balancing act between attracting the employee and not putting themself at a disadvantage.
Before we make it sound too much like an episode of Suits, let’s get to the heart of the matter. In this article, we’ll tell you what phantoms stocks are, how they work, and what the different types are. We’ll also look at the pros and cons, alternatives and we’ll even unveil a more disturbing meaning of phantom stocks.
- Phantom Stock Definition
- How Phantom Stock Works
- Why Employers Choose Phantom Stock
- Evaluation of Phantom Stocks
- Phantom Shares Becoming Taxable
- Types of Phantom Stock Plans
- Advantages of Phantom Shares
- Disadvantages of Phantom Shares
- Phantom Stock Alternatives
- Phantom Shares in Naked Shorting
- Phantom Stock FAQs
Get Started with a Stock Broker
Phantom stock, what’s that 🤔.
Do you want the financial benefits of having shares to your name without the hassle of actually owning them? Then, phantom stocks might be the answer—if your company offers them to you, of course.
They might do so as part of the compensation package—the higher your position, the higher the chance the company will offer them to you. Don’t despair if you’re not up there yet, phantom stock compensation is becoming more and more prevalent.
A specific number of phantom shares are granted to an employee—laid down in an agreement. Besides the number of shares, other important things—such as the type of payout and the vesting schedule—are also disclosed in the agreement.
Phantom shares—as with many other stock compensation types—are subject to a vesting schedule. Vesting happens when the shares are distributed to an employee—the first batch usually after one year.
After this “vesting cliff’’ has been reached, the remaining shares typically vest on a monthly or yearly basis until all of the shares have vested. In other words, the vesting schedule indicates when different batches of shares vest.
When phantom shares vest the recipient gets a specific amount of money equal to the value of the shares—depending on the type of plan. It is, however, also possible that the company distributes actual stock instead of cash.
Mock Stocks 💭
These “mock stocks” give an employee stock ownership without the stocks—yeah, you read that right. Although hypothetical, they go up and down in value along with the underlying company stock.
No, the company is not trying to make you a pro at paper trading—there’s actual cash involved. Depending on the type of phantom stock—as if it wasn’t complex enough—the employee can expect a payout at a specific date or after specific achievements.
How Phantom Stock Works 🔧
Although the name sounds a bit spooky, the only scary thing about phantom stock is paying the taxes—unless you’re the IRS, of course. So, let’s go ahead and shine a light on the shadow stocks—those are all the word jokes, we promise.
Loyalty Pays 🤝
How many phantom shares an employee receives depends on the company—a good way to find out how valuable you are to an employer. Each company—that offers phantom stock—has its own phantom stock plan and policy in place.
Don’t expect to cash in right after signing the agreement—a delay mechanism is activated after phantom shares are granted. The actual payout takes place based on a vesting schedule—usually three to five years.
An employer can also choose to grant phantom shares over time in installments—for example, each month or year. The payout an employee can look forward to depends on the type of plan a company has—more on this later.
Why Do Employers Choose Phantom Stock?
Given the fact that there are many different types of stock-based compensation, you might be asking yourself why an employer would choose phantom shares—as opposed to any of the other stock compensation options.
What all of them have in common is that they reward employees for being loyal and hard-working. As with the other types, phantom shares give employees “skin in the game”—motivating them to be productive.
Share Issuance 📃
What sets phantom shares apart is that the shares are “fake”—who wouldn’t sign for that?
With the shares being non-existent, the employer doesn’t have to issue any new shares.
The advantage of this is the lack of equity dilution—a fancy way to say each shareholder’s piece of the pie gets a little smaller after more shares are issued. On top of that, there won’t be any legal concerns that normally come with the issuance of shares.
Issuing shares to employees also means giving them a bigger stake in the company—partially shifting control. Phantom stock lives up to its name here—it gives the employees merely “phantom” control.
One of the best ways to lose your wealth is to put all your eggs in one basket—you wouldn’t be the first one to go broke by speculating on one or just a few stocks . All the more reason to diversify your investment portfolio properly.
Many stock-based compensation options give employees a disproportionate amount of company stock in their portfolio—after the shares have been distributed. Phantom shares, however, don’t have the same effect since the shares don’t exist.
Golden Handcuffs 👮
To keep key—highly-compensated—employees from leaving, companies have the option of giving them golden handcuffs. Don’t worry, it’s not what it sounds like. The benefits employees receive from these handcuffs are strictly financial.
Golden handcuffs are used to get valued employees “locked in a job”—get cozy with your cubicle. To prevent them from running off to a competitor, they can count on a variety of financial incentives.
The catch is that the executives can forget about the benefits if they leave the company before an agreed-upon date. The incentives motivate high-up employees— who are notorious job-hoppers —to stay around longer than they normally would.
The Evaluation of Phantom Shares 📁
So, how much is a phantom share worth? The simple answer is that the value of a phantom share is tied to the value of an underlying company share. Phantom shares go up and down in value together with the company’s “real” shares.
In reality, it’s a bit more complicated—the company often has to hire an external appraiser to determine the value of phantom shares. No, not just by looking at Google stock charts—the parties involved have often agreed upon adjustments for calculating the value.
These could involve leaving out gains or losses in certain cases or adding dividends paid by the company, for example. An appraiser has to take all of this into account—if the value of phantom shares hasn’t been stipulated beforehand by an agreement.
When Do Phantom Shares Become Taxable?
If you think non-existent shares sound like a good way to avoid paying taxes, think again.
Phantom stock is seen as a form of deferred cash compensation—meaning that employers have to comply with section 409A of the Internal Revenue Code .
You don’t have to go back to college for a degree in tax law—it’s fairly simple to understand.
Thanks to this piece of tax legislation, there is no tax impact when the phantom shares are granted. That all changes, however, when the shares vest and a payout takes place.
The payout received by the employee is taxed as ordinary income—the company usually deducts a certain amount. Since the value of the shares fluctuates, it’s normal for the liability to change every year during the vesting period.
Different Types of Phantom Stock Plans 💼
There are two types of phantom stock plans that employers normally use to compensate employees—the “appreciation only” and “full value” variants. Conveniently, these plans are exactly what the names would have you assume.
Appreciation Only 📈
As the name suggests, companies that use an appreciation-only plan don’t give employees the full current value when a payout takes place. Instead, they receive the share price appreciation—times the number of shares—relative to when the shares were granted
Let’s say you receive 1.000 phantom shares when the company’s share price is at $10 and the shares vest after four years. Lucky you, the share price has doubled after four years and is at $20 when the shares vest.
After the four-year vesting period, each share is worth $10 more than when they were granted. To calculate the total payout we multiply this $10 share price appreciation by 1.000—the number of phantom shares granted.
That leaves you with a $10.000 payout—thank you high school calculus. As you’ve just seen, the payout in our example is based on the share price appreciation and doesn’t include the full value of the underlying shares.
Full Value 💰
The full value type, however, doesn’t only pay out the share price appreciation. This phantom stock plan variant pays out the full value of the company’s underlying shares—great news unless you work for Kraft Heinz that has been in decline since 2017.
Let’s say you found a new job—to retain you and your talents the company grants you 1,000 phantom shares. By coincidence, the shares are also worth $10 apiece and the vesting period is four years.
You patiently wait for four years for shares to vest—luckily, your new company does just as well and the share price has once again doubled to $20. In contrast to last time, you now receive the full value of the shares—20 times 1.000 comes down to a payout of $20.000.
Advantages of Phantom Shares 👍
Phantom shares are seen by many as having more upside than downside—sometimes they’re even considered to be better than “normal” shares. Having said that, phantom shares are not all sunshine and rainbows.
To start on a positive note, phantom shares are often described as a “win-win” situation. They motivate employees to stick around for the entire vesting period and improve productivity—leading to a rising share price, in turn benefiting the employees.
What’s in it for Employers? 👔
It aligns the motives of the employer and employees and postpones paying taxes to a later date—a superpower most of us will envy.
From the employer’s perspective, the absence of share dilution is also an attractive attribute of phantom shares—they’re different from normal company stock, after all. Companies also have full control of phantom stock plans—they dictate the agreement.
If that wasn’t enough, companies also don’t have to worry about giving employees voting rights or dealing with legal issues. Similarly to voting rights, employers won’t have to worry about paying dividends either.
However, employers can choose to pay out “phantom dividends”—these are dividend equivalents. Any dividends the company paid out to “normal” shareholders will also be credited to phantom stockholders after their full value shares have vested.
There is a unique benefit for S corporations—these types of corporations can only have a limited number of shareholders. With phantom shares, there’s no risk of expanding the shareholder base—while employees still benefit from a rising share price.
How About the Employees? 👷
As luck would have it, the benefits employees receive with phantom shares are not merely figments of imagination. With regular shares, investors often lose sleep over another pullback or crash warning —no need to worry about that with phantom shares.
Since employees don’t have to pay for the shares—they are given to them by the company—there’s no initial investment required by the employee. Even if the share price performs badly, all the money paid out to an employee is technically a gain.
The Downsides of Phantom Shares 👎
So, why wouldn’t every company choose phantom shares as compensation?
Mainly because there are many different types of equity compensation to choose from.
Some aspects of phantom shares make them less attractive relative to other stock-based compensation—other downsides apply to most equity compensation types.
More Money, More Problems 💵
Phantom shares can hurt a company’s cash flow—the company has to pay out a large amount of cash to employees after the shares have vested. The balance sheet is also affected by the variable liability of share price fluctuation.
Remember the external appraisers we talked about earlier? Well, they don’t work for free. The company has no choice but to incur these extra costs—every year the status of its phantom stock plan has to be disclosed.
Troubles With 409A 🏢
The IRS’s tax rule 409A can also be to the detriment of both the employer and employee. Thanks to this rule, a company is limited in its ability to choose distribution dates—exacerbating the cash flow issue.
On top of that, it makes it practically impossible for employees to accelerate payouts. Any company not complying with 409A can expect to pay hefty penalties—who would’ve expected that from the IRS?
However, there is a way companies can avoid tax rule 409A—by using the short-term deferral rule. Since a phantom stock plan is a type of written compensation plan it is exempt from section 409A under one condition.
To benefit from this exemption, the payment has to take place shortly after the phantom shares vest . So, companies often pay out the cash right after vesting to avoid 409A—thank goodness for tax loopholes .
Who’s the Boss Here? 📣
That’s not the only downside for employees—with phantom shares, companies are the ones calling the shots. Phantom shares come with very limited rights for employees—and that’s often intentional, as it’s hard to make key decisions when your employees vote against you.
That’s why employees don’t obtain any voting rights and—dependent on the plan’s structure—might not receive any dividends. There is also little room to maneuver when the share price drops—it’s hard to sell shares that don’t exist, after all.
What Are Some Phantom Stock Alternatives?
The sheer number of stock-based compensation options can make it a tough job for employers to choose the right one. In this section, we’ll describe a few of the most popular phantom stock alternatives.
Stock Appreciation Rights (SARs) 📊
Stock appreciation rights or SARs are again exactly what the name suggests—who said finance was complicated? They are very similar to appreciation-only phantom shares—they also give employees the right to share price appreciation.
However, the main difference is that the employee often gets the payout in shares instead of cash. There also doesn’t have to be a specific payout date—giving employees the flexibility to choose when they want to receive the money.
Phantom shares can be tied to specific achievements—whereas SARs aren’t. For employees interested in dividend investing SAR would be a bitter disappointment—they don’t offer any dividend equivalents.
SARs are often granted to employees together with stock options—the money to buy the options has to come from somewhere, after all. Options trading is one of the reasons that GME and AMC still make the headlines regularly in the later summer of 2021.
Although it’s not any company’s intention to take its employees on such a wild ride, the options work the same way. By granting stock options, employees get the right to purchase a specific number of shares at a date in the future—with a pre-set price.
Restricted Stock Units
Restricted Stock Units or RSUs are, in essence, a promise of value by the employer to the employee. The employer promises to give the employee shares in the company if the employee stays at the company for a specific amount of time.
As with many of the other stock compensation types, they’re sometimes distributed after certain milestones are achieved. During the vesting period, the shares are usually given on a monthly or yearly basis after the employee has reached a “vesting cliff.”
The main difference here with phantom shares is that vested RSUs are actual shares in the company. This also gives the employee—possible—dividends and voting rights that phantom shares lack.
The Meaning of Phantom Shares in Naked Shorting 📰
You must have lived under a rock if you’ve missed the whole GME/AMC saga that saw an army of retail traders take aim for a couple of big hedge funds. The reason they saw an opportunity to squeeze out the hedge funds was the big guys’ massive short positions.
Luring people into the cinema and selling video games the old school way both have become increasingly difficult over the last decade—no surprise then that AMC and GME became a target for hedge funds. To add insult to injury, these funds shorted more than 100% of the shares in existence.
This happens in a process called naked shorting —it’s less exciting than it sounds. The hedge funds short shares which have “not been determined to exist”—this way they gain more leverage easily. These newly “created” shares are called phantom shares—often compared to counterfeit money.
Final Words 📌
Phantom shares are shares that don’t exist, but the benefits employees can expect are not a fantasy—neither is the role of phantom shares in naked shorting. Understanding what phantom shares exactly are is necessary to take full advantage of them—it also helps you understand the shenanigans going on in the financial markets.
So, hats off to you for putting in the effort to educate yourself on this topic. You’ve learned what phantom stock is, how they work and what the different types of phantom stock plans are. We’ve also discussed the pros and cons of phantom shares, a few alternatives, and the other meaning of phantom shares.
Phantom Stocks: FAQs
Do phantom shares lead to share dilution.
No, granting phantom shares does not lead to share dilution—this is one of the biggest benefits for employers. There is no dilution because employees don’t receive actual shares—they normally get a cash payout.
Do S Corporations Use Phantom Shares?
Yes, phantom shares are very popular among S corporations—these corporations can only have a limited number of shareholders. By granting phantom shares, the shareholder base doesn’t grow—no actual shares are issued, after all.
Is it Possible to Avoid 409A with Phantom Shares?
Yes, it is possible to design phantom stock plans that avoid section 409A limitations—companies use the short-term deferral rule for this. This rule applies when payouts take place right away when the shares vest.
Is Phantom Stock Considered to Be a Security?
No, phantom stock plans are written compensation plans—therefore Rule 701 under the Securities Act of 1933 applies. Thanks to this rule, companies don’t have to register any securities with the SEC when they grant phantom shares.
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Phantom Stock: Everything You Need to Know
Phantom stock is an employee benefit where selected employees receive the benefits of stock ownership without the company giving them actual stock. 8 min read
What is Phantom Stock?
Phantom shares (phantom stock agreements) are an employee benefit where selected employees receive the benefits of stock ownership without receiving actual stock from the company . While not stock in the company, phantom stock is worth money just like real stock— its value rises and falls with the company's actual stock (or what the company is valued at, if it's not a publicly traded company). Employees are paid out profits at the end of a pre-determined length of time.
Also known as ghost shares , shadow stock , simulated stock , or phantom shares , phantom stock is often provided as a bonus for employees’ hard work and longevity. One form of phantom stock is Stock Appreciation Rights.
There isn't one exact one-size-fits-all definition of what phantom stock is or how companies use it. The term “phantom stock” can apply to any reward that takes time to mature . Usually, the award is for a specific number of units, or phantom shares, that follow the price of the company's actual shares — going up as the company is worth more and down as it's worth less.
Each phantom stock plan has a plan charter. This charter dictates the vesting schedule. If there are goals or tasks that participants must accomplish in order to vest, the charter outlines what these are and what the participants will receive. The charter also states voting rights, if any. If the phantom stock can be converted to actual shares in the company upon payout, the charter will outline how this is done. Having a well drafted plan charter is imperative for companies.
Why Do Companies Use Phantom Equity?
Awarding employees company stock can provide many benefits, including motivation to work harder because if the company is successful, its stock prices will go up. This system also encourages loyalty to a company: employees feel invested, which makes it less likely that they'll seek new opportunities elsewhere.
However, even with these incentives, phantom stock might be a better option for employers in certain situations:
- When there are legal concerns.
- When the company is unwilling to issue additional shares.
- To prevent diluting stock by giving it to many employees, which may influence voting control.
Providing phantom stock allows the company to reward employees for their hard work without worrying about those big problems.
Phantom shares are typically used to encourage senior leadership to produce better results for the company. The number of shares awarded usually depends on the leader’s place in the organization and how well their team has performed. Though the promise of the money is given today, the benefits are long-term—paying out after two, three, or five years, depending on the term that the company sets. As previously noted, the phantom stock can also be contingent on accomplishing a specific goal or task.
Form and Structure of Phantom Stock Agreements
There are two types of phantom stock agreements that most companies use:
- Appreciation only
When companies use appreciation-only phantom stock, recipients don't receive the current value of real stock when they cash out their phantom stock. Instead, they receive anything above and beyond what the phantom stock was worth when it was granted.
For example, let's say that Bob was granted 500 phantom shares on June 5, 2020. When the shares were granted, they were worth $60.50 each. In order to receive the benefit of these shares, Bob needs to stay with the company for five years. At that time, on June 5, 2025, the shares are worth $85.25.
For each of Bob's shares, he'll get the difference between the current value ($85.25) and the initial value ($60.50), which is $24.75 per share. Multiply that by 500 shares, and Bob's bonus ends up being $12,375.
Where appreciation-only phantom stock pays out the difference between the shares' initial value and their current value, full-value phantom stock pays out exactly what it's worth.
For example, let's say that Mary is granted 500 phantom shares on June 5, 2020, for the company she works for. Coincidentally, the stock for her company is also worth $60.50 a share, and she also has to wait five years for them to mature. Once those five years have passed, the shares are (strangely enough) also worth $85.25.
However, unlike Bob's phantom shares, Mary's are worth the full value — which means she's paid out the full $85.25 per share and gets a bonus of $42,625. Go Mary!
Why Is Phantom Equity Important?
For employees , phantom stock rewards the time and effort they have invested into their company . When the phantom stock matures, companies will typically pay employees the cash value of the shares or, in some less often circumstances, convert the phantom shares into actual stock.
For company owners , phantom stock can help grow their business offering top employees a reason to stay and help the company succeed for the long-term. Strong leadership is essential to a company's success, and replacing senior leadership can be expensive and time consuming.
Phantom shares could be granted every year, even if they take five years to mature. This means that once leaders have been at the company for five years, they can expect to benefit from these rewards annually. On the other hand, if they leave the company before the shares mature, they will not receive any of those rewards.
Reasons to Consider Not Using Phantom Stock Plans
Phantom stock is not a good idea if the company is planning on issuing it to most or all employees, especially if the phantom shares will be paid out when the employee leaves the company or retires. In that case, phantom shares may be ruled illegal because of the Employee Retirement Income and Security Act ( ERISA ). Employee stock ownership plans (ESOP) and 401(k) plans are qualified plans that are considered legal under ERISA. However, ERISA prevents non-qualified plans from acting like qualified plans. Sometimes awarding phantom stock, especially if given to a large percentage of employees, may be seen as a non-qualified plan under ERISA.
Companies should also make sure they're in compliance with Internal Revenue Code Section 409A . This addresses executives that might be tempted to accelerate distributions because of knowledge that the company is nearing financial collapse. When setting up a phantom stock plan , Section 409A must be followed, which includes the guidelines for distributions and terms of the plan.
Phantom stock might not always be your best option. Phantom stock only benefits employees if the company grows; issuing phantom shares when you don't foresee growth in the near future could backfire and lower morale. Additionally, some employees may get more excited about having actual shares in the company, which can be kept for years to come, rather than having phantom shares.
Reasons to Consider Using Phantom Stock Plans
Despite some of the challenges associated with phantom stock, it is important to note that phantom stock definitely has its advantages. These advantages include:
- Little to no complications. Phantom shares are only paid out if the employee meets certain terms. If an employee leaves the company before those terms are met, the phantom stocks disappear. If the company had used actual stock, those would have to be repurchased, which would make things more complicated and potentially, more expensive.
- No voting rights. Since phantom shares are not the same as real stock, you don't have to worry about employees voting down key decisions, such as selling the company or changing leadership roles.
- Invested employees . Even without voting rights, employees will still be invested in the company because typically, when the company succeeds, stock prices (and therefore the value of phantom shares) will rise.
- Less expensive. Setting up a phantom stock bonus plan is much less expensive than setting up an ESOP, and when you're running a business, anything that saves you money is a good thing.
- More flexibility. Phantom stock plans can be used in privately held companies and public ones, in small and large companies, in LLCs and C Corporations , and even in non-profit organizations to some extent.
- No taxes are owed till the stocks mature. When company stocks are given to an employees, even if they have to hold onto them for a specific term, it's considered taxable income. Phantom stock doesn't have this issue and is not considered income until the bonus is paid out.
As long as phantom shares are created according to the applicable laws, including ERISA and IRS Code 409A, they bring a lot of advantages with them.
Frequently Asked Questions About Phantom Stocks
- What are the differences between phantom stocks and an ESOP? An ESOP is a qualified retirement program, similar to a pension plan. Though stocks are involved, the employee doesn't usually gain ownership of the shares. Instead, a specific number of shares are awarded to each employee, when that employee is ready to retire, the shares are cashed out. The value of those shares increases and decreases as company stock increases and decreases, because they are actual shares. All employees in a company are eligible for this plan, similar to a 401(k). Having an ESOP in place is like having a second set of owners that need to approve key decisions, which is not the case with phantom shares. Phantom stock is only given to a small percentage of employees. Most commonly, this group is the core leadership team. Here, the employee never actually owns shares, because the shares don’t actually exist. There is also more flexibility regarding how and when phantom stock can be cashed out. Until that point, phantom stock is not actually equity.
- SARs are for the amount of money equal to the increase in value of a specific number of shares over time.
- They may or may not have a specific date when they pay out.
- If they don't, employees can choose when they want to cash out once the shares vest.
- SARs don't offer dividend-equivalent payments.
- They are often granted along with stock options in order to help finance the purchase of options or to pay tax if any is due.
There's a lot of flexibility when it comes to SARs, which means that there are also a lot of decisions to make with things like vesting rules, eligibility, and who gets how much. The main difference between SARs and phantom shares is that phantom shares have the possibility of offering dividend-equivalent payments. Additionally, phantom shares can be dependent on performance criteria.
- Does your company expect growth? The only way that this program will work is if growth is expected in the coming years.
- If there is projected growth on the horizon, will it work to share 5 to 15 percent of that growth with employees?
- Will the amount of money that you are able to share be enough that it is meaningful to your employees?
- Are there key employees who are essential to the successful growth of your company?
Once you've considered the answer to these questions, you should have a better idea of whether a phantom stock program would benefit your company.
- What happens to phantom stock if the company is sold? If a business is sold, employees that own phantom stock receive money that is equal to the amount they would have received had they owned actual stock in the company. For that reason, it's financially beneficial to employees to own phantom stock, as they don't need to worry about dilution.
- Do phantom stocks take dividends into account? It depends on how the phantom stock plan is set up, but they definitely can include dividend payments to phantom shareholders, which is a great benefit to owners of said phantom stock.
If you need help with creating a phantom stock program or just have questions about how phantom shares work, post your question or concern on UpCounsel's marketplace. The lawyers at UpCounsel come from law schools that include Yale Law and Harvard Law and have an average of 14 years of legal experience. These lawyers are the top 5 percent of lawyers, and have worked with or on behalf of companies such as Menlo Ventures, Google, and Airbnb.
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Phantom stock, explained
In today's competitive job market, startups are constantly looking for ways to attract and retain top talent. One way to do this is by offering equity compensation, which can give employees a stake in the company's success. In some cases, traditional equity compensation plans, such as stock options or restricted stock, aren't possible (in particular when trying to issue to non-employees in certain countries, like India), may clash with company strategy, or too complex, especially if you want to issue equity across borders .
Enter phantom stock, a type of equity-based compensation plan that can be offered to employees, senior management, and service providers, instead of actual equity.
Phantom stock plans are a relatively new concept but they are quickly gaining popularity as a cost-effective and flexible alternative to traditional equity compensation.
In this guide, we will deep dive into the world of phantom equity, how they work, its advantages and disadvantages. We will also provide answers to some frequently asked questions about phantom stock plans and some best practices for startups who are considering using them.
Understanding phantom stock
What is phantom stock.
Phantom stocks are also referred to as phantom shares , phantom stock options , phantom equity , ghost shares , virtual shares , or shadow stock . Don't be confused when they're used interchangeably! There isn't a universal definition that applies to all cases. In general, as the terms suggest, the concept of phantom stock is simply a ghost or virtual stock that may appreciate (or depreciate) over time.
The concept is fairly straightforward: A phantom stock plan is a contractual agreement between the company and the employee or service provider, where the company promises to reward the phantom stockholder with the equivalent cash value of the company's actual stock at a future date.
Unlike traditional options or stock grants, phantom stock does not equate to actual ownership of company stock. Instead, they offer employees a hypothetical stake in the company's value, which is tied to the company stock's performance.
How does a phantom stock plan work
A phantom stock plan is less complex than traditional stocks precisely because it does not involve actual stock ownership. Instead, they create outcomes similar to stock option plans by incorporating a deferred cash bonus program. The agreement provides the employee with virtual shares which hold the right to a cash payment at a future event designated by the employer.
Let's break this down:
- The company creates a pool of phantom stock that is tied to the value of the company's real shares.
- The company then sets a vesting schedule, which is the time period during which the employees must remain with the company in order to receive the bonus. The company can also set a trigger event, like a milestone or a liquidity event.
- When the vesting schedule is satisfied (including any trigger events being met), the company will pay the employees a cash bonus equal to the value of the phantom shares, based on the performance of the company's stock price.
- If the company's stock price goes up during the vesting period, the value of the phantom shares also goes up, resulting in a larger cash bonus for the employees. If the stock price goes down, the value of the phantom shares decreases, resulting in a smaller bonus.
Phantom stock example
For example, if a company grants an employee 100 phantom stocks with a value of $10 per share, then the employee's total bonus would be $1,000 (100 shares x $10 per share). If the company's actual share price increases to $15 per share when the phantom shares are settled, then the employee would receive a payout of $1,500 (100 shares x $15 per share).
Now, this example changes depending on the types of phantom stock being used.
Two types of phantom stock plans
There are two types of phantom stock:
Simply put, employees receive payouts based only on the increase in the value of the company stock. Or if the stock price goes down, employees do not receive anything.
Employees receive a cash bonus based on the full value of the company stock, including any appreciation in value. This type of phantom stock plan is less common than appreciation-only phantom stock.
It’s also worth noting here, that under this type of phantom plan, the employee will end up receiving money even if the company's share price goes down.
Appreciation only vs. full value, example
Assume an employee receives 200 phantom stocks with a starting price of $15. At a predetermined future date, the company will calculate the value of the company stock and pay the employee any positive difference.
Let's say the share price grows to $18.
In an "Appreciate Only" plan, the company will pay the employee the difference between the starting price and the new price ($18-$15) which is $3 (the 'Spread'). With 200 phantom stocks, the employee receives 200 x $3 = $600.
In a "Full Value" plan, the employee receives the value of the underlying shares as well as any appreciation that has occurred. Thus, referring to the above example, the employee would receive 200 (phantom stock) x $18 (appreciated value) = $3,600.
In contrast, let's say the share price goes down to $10.
In an "Appreciate Only" plan, the employee will not receive any compensation.
In a "Full Value" plan, however, the employee still receives the full value of the underlying shares. So, the employee would receive 200 (phantom stock) x $10 (depreciated value) = $2,000.
Still here? Let's keep going!
Who qualifies for phantom stock plans
Generally speaking, employees are the main recipients of phantom stocks. However, phantom stock can be issued to anyone that your company has a direct relationship with, such as directors and other third-party recipients (including contractors, service providers, or consultants).
As a phantom stock plan is simply a deferred cash incentive plan, it typically requires liquidity and your company to have accessible cash when the trigger event occurs. Due to this requirement, phantom stock is often considered for senior, top-performing, or key employees.
It is important to consider the cash-heavy venture of a phantom stock program and what works best for your company.
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Drawbacks of phantom stocks.
There are potential drawbacks to consider when implementing a phantom stock plan.
- Lack of ownership. Phantom equity does not give employees actual company stock ownership, which can be a disadvantage for some employees. Employees who are looking to invest in the company may prefer traditional equity compensation plans, such as actual stock through an ESPP, stock options, or RSUs, where they have actual ownership and decision-making influence (e.g. gain voting rights when the stocks vest).
- Lack of liquidity. Unlike actual shares, phantom shares cannot be sold or transferred, so employees have to wait until there's sufficient liquidity at a future payment date or event to receive their reward.
- Uncertainty. Since phantom shares are based on the performance of the company, employees may be unsure of the actual value of their shares until the actual payment date.
- Taxes may be higher for employees. Much like a bonus, the cash received from phantom stock is taxed as ordinary income. These rates are generally higher than the long-term capital gains rates that employees typically qualify for under other traditional equity schemes.
Benefits of phantom stocks
In spite of its drawbacks, phantom stock plans are still widely popular in the startup world as both an alternative and supplement to, traditional equity compensation. Some key benefits include:
- Increased productivity. Because the value of phantom stocks is directly tied to performance, employees are motivated to contribute to the company's growth, be more efficient, and work harder.
- Low barriers to participation. Unlike stock options which involve the actual buying/selling of stock, employees don't have to fork out any cash to participate in these schemes.
- Cap table bloat (non-dilutive). As a founder, you're probably concerned about the effects of dilution on the cap table and other shareholders/investors. Phantom shares are a great way to give employees exposure to the increases in your company's share price, without granting them equity that dilutes the value of your shares.
- Cost-effective. Due to their low cost of implementation, employers can use Phantom Plans to hire, attract, and retain top talent while managing capital outflows, and focusing on developing their product.
- Flexibility. Companies have a lot of flexibility when it comes to designing phantom stock plans. They can choose to offer appreciation-only or full-value phantom stock and can set time-based or performance-based vesting conditions as they see fit.
- Tax benefits. Phantom stock can offer tax benefits for both the company and the employee. If structured properly, phantom stock payouts may be tax deductible for the company, while employees can defer taxes until they actually receive payment.
As always, it is best to seek advice from experts when you're thinking about implementing a phantom stock plan and whether or not this fits your growth requirements and strategy.
How are phantom stocks taxed
The beauty of a phantom stock plan is that they are not taxed on grant or vesting! Simply put, the payment is taxed as ordinary income (W-2) and is deductible to the employer at the time of payment.
Since phantom stock is a form of deferred compensation, for the taxable event to be deferred until payment, your plan will need to be compliant with Section 409A . In order to be exempt from Section 409A, we see most phantom plans structured so that payments are made no later than March 15th of the year following the year of vesting; allowing the phantom plan to be exempt from Section 409A under the short-term deferral exception.
Establishing this form of equity is often quite straightforward given the employees are not offered actual shares in the company. Most payment triggers for these plans are usually tied to a specific liquidity event (think asset or share sale, or a big funding round/capital raise).
These events can be few and far between, so it's important to structure your phantom stock plan in a way that ties it to company performance, and when your company will have sufficient liquidity to make the cash payments.
Start your phantom stock plan in 3 steps
Step 1: Develop a phantom stock plan
The Plan Rules will outline the terms and conditions of the plan, including eligibility, vesting schedules, payout calculations, and termination provisions.
Step 2: Obtain a 409A
When issuing phantom shares to US-based stakeholders, you will need to conduct a 409A valuation to determine the fair market value of the phantom stock.
Step 3: Issue the phantom stock awards
Note here, before issuing phantom shares to non-US recipients, be aware of variations in terminology and legal hurdles. Some phantom stock equivalents include:
- Australia: Virtual Stock Option Plans
- UK: Phantom Share Scheme
- Canada: Restricted Stock Unit Plans, Deferred Stock Unit Plans
Interested to set up a phantom stock plan and integrate phantom shares into your equity program? Reach out to our team of equity experts and let us help you get started for free .
Whether you're looking to attract or retain key employees, use alternative employee compensation to increase cash flow, or simply want an easy-to-use employee benefits program, shadow stock can help!
Giving your teams a stake in the company's future will reward employees with a cash payout that could mean the world to someone. While they do have some potential drawbacks, phantom stocks offer many benefits, including flexibility, cost savings, and most of all, more company owners! (which we love to see at Cake).
As always, be sure to consult with a qualified professional to determine whether they are the right fit for your company's needs. With the right strategy in place, phantom stocks can be a valuable addition to your company's employee benefit plan.
Faqs on phantom stocks, are phantom stocks the same as stock options or rsus.
No, phantom stocks are a different type of equity compensation that does not require the company to issue actual shares of stock.
What's the difference between phantom stock and stock appreciation rights?
Stock appreciation rights (SARs), like phantom stock, offer the advantage of potential stock appreciation to employees without granting them actual stock ownership. However, SARs are more akin to stock options, allowing employees to exercise them at their discretion within the specified timeframe of vesting and expiration.
Can phantom stocks be used for startups?
Yes! phantom stocks can be a great fit for startups and other fast-growing companies that are looking for a flexible and cost-effective way to offer equity compensation to their employees.
How are the payouts for phantom stocks calculated?
The cash payment for fully vested and exercisable phantom stock units are typically calculated by multiplying the number of phantom stock units the employee has by the increase in value of the company shares.
This article is designed and intended to provide general information in summary form on general topics. The material may not apply to all jurisdictions. The contents do not constitute legal, financial or tax advice. The contents is not intended to be a substitute for such advice and should not be relied upon as such. If you would like to chat with a lawyer, please get in touch and we can introduce you to one of our very friendly legal partners.
Alex Kazovsky is a seasoned leader with a track record of driving business growth and operational excellence. Currently, Alex serves as Global Equity Lead here at Cake Equity. In this role, Alex is responsible for the overall equity management strategy, including equity compensation plans, local compliance, and long-term incentive structures. Alex brings a data-driven and analytical approach to equity management, aimed at maximizing the impact and effectiveness of global equity.
Prior to his current role, Alex held various leadership positions in finance, strategy, and operations. Alex holds a Diploma of Legal Practice from The College of Law Australia.
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Phantom Stock Option Plan
A Phantom Stock Option Plan, also known as a Stock Appreciation Rights (SAR) plan, is a deferred cash bonus program that creates a similar result as a stock option plan . The sponsoring company determines a phantom stock price through an internal or external valuation of the company. Employees are awarded some number of phantom options that carry specific terms and conditions. Should the company phantom stock appreciate over time, employees will receive a cash payment equaling the difference between the original price and the appreciated price. For example, assume an employee receives 100 phantom stock options (PSOs) with a starting price of $10. At a pre-determined future date the company will calculate the value of the phantom stock price and pay the employee any positive difference. Assume, for this example, the share price grows to $18. The company will pay the employee $800. Phantom stock plans do not result in shareholder dilution because actual shares are not being transferred. Employees do not become owners. Instead, they are potential cash beneficiaries in the appreciation of the underlying company value. Phantom options result in ordinary income taxation to the employees when they turn into an actual cash payment.
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The A to Z Explanation About Phantom Stocks
Phantom stock. Unusual name isn’t it? A phantom stock, also known as “ shadow stock ” or “ ghost shares ”, gives employees the opportunity to share in the wealth and success of the company. Companies do this by providing employees with a stake in the company's stock as well as a retirement plan to ensure they have enough money later on in life.
Back in the day, public companies used phantom shares primarily to generate cash for executives who held stock options. Nowadays, it has become more popular in private companies as a substitute for actual stock grants or awards.
A software engineering firm with $28 million revenue and 85 employees carried out a case study . They wanted to implement phantom stock options as a solution to reduce turnover, increase revenue, and attract stronger talent.
At the end of the year, the company achieved 50% growth and the employee turnover problem was erased. The company also became stronger in its competition for talent.
While phantom stocks may sound good right now, there are many things you should know before you give phantom shares to your employees, including how they work and the tax implications.
In this article, I will help you understand what phantom shares are, why they're different from other types of equity, and how to set them up.
Let's get started!
What Is Phantom Stock?
The idea of phantom stock plans is to mimic the value of a share to an employee without actually handing over the shares. Phantom stock plans, also known as equity compensation plans, equity pay plans, stock bonus plans, or phantom equity plans, are a form of employee stock option plan (ESOP) .
It is an employee benefit that gives employees the opportunity to purchase company shares at a predetermined price, known as the “equity value.” Companies use phantom stock options as a part of their total reward strategy .
In most cases, phantom stock programs are a combination of employee stock options and a compensation program. That makes it an incredibly effective employee retention strategy .
In many US-based companies, phantom shares are granted as a long-term compensation incentive program to reward long-term service or as a retirement recognition.
Further Reading: The Perfect Retirement Gift Ideas For 2022
Types Of Phantom Stock
Phantom stocks are mainly categorized into two types.
Here is a phantom stock example. Let's say Albert was granted 100 phantom shares in January 2020.
At that time, the price per share was $50. Let's take the vesting period to be five years. After five years, the share price has appreciated from $50 to $60.
In the " appreciation only method ", in January 2025, Albert will receive the appreciated amount per share. That is, ($60-$50) X 100 shares = $1000.
In the " full value phantom stock ," after the vesting period of 5 years, Albert will receive the full value of the shares. That is $60 X 100 shares = $6000.
How Does A Phantom Stock Work?
As per the phantom stock agreement, an employer grants selected employees units or "phantom" shares.
The agreed-upon plan grants the employees some shares in the company or phantom units. The program should also detail the starting value, along with other conditions, such as the vesting schedule, payment dates, dividend availability, and other specifics.
The employees will receive a payment in exchange for their shares of stock according to their type of phantom stock program.
The amount is calculated based on:
- The number of vested shares they hold.
- The value of the shares at the time of payment.
- Whether or not they own stock in full or just the appreciation in value since it was received.
The phantom dividends are often redeemed in cash payment, much like a employee bonus . However, should the plan agreement allow it, the payment obligation may be satisfied by distributing actual stock to the employees.
Pros And Cons Of Phantom Stock
Now, as we have a fair idea, let’s look at the advantages and disadvantages of phantom stock programs.
What To Consider When Designing A Phantom Stock Plan?
Here are the top 5 things to consider while designing a phantom stock program:
1. Decide On Your Goals And Offerings
You should consider certain factors before offering phantom equity to employees. Plan out the objectives, identify the eligible employees, and decide on the percentage of equity.
Since phantom stocks are a deferred employee compensation plan , employers can modify the plan as and when required.
Eventually, a phantom stock program should reflect the company culture you are trying to establish.
2. Establish A Proper Phantom Stock Valuation
When you're trying to value your company, you can either get a formal appraisal or set the value yourself. Most companies use a formula or use one of their key metrics ( EBITDA , for instance) to determine the value of their business.
Just make sure you don't set it too high, or your shares could be worth more than the company is worth.
3. Set Up Your Shares
Many people think phantom shares should be equal to the number of company shares. However, this is not the case.
Phantom equity is an employee incentive program tied to the valuation and long-term goals you want to accomplish. It is meant to incentivize employees by linking their performance to a successful company. Still, it is not meant to be a substitute for company shares.
You only need enough phantom shares to incentivize your employees and meet your short-term goals.
4. Decide How To Allocate The Stock
Phantom shares come in two forms, as mentioned earlier in the blog. "Appreciation only" and "Full Value."
You can now decide which type of phantom plan will meet your needs and organizational goals.
Besides the two ways, you can also grant employees to defer their income to phantom shares. In this method, the employee will invest a percentage of their annual income to the phantom stock options.
5. Plan A Payout Schedule
Most companies schedule their phantom stock payouts annually.
If you want to reward a longtime employee who is integral to your plans, an upfront one-time grant might be the way to go.
Some people worry that this might not be as good as annual rewards over a predetermined period of years. However, by giving them an equal lump sum now, you can show your appreciation for what they've done for your company.
6. Draft The Phantom Stock Agreement
Your employees need to be protected when it comes to their rights. Phantom share agreements must be designed in a way that ensures the correct tax treatment and the desired deferred compensation for employees.
If you are drafting phantom stock agreements, consider them an additional asset within your offerings intended to retain key employees .
Some Frequently Asked Questions About Phantom Stocks
1. what determines the value of phantom stock units.
Phantom stock units are set equal to the unit value of the real shares. The company uses the same formula to calculate the actual stock price as well as the phantom stock.
2. How is phantom equity taxed?
Phantom shares don't usually pay dividends. Initially, the grant had no tax implications. However, the payout is tax-deductible by the employer as regular income.
3. Can phantom shares be diluted?
Phantom equity does not dilute shareholders as actual shares are not being transferred. An employee does not become the owner of the business. They are potentially the cash beneficiaries of the company's value.
4. How do you avoid section 409A with a phantom stock plan?
Phantom stock awards are typically structured to avoid 409A limitations by making the award payable on the date of vesting.
This is to follow the short-term deferral rule, which states that the payment will be made within two and a half months after the end of the tax year in which the vesting date occurred.
5. Are phantom stock plans subject to Erisa?
Qualified plans under the 401(k) plan are subject to all rules and regulations of ERISA . A phantom stock plan is not subject to ERISA rules on participation, vesting, funding, and fiduciary responsibilities.
6. Can an S-Corp have phantom stock?
It is possible to have a phantom stock plan without terminating the S-corp status. But you must carefully structure the phantom stock plan to avoid complications:
- Make sure the liquidation rights are limited.
- Requests for immediate stock ownership should not be accepted.
- Capital contributions by employees should not be accepted.
7. Can an LLC issue phantom equity?
Limited liability companies (LLC) can issue phantom stock as "phantom unit rights." Phantom Unit Rights encompasses both the past and future value of an LLC unit.
8. Phantom stocks Vs. ESPP?
A phantom stock plan is an alternative to employee stock purchase plans (ESPP). The primary difference between the two lies in the time at which you can make a return on your investment.
With an ESPP, the stock price will increase over time, but you cannot sell shares until the end of the offering period. With a phantom stock plan, you can choose to receive your payment upon vesting or to have the payout occur at the end of the life of the program.
9. Phantom stocks Vs. ESOP?
ESOP stands for Employee Stock Option Plan . Phantom stock or phantom equity is a type of ESOP. While some ESOPs might grant the employees actual stocks, phantom stock grants benefits that mimic the actual stock.
10. Phantom stocks Vs. RSU?
Phantom stock is settled as a cash bonus, while RSUs are settled in actual shares. RSUs also have the option of giving the employees voting rights, dividends, and other benefits even before the vesting period.
11. Phantom stocks Vs. SARs?
Stock appreciation rights (SAR) are similar to phantom stocks, except they provide the right to receive the monetary equivalent of increases in value over time. This is applied to a specified amount of shares. With phantom stock, the stock value is normally paid out in cash.
12. Phantom stock Vs. Profit-sharing?
Profit-sharing plans are the type of plans where a portion of the profit made by the company is distributed to the employees. It does not involve the distribution of company shares or share price. Phantom stocks are deferred employee compensation where the employees are granted the equivalent to the company share price.
13. Phantom stock Vs. Equity?
Equity comprises real stocks, subject to capital gains as per the fluctuation of the share price. Phantom stocks are also called shadow stocks is a simulating stock, subject to capital gains only after the vesting period.
14. How does an employer benefit from phantom stock?
Phantom equity program is a strategy that companies use to motivate employees and increase productivity by giving them a stake in the company. It also helps the company earn more profits by driving the company stocks higher.
When in doubt, phantom stock options are the most secure form of ESOPs. Risk is minimal, and the terms and conditions are flexible as per the employer at any time. If the value of your share price does not go up after the vesting period, there will be no payout. Further, you can use this option to mark special occasions like the Employee Appreciation Day , where you can delight your employees with phantom stocks to show your gratitude.
Thadoi Thangjam is a digital marketing executive at Vantage Circle . When she’s not geeking out over content strategies, she is probably hunting for the next perfect track to add to her playlist. For any related queries, contact [email protected]
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The ideal plan for growing private companies.
“I have a key employee who’s asking for some stock in the company or else he may move on—should I give it to him?” This is a question with which many owners of closely held businesses wrestle. It is multi-layered in its implications; however, the answer is really pretty simple: “No. But you should be glad he’s asking for it! This is a great opportunity.”
The question the key employee poses reveals both good news and bad news to an owner. The good news? One of the talented producers in the company recognizes that the business has a compelling and profitable future. He believes in the future so much that he wants a piece of it. And he’s confident enough to believe he deserves it. This is why the question represents such a great opportunity. The bad news? Sharing equity in a private company is a pain. And it’s often one of the most inefficient ways to share value—from both the owner’s and employee’s perspective.
The scenario is understandable. Top performers expect to be paid well; and if they help create economic value, they deserve some of what they’ve created.
Instinctively, owners assume that employees with equity will be better employees. If employees have stock perhaps they will think and behave like owners. Maybe they will have greater incentive to manage expenses, service customers, innovate, work hard and even invest their own money in the business.
These are correct instincts and reactions. It’s obviously desirable to engender an ownership stake, or at least an ownership mentality, among employees. However, the means to achieving those attractive outcomes shouldn’t create more problems than it solves, and too often that’s what happens when closely held business owners go down the path of equity sharing.
Why Not Stock or Options?
Granting stock or even stock options will not usually address all of the issues a business owner needs to consider when creating a value sharing arrangement for key contributors. Here’s why.
Let’s take a look at three different ways to get stock into the hands of Sally, the leader of your national sales team, and the potential consequences of each approach.
- You can simply give Sally some stock. More formally, this is called a Restricted Stock Grant (or one of its variations). Congratulations, you have a new partner-shareholder. She’ll be entitled to take a look at the books. She may want to discuss the new compensation program—hers and yours! She’ll be entitled to her share of profit distributions. And so on. You get the idea. Of course, you’ll control the majority of the shares and the final decisions. But the nuisance factor may become intense. If you’re lucky, Sally won’t be interested in those details. She’ll trust you and be truly grateful for the award—so she won’t want to cause problems. That’s good. But we have to consider the tax consequences. Your award of stock to Sally results in an immediate tax cost for her. Let’s say your accountant tells you your stock is worth $10 per share. If you give her 5,000 shares that’s $50,000 of value. Sally will need to pay taxes on that value. As far as the IRS is concerned, it’s as if you gave her $50,000 of cash. Now, assuming you placed restrictions (like a vesting schedule) on the shares (which you should do), she could defer the income taxes until she vests. In that case, however, if your share price goes up (which you’re both hoping for) she’ll wind up paying taxes on the higher amount. Sally will love the idea of getting stock, but she may not love the idea of coming up with the money to pay the taxes. There are more potential problems ahead. What if things don’t work out with Sally? If you let her go (or if she chooses to move on) what will become of her shares? Will you buy them back? Or will she just retain them? You’ll really like the latter solution when you discover that Sally went to work for a competitor. By the way, if you do buy them back how will the value be determined? And don’t expect a tax deduction for the redemption. You’ll buy them back with after-tax dollars. There’s more, but the point’s made. Making employees shareholders opens up a Pandora’s Box of potential headaches.
- Sally could buy Now she’s putting her own money into the deal. Investing her own capital will tie Sally more closely to the success of the company. Hopefully so. It’s not the worst of ideas. But, you still have many of the same problems described above. The open books. The discussion about your compensation. The little chat about the size of dividends. Redemption issues. Buy-and-sell agreements. Termination-of-employment loose ends. And does Sally even have the cash to buy in? If she was going to be concerned about the taxes on a grant, how is she going to come up with the full amount needed to purchase the shares? Maybe you’ll consider lending her the money. Think about that one. You’ll loan her the money that she can give back to you (to buy the stock) so that you can have all the headaches described above? Some employers envision allowing her to use her share of company dividends to repay the loan. How is this any different than giving her stock in the first place—you’re paying yourself back for helping her buy some of your stock by reducing the dividends you would otherwise have been entitled to? That’s quite a partnership!
- Public companies use stock options . Why shouldn’t you? This would enable Sally to acquire some stock at a fair price and get capital gain taxation if you sell the company some day. Maybe. Maybe not. First of all we still have a cash-flow concern. Sally will need to come up with enough cash to exercise her option after the vesting period has passed. Let’s say the stock is worth $10 today (same as above) and you give her 5,000 options to buy the stock at that price. Her three-year vesting period passes and Sally scrapes together the $50,000 to exercise her options. Let’s assume the company share price has grown to $18 in the meantime. She now has $40,000 of new equity value (($18-$10) X 5,000). There are two different types of options—nonqualified and qualified (or incentive). There’s not enough space here to cover the differences in taxes except to say that incentive options, generally, produce a better tax result for Sally and a worse tax result for you. Meanwhile, Sally may now be in a position for capital gain taxation under a future transaction (i.e., sale of the company or IPO) assuming the event occurs at least a year from the date of the exercise of the options. However, what if neither event ever occurs? You’re back to our original problems of redemptions, dividends, etc. Typically, closely-held businesses seldom produce the “future transaction” that the employee was relying upon. As a result the majority owner and the owner-employee face the grind of negotiating a “fair” price for the stock at the time of a future separation of service. How well do you think you’ll enjoy that future conversation with Sally’s attorney?
The bottom line: the financial results of stock or stock option awards can appear to justify the effort—under the perfect circumstances. But reality is never as simple as you expect it to be. The majority of private company owners will regret the move to stock awards for employees. The perceived value of employee ownership is, nine times out of ten, not nearly worth the price. 
 The author acknowledges the primary exception to the rule: if your company is on a clear path to an IPO, stock options offer an excellent and efficient way to reward employees.
The Better Approach
Each of the ideas for Sally outlined above has merit. Granting stock is relatively simple and clear-cut. It provides instant recognition and value. It’s great, particularly, for someone who’s been with you for awhile and has made a contribution to your past success. But, the concept carries the baggage described above.
Having Sally buy stock also is intriguing. It deepens her commitment and aligns her with both short-term and long-term goals of the company. But again, there’s baggage.
Stock options are attractive because they’re win-win. Sally only wins if shareholders see their stock value go up. Sally is tied to future growth of the company. But, again, the baggage issue looms large.
What if we could replicate any or all of these approaches without making Sally an actual owner? Is it possible to generate the ownership value and mentality without the baggage? In a word, yes. We can do it with phantom stock.
Phantom Stock Defined
A phantom stock plan is a contractual agreement wherein a company promises to make cash payments to employees upon the achievement of certain conditions. What’s the purpose? Just as with stock awards, the purpose of a phantom stock plan is to generate an ownership mentality and reward key employees for helping to grow the business value.
However, phantom stock has one big advantage—there is no sharing of actual equity with the employees. No requirement to open the books. No ownership rights. No need to pay dividends (although some plans do). The existing owners stay in control of 100% of the stock or interest in the company.
At the same time, phantom stock can create comparable or even identical value as actual stock. Here are the key things that happen when you create a plan on behalf of employees.
- First, you must establish a way to value the phantom shares. In essence, you’re trying to identify the value of the company. You can obtain a formal appraisal or you can establish the value by a formula. The latter will work best in most situations. Perhaps the formula will reflect a multiple of EBITDA or Net Income. Any reasonable formula can work. To be safe, use a formula that is going to be less than the actual fair market value you might sell the company for some day. You don’t want the employees’ phantom shares to be valued higher than your own.
- Full value grant . We could give Sally some shares that are valued, in full, at $10 per unit. We’re going to specify some conditions and restrictions (see #4 below). Nonetheless, we’re committing the full $10 in value times the number of shares we decide to give her. If we give her 5,000 shares she’ll start with a true value of $50,000 (subject to vesting and other restrictions). At some future date she’ll redeem those awards for real cash. Assuming EBITDA grows to $18,000,000 on her redemption date, Sally will receive a check for $90,000. What about Sally’s taxes? Well, remember that with actual stock awards Sally would pay taxes when she received the grant or when the vesting lapsed. With phantom awards, Sally pays no taxes until she actually receives her award value (e.g., the $90k). In this way, she never has to pay income taxes until she’s in receipt of the actual cash. It’s true that had she received actual stock (and paid the taxes up front) she might have saved some taxes in the long run. However, with phantom stock your tax deduction (i.e., the company’s) is higher than it would have been with actual stock. In the first case (actual stock), your deduction was for $50,000, thus a tax benefit of $20,000 (assuming 40% bracket). With the phantom stock example, you get to deduct the full $90,000, resulting in a tax benefit of $36,000. If you’re feeling guilty about Sally’s taxes go ahead and give her more shares, enough to result in your “after-tax cost” being the same.
- Sell phantom shares . This is commonly referred to as a Deferred Stock Unit plan—a form of deferred compensation. Here’s how it would work. Sally would be given the opportunity to defer some of her cash compensation (e.g., salary or bonus) into units of phantom stock. Said differently, Sally would “convert” some of her future pay to phantom stock. An example: Assume Sally makes $200,000 in annual salary. She might defer up to 25% (let’s say) of her salary into the plan. Assuming she does so she would acquire a deferred compensation interest that would have $50,000 worth of starting value. In other words, she would have 5,000 units of phantom stock (at $10/share) credited to her deferred comp account. Technically, you’re not selling shares to her. She’s not acquiring an ownership right in exchange for writing you a check. She’s deferring some of her income into an unsecured account that is measured by the growth of the phantom share price. But it has the same essential effect as selling Sally phantom shares. She is voluntarily foregoing wages in order to ‘invest’ in the company ! That’s a pretty serious commitment. Plus, it’s much better for Sally tax-wise than buying actual stock. Why? Because she gets to do it with pre-tax dollars . Tax-wise for you it’s not perfect, but it’s not so bad. You (or the company) will forego the current tax deduction on the income Sally chooses to defer. However, it’s a delayed deduction, not a lost deduction. Instead, of getting the deduction today of $50,000 (wages) you’ll get the future deduction on $90,000 (assuming our EBITDA growth example given above).
- Phantom Stock Options . This one is a favorite of many private business owners. Stock options (real ones) are attractive because they’re “win-win.” Employees only win if the other shareholders win (by seeing their stock price go up by a value that exceeds the amount by which they were diluted). In a public company environment there are markets that help to handle the exercise of the option. However, in a private company no such market exists. Instead, the employee and the company sponsor have to work out the cash flow mechanics of the exercise. And there’s no “cashless exercise” arrangement that permits the employee to get a reduced number of shares by surrendering a portion of his options to cover the strike price. So let’s use phantom options. Easy. Recall that phantom stock is a cash compensation arrangement. Assume we give Sally 5,000 phantom options with a starting value of $10. What will she really have at that point? Nothing—because the options must go up in value before she realizes any gain. But later, when the phantom share price reaches $18 and it’s time for redemption, Sally is simply handed a check for $40,000 (($18-$10) X 5000). No muss, no fuss. Sally doesn’t need to scrape together the $50,000 to exercise the options. She simply receives a nice payment that reflects a reward for her contribution to growth in company EBITDA. Sally has tight alignment with the shareholders without the pain and complication of dealing with a stock transaction. (And you have a happy employee without the headaches of another shareholder.) By the way, what’s described here as a phantom stock option is also known as a Stock Appreciation Rights. However, some find the term phantom stock option more appealing and descriptive.
- So you’ve selected a plan type for Sally—full value grants, deferred stock units, or phantom stock options. Or maybe you’ve done a combination of two or more—which may be the right thing for your company. What’s next? Now you need to fine tune the plan provisions. Select a vesting schedule for full value and option awards. Determine the year in which they’ll be paid out. (It doesn’t necessarily have to coincide with the vesting period.) And over what period of time do you want to pay them out? In a lump sum? Or over 3 or 4 or 5 years? Then there are possible scenarios to define and refine: change-in-control, separation of service, disability of a participant, death, termination (for cause or not for cause), and so forth. The plan will need to be pulled together into a document that outlines what will occur under each of these circumstances. You’re going to want some help with these issues. Seek advice from someone who’s had experience dealing with these plans. He or she can help you see the pros and cons of these important decisions.
- The last thing to do (other than actually enrolling Sally in the plan) is to determine how many shares you’re going to give her. (We’re assuming, at this point, you’re doing full value shares or phantom options.) We mentioned earlier that the number of shares you establish in the plan wasn’t crucial…at least then. Now it becomes important. You don’t want to award too few, or too many. So how do you decide? It’s best not to get hung up on the number of shares you award. Focus instead on the potential future value of the shares as a percentage of the growth in the company. This will usually require some spreadsheet modeling. First, project the possible future value of the company over some period of time, given your favorite growth assumptions. Now carve out a percentage (start with 15%) of the growth (not the total value) that you’d consider sharing with your leaders. Then, allocate that to the positions or people you’d consider for participation. Now, calculate the number of grants that will produce the targeted values. In other words, the number of grants is simply a device for generating the dollar value you feel is appropriate for the people who are helping you build the company. This approach to grants achieves the following results:
- Guidelines for grants are established within a pre-approved budget, thus simplifying the annual award process;
- Shareholders are assured that value dilution is being managed within reasonable limits;
- Employees can receive a forecast of value that demonstrates potential personal earnings tied to company growth.
As with any rewards strategy, there are plans that work well and others that fail. To ensure your approach to Phantom Stock has a greater chance of success, here are some “do’s and don’ts” to consider.
- Don’t do one-time grants. Schedule and award grants annually. Make each grant a celebration. One-time grants always lead to regrets (e.g., “I shouldn’t have given him so many.”)
- If you’re not sure which type to use, go with phantom options. There’s less risk. No increase in value results in no payments to employees. Even if your share price goes down in some years employees can still come out ok (as long as you’re doing annual grants—see #1).
- That said, consider some full value grants for the key long-term employees who’ve been with you “through thick-and-thin.” This will give them some starting credit for prior contributions. Perhaps you’ll just do this in the first plan year, and then include them in your annual option awards. (This could be done for as few as one employee.)
- Start with a small group and expand participation as time goes by. It’s always easier to add participants than to subtract.
- Schedule payouts every five to six years. (Sooner is ok, but longer is not.) Unlike regular stock options and restricted stock, employees cannot (with some exceptions) choose when they’ll “exercise” or “redeem” their shares. You, the plan sponsor, decide. The temptation will be to push the payment date out too long. This has two negative results: (a) the value may compound for a long time resulting in very large payouts, and (b) employees will have no way to access their money unless they quit—not the ideal scenario.
- Don’t make your formula (for share price calculation) too complicated. We’ve seen plans where the company officers don’t even understand the formula (or can’t remember why some things were included). Keep it simple. “Hey gang, if we grow profits we all make money!”
- Don’t ignore the rules. Most phantom stock plans will be subject to ERISA (the Fed’s 1974 rules on pensions) and Internal Revenue Code Section 409A. Sorry. There are rules. Fail to know and follow them at your own peril.
- Don’t try this at home. Get advice. It’s risky to decide upon the best choices for a phantom stock plan without the guidance of someone who’s done it before, a lot. You may intend to give away 10% of the growth of your company to your employees and you wind up giving away 30% via bad design and operation. This is important. Get help.
- That said, don’t use your attorney as your principal advisor. Your lawyer will be needed in the process—towards the end—to make sure the documents are in order. But, your attorney will not be experienced at the realities of plan operation. Find someone who’s lived with, slept with and eaten with phantom stock over the years. Let them put the structure on your important decisions. Then use your attorney to “cross the t’s and dot the i’s.”
- Manage the plan effectively. Don’t start the plan and forget about it. Keep it fresh. Be flexible. Communicate it. Give the employees statements that show their value. This is a big investment. Use it wisely.
This article has been an introduction to the processes you can follow to properly structure a phantom stock plan. Hopefully you’ve learned something of value. These plans can be, without a doubt, one of the most important steps you ever take in assembling the team of people who will take your company to new heights. However, there’s something more important that getting the right structure. You need to create the right mindset.
If you create a “perfect” plan but don’t establish the right mindset your plan will flop. You’ll wonder what went wrong with the plan. But it won’t be the plan’s fault. It will be yours. Ultimately, it’s your job to see that the employees not only understand the plan but that they are inspired by it.
Mindset relates to the perception of the plan in the minds of participants. When you make Sally a participant in this plan she should feel like she was just made a partner in the company. She should understand that her financial future is tied to yours (and vice versa). She should realize that you trust her to help produce the results that will create value for both of you.
Always position the plan in a positive light. Explore and discover ways to make your plan one of the highlights of your relationship with your key people. You’re investing in them. Make sure they know how much you value their efforts and how much you trust them to generate great results. Your phantom stock plan is a symbol of your commitment to a partnership relationship. They aren’t getting actual stock but they don’t really want those headaches anyway. They want to know that they have a chance to participate in the value they help create. A phantom stock plan, properly designed, can do just that because it sends the right message about the future:
We’re building a great company.
We’ve got the right people.
We’re united as partners in our financial success.
Let’s go make it happen.
Are You Ready for a Plan? If you lead a business and are struggling with developing an effective long-term compensation approach, it might be the right time to have a conversation with a VisionLink consultant. To speak with one of our experts about the rewards issues you are facing, call us at 1-888-703-0080.
About the Author Tom Miller President, The VisionLink Advisory Group Tom Miller is the founder and president of The VisionLink Advisory Group. He has been consulting with businesses for over 39 years on a range of compensation and executive benefit issues. Tom is a frequent speaker with business groups throughout the country and has authored numerous articles on topics related to compensation, benefits and related issues. He is VisionLink’s chief strategist and innovator. An inveterate entrepreneur, Tom has founded and operated two compensation consulting businesses as well as a benefits administration company and a registered investment advisory firm. His current company, The VisionLink Advisory Group (“VisionLink”), has served more than 500 companies across North America and Great Britain. VisionLink provides guidance and support on all forms of employee and executive compensation including salaries, short- and long-term incentives, and equity plans. In 2016, Tom established another company, BonusRight.com, a cutting-edge “software-as-a-service” incentive plan design platform. BonusRight is the first online tool supporting Tom’s mission to transform the way businesses share wealth with their employees. Tom’s passion lies in converting the visions of business owners into fuel for growth by linking employee compensation to the achievement of challenging goals. Tom can be reached at [email protected] or 949-265-5700.
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Phantom Stocks: All Pros and Cons Analyzed
Employees are the pillars of every company. And offering benefits to employees like company stocks is a great way to retain talent. Such compensation is mainly beneficial for startups that cannot offer competitive salaries to compensate for the employee’s experience and skill. This comes under the employee equity plans, which also include other schemes like ESOPs .
So if you want to retain some senior-level employees and stop them from eyeing other opportunities, it’s time to understand how you can steer away from the usual salary increment route and opt for phantom stocks.
Phantom stocks could be the bridge to establish a profitable arrangement both for your employee and your company.
What is a Phantom Stock Options Plan?
Phantom stocks are types of compensation that are primarily meant for senior-level employees. Under this plan, employees enjoy the benefits of stock ownership . However, these stocks are hypothetical.
Meaning, phantom stock options have the characteristics of regular stock. It’s worth money, and the price keeps fluctuating according to the market. But employees gain from the profits of the stock price change only after a fixed and agreed-upon tenure. These stocks, also known as ‘shadow stocks,’ do not give the employees voting rights or even a say in the decisions taken for and by the company. They only reap financial benefits.
Each phantom stock plan contains an agreement that outlines the plan’s vesting timeline. Each rule would be outlined in the agreement, including the goals or tasks that a participant must complete before the shares can vest.
It also describes these goals and what is delivered to participants once they have met their objectives.
What are the Different Types of Phantom Stock Options?
There are two types of Phantom stocks: Appreciation Only and Full Value.
1. Appreciation Only
Under this type of phantom stock, the employees only get compensated with the stock’s appreciated value. This means that at the time of cash settlement, they will receive the difference between the current value and the value of the stock when it was granted.
Also read: Experts Discuss: 5 Must-Knows on Incorporating in the United States
2. Full Value
As the name suggests, employees who are given full value phantom stocks get the entire value of the stock as compensation when the cash settlement is released.
It must be noted that both types of plans are similar to traditional non-qualified plans in many ways. Vesting schedules in phantom stock plans are usually dependent on tenure or the achievement of specific goals or tasks outlined in the plan charter.
This document also specifies whether participants will receive monetary equivalents in the form of dividends or voting rights.
So far, we’ve discussed the nature and types of phantom stock options. Now, let’s dive into the pros and cons of employee stock options.
What are the Pros of Using Phantom Stocks?
There are several benefits of using phantom stocks. They are:
1. Financial Gain at Zero Debt
By transferring the value of stocks of the company, employers save a lot on their employee wages. This means they get to retain quality talent without having to drain their financial resources.
At the same time, phantom stocks do not mess with existing shareholders’ control over the company.
Also, under the phantom stock scheme, employees receive the value of the stock as compensation and not the stock itself. Hence, there are no chances of equity dilution.
2. Increased Employee Productivity
Implementing phantom stock pros the company in terms of its human resource in two ways:
- The employees work with renewed enthusiasm which leads to an increase in overall productivity.
- Furthermore, with better compensation, the employees stop looking for other opportunities. This is a rather significant advantage of phantom stocks.
Every company needs experienced, senior-level employees in managerial and leadership-related positions. But financing these talents and retaining them is pretty expensive, and that’s where phantom stocks step in.
The best part here is that when you transfer real stocks to an employee, they also have the right to vote in your organization’s decisions.
However, since phantom stocks aren’t real, you get to increase their productivity and loyalty without giving them the right to vote.
3. Easy Exit Mechanism
Phantom stocks provide an easy exit mechanism in comparison to ESOPs . Since they are not actual stocks, there is no hassle of repurchasing them from the employee or from the secondary market where an employee may sell the shares.
Employees cease to reap the benefits of phantom stocks once they leave. You might feel that this might bother employees, but no, their profits aren’t compromised here.
Also read: What Is the Right Time to Exercise Stock Options?
Unlike ESOPs, phantom stocks are much more flexible, and they do not have to wait till their retirement to access the cash benefits.
They can do so even while they are in the service. Here, the employees are only given financial help if they meet specific requirements. Once they leave, the economic benefits stop, simple.
4. Non-Taxable Before Maturity
When employees hold equity shares for a specific period, it comes under the company’s taxable income. However, when you issue phantom stock to your employees, it will be exempted from tax until the stock matures.
However, even when it matures and you have to release the cash settlement, the tax for the transaction will be governed by the guidelines set for the salary income head.
What are the Cons of Using Phantom Stocks?
Like every other aspect, there are certain drawbacks of using phantom stocks as well. They are:
1. You Need to Have Cash in Hand During Settlement
No matter how things are looking for your company when settling employees’ cash benefits, it would help if you had the financial means to compensate them.
Unlike real stocks, phantom stock options only benefit employees through monetary compensation. And if you fail to pay them, they have all the rights to take a legal course of action against you.
2. You Need to Pay for Third-Party Stock Valuation
In case you need to opt for a third-party stock valuation, you alone will have to bear the charges of the advisory firm. Since your company implements the phantom stock scheme, your entitled employees cannot share the cost.
3. Capital Gains Treatment Does Not Apply to Phantom Stocks
Since phantom stocks aren’t real stocks, your employees will miss out on quite a few benefits with Phantom stocks. Regular stocks undergo capital gains treatment under which you will be required to pay a tax on the profit you made from the sale of the stock.
However, phantom stocks aren’t real and they only benefit the employee financially. Hence, it gets taxed as ordinary income and your employee has to pay that.
The disadvantage here is that capital gains have lower tax rates than regular income. So although you will be saving on capital gains tax, your employee will have to pay a tax on the extra benefit. This might give them second thoughts about the arrangement and reconsider if it’s worth it.
You can see that the downsides of phantom stocks are outnumbered by the benefits they bring along. And there is no doubt that they act as an excellent tool to motivate and retain employees.
So if you want to scale your business by compensating your senior-level employees, who hold key positions in your company well, then reach out to us to request a demo and take your business to new heights.
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What Is Phantom Stock?
Brian O'Connell was a Wall Street trader and now is an expert on investing in stocks, business trends, fintech, and career management. Besides The Balance, he's written for U.S. News & World Report, TheStreet.com, and more. Brian has also published several books, including "The 401(k) Millionaire” and "CNBC's Creating Wealth."
Definition and Example of Phantom Stock
How phantom stock works, types of phantom stock, pros and cons of phantom stock.
Phantom stock is offered by some companies to their senior employees. It gives these employees some financial benefits of owning shares without having actual ownership of company stock.
- Phantom stock plans can be both a good employee-motivation tool for employers and a solid cash incentive plan for employees.
- Neither the employer nor employee loses any money directly in the deal if events go sour, and the stock price doesn’t appreciate.
- Phantom stock plans provide more upside than downside.
- They are increasingly offered as part of employee compensation packages.
Phantom stock is a form of employee compensation that gives employees access to stock ownership without actually owning the stock. Like any genuine stock, phantom stock's value rises and falls in line with the underlying company stock. Staffers are compensated with profits incurred from any company stock appreciation on specific dates.
Phantom stocks are becoming increasingly prevalent as part of a total compensation package. They're not restricted to tech companies. Some companies tie the award to performance goals.
- Alternate name: Shadow stock
The number of phantom shares given to an employee or manager often depends on that person’s perceived value to the company. The more an employee is valued, the greater the number of shares they're likely to receive.
A “delay mechanism” kicks in when phantom stocks are awarded. The actual financial payout is made after a long period, such as two to five years, but it depends on the agreement made between the company and the employees.
Companies use phantom stocks both as a motivational tool to reward employees and to give those employees “skin in the game." The goal is to increase workplace productivity and earn the company more profits.
Companies tend to use either “appreciation only” phantom stocks or “full value” stocks.
An appreciation stock will bar recipients from garnering the current value of the phantom stock. Recipients instead earn any profit that the phantom stock might earn over a specific period, such as stock price appreciation.
The current value of the company stock would be $20,000 if employee “A” were to receive 1,000 shares of phantom stock, with each stock worth $20. Suppose that under the terms of the agreement, the employee must stay with the firm for five years to benefit fully from the phantom stock deal. This time frame is known as the “vesting” period.
The company’s stock has risen to $40 per share at the end of the vesting period. Employee “A” would receive the difference between the $20-per-share value of the stock on the date when the deal was struck and the $40 share price on the date when they become entitled to any profits from the stock. The appreciation in this case is $20 per share, which would give the phantom stockholder a profit of $20,000.
The recipient earns both the current value and any stock price appreciation once the due date is reached under a full value phantom stock deal.
Employee “A" would receive the $20-per-share price increase after five years in this case. They would also earn the current price appreciation on the shares since the date when the deal commenced.
Employees benefit as the stock price appreciates.
Employees don’t have to take any action to purchase stocks.
The company gets to retain control of the stocks.
Employees have no options or control if the stock price plummets.
Employees can lose benefits if they’re terminated, even for reasons outside their control.
Phantom stock plans can incur additional costs for companies.
- Employees benefit as the stock price appreciates: Phantom stocks are a solid motivational tool to keep key employees on board for the entire vesting period. They boost employee productivity. The recipient benefits, too, when the phantom stock price appreciates.
- Employees don’t have to take any action to purchase stocks: There’s no need for these employees to purchase phantom stock shares the way regular stockholders must acquire them on the open market. Phantom shares are instead given to employees, with no money changing hands. That’s a big benefit to employees. They share in the stock's profits without having to pay for it.
Shadow stocks aren’t the same as regular company stocks, so actual company stockholders don’t see their shares diluted in value as a result of this kind of arrangement.
- The company gets to retain control of the stocks: Company control of phantom stocks is advantageous to employers. A company can dictate the structure of the agreement under a typical phantom stock charter or contract. It can control the level of equity participation in the form of dividends that are paid out to employees. Companies can also include a provision in a phantom stock agreement that “forfeits” any phantom stock benefits if the employee in question departs the company before the agreed vesting-completion date.
- Employees have no options or control if the stock price plummets: The company calls all the shots in a phantom equity deal, giving employees little control or maneuverability if the share price goes south. Taxes factor into phantom stock deals, too. Companies must strictly adhere to the Internal Revenue Service’s (IRS) tax rule 409A , which limits a company’s options in instituting distribution dates. It also blocks employees and managers from accelerating phantom stock payouts if they think the company might be in severe financial stress.
- Employees can lose benefits if they’re terminated: Termination before the deal triggers, even over issues outside the employee’s control, leaves them out of luck on collecting any phantom stock cash benefits.
- Phantom stock plans can incur additional costs for companies: Companies that implement phantom stock plans can incur additional costs, particularly if any stock valuation overview must be completed by an outside accounting company.
National Center for Employee Ownership. " Phantom Stock and Stock Appreciation Rights (SARS) ."
PhantomStockOnline. " Vesting Schedules ."
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Introduction to Phantom Stocks and SARs
Although rewarding employees with company stock can provide numerous benefits for both employees and employers, there are times when either legal concerns or an unwillingness to issue additional shares or shift partial control of the company to an employee can cause companies to use an alternative form of compensation that does not require the issuance of actual stock shares.
Phantom stock plans and stock appreciation rights (SARs) are two types of stock plans that don't really use stock at all but still reward employees with compensation that is tied to the company's stock performance.
- Rewarding employees with company stock has been shown to provide numerous benefits for employees and the employer.
- Phantom stock plans and stock appreciation rights (SARs) are two types of stock plans that don't actually use stock at all but still reward employees with compensation that is tied to the company's performance.
- A phantom stock plan pays a cash award to an employee that equals a set number or fraction of company shares times the current share price.
- There are two main types of phantom stock plans: appreciation only and full value.
- SARs gives participants the right to the appreciation in the price of their company stock, but not the stock itself
Also known as "shadow" stock, this type of stock plan pays a cash award to an employee that equals a set number or fraction of company shares times the current share price . The amount of the award is usually tracked in the form of hypothetical units (known as "phantom" shares) that mimic the price of the stock. These plans are typically geared for senior executives and key employees and can be very flexible in nature.
Form and Structure
There are two main types of phantom stock plans . "Appreciation only" plans do not include the value of the actual underlying shares themselves and may only pay out the value of any increase in the company stock price over a certain period of time that begins on the date the plan is granted. "Full value" plans pay both the value of the underlying stock as well as any appreciation.
Both types of plans resemble traditional non-qualified plans in many respects, as they can be discriminatory in nature and are also typically subject to a substantial risk of forfeiture that ends when the benefit is actually paid to the employee, at which time the employee recognizes income for the amount paid and the employer can take a deduction .
Phantom stock plans frequently contain vesting schedules that are based on either tenure or the accomplishment of certain goals or tasks as covered in the plan charter. This document also dictates whether participants will receive cash equivalents that match dividends or any type of voting rights .
Some plans also convert their phantom units into actual stock shares at the time of payout in order to avoid paying the employee in cash. Unlike other types of stock plans, phantom stock plans do not have an exercise feature, per se; they only grant the participant into the plan according to its terms and then confer either the cash or an equivalent amount into actual stock when vesting is complete.
Advantages and Disadvantages
Phantom stock plans can appeal to employers for several reasons. As an example, employers can use them to reward employees without having to shift a portion of ownership to their participants. For this reason, these plans are used primarily by closely-held corporations , although they are used by some publicly traded firms as well.
Also, like any other type of employee stock plan, phantom plans can serve to encourage employee motivation and tenure and can discourage key employees from leaving the company with the use of a " golden handcuff " clause.
Employees can receive a benefit that does not require an initial cash outlay of any kind and also does not cause them to become overweighted with company stock in their investment portfolios. The large cash payments that employers must make to employees, however, are always taxed as ordinary income to the recipient and may disrupt the firm's cash flow in some cases.
As phantom stock plans are deferred compensation plans they must comply with section 409A of the tax code.
The variable liability that comes with the normal fluctuation in the company stock price can be a drawback on the corporate balance sheet in many cases. Companies must also disclose the status of the plan to all participants on an annual basis and may need to hire an independent appraiser to periodically value the plan.
Stock Appreciation Rights (SARs)
As the name implies, this type of equity compensation gives participants the right to the appreciation in the price of their company stock, but not the stock itself.
SARs resemble non-qualified stock options in many respects, such as how they are taxed, but differ in the sense that holders of stock options are actually given shares of stock that they must sell and then use a portion of the proceeds to cover the amount that was originally granted.
Although SARs are also always granted in the form of actual shares of stock, the number of shares given is only equal to the dollar amount of gain that the participant has realized between the grant and exercise dates.
Like several other forms of stock compensation , SARs are transferable and are often subject to clawback provisions (conditions under which the company may take back some or all of the income received by employees under the plan, such as if the employee goes to work for a competitor within a certain time period or the company becomes insolvent).
SARS are also frequently awarded according to a vesting schedule that is tied to performance goals set by the company.
SARs essentially mirror non-qualified stock options (NSOs) in how they are taxed. There are no tax consequences of any kind on either the grant date or when they are vested. Participants must recognize ordinary income on the spread at exercise, and most employers will withhold supplemental federal income tax of 22% (or 37% for the very wealthy) along with state and local taxes, Social Security , and Medicare.
Many employers will also withhold these taxes in the form of shares. For example, an employer may only give a certain number of shares and withhold the remainder to cover the total payroll tax . As with NSOs, the amount of income that is recognized upon exercise then becomes the participant's cost basis for tax computation when the shares are sold.
The previous examples illustrate why SARs make it easy for employees to exercise their rights and calculate their gains. They do not have to place a sale order at exercise in order to cover the amount of their basis as with conventional stock option grants. SARs do not pay dividends, however, and holders receive no voting rights.
Key information to be aware of regarding SARs includes the grant date, the exercise price, the vesting date, and the expiration date.
Employers like SARs because the accounting rules for them are now much more favorable than in the past; they receive fixed accounting treatment instead of variable and are treated in much the same manner as conventional stock option plans.
But SARs require the issuance of fewer company shares and, therefore, dilute the share price less than conventional stock plans. And like all other forms of equity compensation , SARs can also serve to motivate and retain employees.
The Bottom Line
Phantom stock and SARs provide employers with a means of providing equity-linked compensation to employees without the need to materially dilute their stock . Although these programs have some limitations, industry pundits predict that both types of plans will likely become more widespread in the future.
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Phantom Stock – What exactly is it and How does it work?
Phantom stock is considered a great way to reward senior-level employees
A lot of companies offer their senior-level employees with extra company benefits along with their salaries. These benefits normally include employee compensation in the form of company stock. There are a lot of employee equity plans that are used including ESOPs , stock options , and phantom stock . Among these plans, phantom stock is considered a great way to reward senior-level employees.
Phantom Stock Plan
A phantom stock plan is employee compensation that gives selected employees, mostly in senior management, benefits of stock ownership without actually giving them company stock. This is sometimes referred to as phantom shares , simulated stock , or shadow stock . It is basically offered as a bonus for staying with the company for a long time and the hard work that employee puts in.
Just like real stock, phantom stock is worth money, and its value increases and decreases just like normal stock. Employees get profit gained from a phantom stock plan after a time period is complete . There are also multiple kinds of phantom stock plans to choose from, based on the preferences of the company, which usually varies on the vesting schedule .
Each phantom stock plan has an agreement that defines the vesting schedule of the plan. The agreement would outline each rule including the goals or tasks that a participant needs to accomplish before the shares can vest. It also defines these goals and what is given to the participants once they reach their goals. If there are any voting rights , those rights are also mentioned in the agreement It would also outline the rules of if the phantom stock can be converted to actual shares upon payout.
Why Do Companies Use Phantom Stock?
Offering employees with employee compensation in the form of equity can offer a lot of benefits. The main benefit is motivating them to work harder by aligning their interest with the company’s. It also helps create loyal employees, as they feel invested in the firm, and may stay with the company longer to receive the full amount of phantom stock. Nonetheless with such incentives, phantom stock is great for certain situations, such as:
- When the organization is reluctant to issue additional shares .
- When there are legal concerns .
- To offset the effect of stock dilution
The number of shares given to an employee is usually based on how senior they are in the organization and their performance. And even though they are promised money today, their benefits are long-term . As per the phantom stock plan, the company would pay out the benefits in two, three, or even five years, with some being subject to certain milestones as well.
Types of Phantom Stock
There are two kinds of phantom stock plans that are given as employee compensation. These include either “full value” phantom stock , or “appreciation only” phantom stock . Each has been explained below:
#1 Appreciation Only Phantom Stock
The recipients of “appreciation only” phantom stock would not get the current value of the stock. Instead, they earn the stock price appreciation as profit where the stock value increases over time. For instance, let us say an employee is going to get 2,000 shares of phantom stock and each stock is worth $20 . This would mean that the current value of the company stock would be $40,000 . And in this example as per the agreement terms, the employee has to stay with the firm for at least four years before they can “sell” their shares. This requirement with a timeframe is called the “vesting” period.
Now, let us say that the vesting period has ended , and the company stock value is $50 per share . The employee would get the difference between the $20 per share value when the deal was made and the $50 per share when the vesting period is complete. This means that the appreciation is $30 per share , which would give the phantom stock shareholder a profit of $60,000 .
Here is a table that summarizes this “appreciation only” scenario:
#2 Full Value Phantom Stock
As per a “full value” phantom stock deal, the participant gets both the current value and any stock appreciation once they have fulfilled the requirements of the phantom stock plan. Taking the same example as before, we know that the employee would get the $30 per share price increase after four years . Nonetheless, they would also get the current value on the shares from the date the deal started. So, this means that the employee would get a total of $100,000 after the four-year vesting period is complete.
Here is a table that summarizes this “full value” scenario:
How does a Phantom Stock Plan work?
For companies to be able to issue phantom stock to employees , both parties need to enter into an agreement. Adhering to the terms of the plan, the company would offer an amount of phantom stock or shares to the participating employees over a specified period of time. The agreement would have all the details like the payment events , vesting schedule , and any other conditions.
Pros and Cons of Phantom Stock
Now that you know what phantom stock is and how it works, let’s take a look at the pros and cons of giving out phantom stock for your company.
Pros of the Phantom Stock Plan
The phantom stock plan has many advantages for a company. They include:
- Phantom stock is highly flexible and they can be used by both private and public companies.
- Setting a phantom stock plan is a lot cheaper than setting up ESOPs . It saves the employer a lot of money.
- There are no taxes that have to be paid by the employee s getting phantom stock until the stock mature.
- There are less complications in a phantom stock plan, where the employees are paid only if they meet the set terms. And since the plan uses cash and not actual stock, if an employee leaves, the company would not have trouble in handling half the vested stock.
- Even though voting rights are not offered, the employees are still invested to increase the share price of the company .
Cons of the Phantom Stock Plan
Just like everything, there are cons to phantom stock as well, which include:
- Every benefit that the employees get is taxed as ordinary income . And since the benefits are paid in cash, capital gains treatment is not available.
- Participants who are a part of the “appreciate-only” phantom stock plan may not get a thing if the company stock doesn’t appreciate at price.
- For employees, if the value of the shares drop, the employer can take a call in the deal by offering little control to the employee . There are also chances where they can terminate the deal.
- When the time comes, it is important for employers to have cash in their hands to pay for the benefits.
- For the SEC and all the true shareholders , if the company is publicly traded, employers would have to report the status of the phantom stock plan at least annually to all participants.
- The employers would have to pay if the overview of the stock valuation has to be done by a third-party firm.
If you can handle the downsides of phantom stock plans , then this form of equity compensation may be suitable for you.
Important Legal Framework For Phantom Stock
Even though it is possible, it is tough to avoid some main parts of the federal legislation if you are going to use a phantom stock plan. The very first thing is the ERISA , which is the pension law of 1974 that looks at all the long-term deferred cash of a retirement plan. For meeting ERISA requirements , you need to include the top group of employees in the plan. You also need to give the ERISA a document with specific language. So, to be compliant for this law, you will need to have the phantom stock plan created and administered properly.
The second federal law is the IRC 409A where there are rules in place for the definitions of triggering events , acceleration of vesting limitations , payout timing and many other things. If the company fails to comply with all these rules, the penalties are onerous. It also includes huge tax penalties for the participants of the plan. In short, if you want to avoid these two limitations, you will have to narrow the rules of your plan. And you will need the help of a professional for preparing a 409a valuation for the company.
Taxation of Phantom Stock
Regardless of how payments for a phantom stock plan is made, the gains are considered as ordinary income and taxed as such . And the tax rate is on the stock price received at the end of the deal. When this happens, the employer has the option to get a deduction in the year the employee reports income, equal to the amount of bonus given out to the employee.
This income is reported in the employee’s W-2 and is subject to withholding tax requirements . But one thing about this plan is that it does not get any special tax treatment or benefit from any deferral of tax beyond the time of payment. Based on the time of the year the phantom stock amount is paid, you may not be required to pay FICA and FUTA . This means that if the compensation was given at the end of the year, then the employee may be over the required wage base amount for FUTA and FICA taxes. But medicare tax still needs to be given as it is not subject to the wage base limit.
Recording Phantom Stock on Eqvista
Eqvista now allows you to manage your company’s phantom stock easily . With Eqvista, issuing phantom stocks to your employees can be done in minutes. Also, your phantom stocks are recorded in real-time in your company’s equity page, cap table, and reports, making it easier to keep track of them and stay up-to-date with your company’s activities.
Aside from issuing and managing your phantom stocks, you can also repurchase them on Eqvista. To learn more about Eqvista’s phantom stocks feature , you can go to our support page and read up the guides we have prepared.
Interested in using Phantom Stock for your company?
A phantom stock plan is a solid employee compensation and a great motivation technique for employees. The best part about this is that if the stock price does not appreciate, both the employee and the company lose nothing. This is a major upside that other plans don’t have. It makes phantom stock one of the best plans to implement in the company.
But while you do this, ensure that you keep track of all the shares in your company . The best way to do this is by using a cap table app such as Eqvista . It can help you keep track of all the phantom stock in your company. Check it out here and begin using it today !
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Stock Market News, Oct. 11, 2023: S&P 500 Closes Higher to Extend Winning Streak
Birkenstock shares fell in their market debut.
A Stock Rally Into Year End? Options Traders Are Betting on It
, Lead Writer
That was quick.
The S&P 500 has staged a rapid turnaround, rallying more than 2.3% over the past three sessions—its best three-day performance since late August. Options traders are betting the gains will continue, driving up the prices of bullish trades that would profit if stocks continue to advance.
"We have seen a clear trend of bullish flow this week as investors use options to make sure they are positioned for [a] rally into year-end," wrote Christopher Murphy, co-head of derivatives strategy at Susquehanna International Group, in a note to clients Tuesday.
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Options traders see larger-than-usual stock swings as banks report results
A sign outside the headquarters of JP Morgan Chase & Co in New York, September 19, 2013. REUTERS/Mike Segar/File Photo Acquire Licensing Rights
NEW YORK, Oct 12 (Reuters) - Options traders are braced for larger-than-usual post-earnings stock price swings for some U.S. banks, despite signs of cooling volatility in broader markets, options data showed.
Big banks, including JPMorgan (JPM.N) , Wells Fargo (WFC.N) and Citigroup Inc (C.N) are set to report financial results on Friday, with others, including Goldman Sachs (GS.N) and Morgan Stanley (MS.N) , due next week.
The biggest U.S. consumer lenders are set to post higher third-quarter profits, in contrast with investment banks still facing a dealmaking slump, analysts said.
Options data shows traders braced for a larger-than-usual post-earnings move from Wells Fargo in particular. Traders expect shares of the fourth largest U.S. bank to move about 4% in either direction by Friday, compared with a median move of 2.6% over the last eight quarters, according to data from options analytics service Trade Alert.
Wells Fargo, which has been trimming its workforce since the third quarter of 2020, could cut more jobs as it aims to improve efficiency, Chief Financial Officer Mike Santomassimo said in September.
The options-implied earnings move for Goldman Sachs, Morgan Stanley, Bank of America (BAC.N) and Citigroup also signal a larger-than-usual post-earnings swing, data from Trade Alert showed.
"The implied volatilities are relatively high in light of these companies' earnings history," Steve Sosnick, chief strategist at Interactive Brokers, said.
"It's worth noting that they show some risk aversion amidst a broad market that seems to be reverting to its complacent ways."
The Cboe Volatility Index (.VIX) - an options-based gauge of investor expectations for how much the S&P 500 is seen swinging over the next 30 days - fell to a three-week low of 15.44 on Thursday after surging as high as 20.88 a week ago.
Expectations for bank stock moves increased as exchange-traded funds tracking U.S. banks have logged significant outflows since the start of October, amid a broad risk-off move in markets and ahead of earnings as investors took money off the table fearing elevated interest rates and stricter regulations in the aftermath of the regional bank crisis.
Reporting by Saqib Iqbal Ahmed; Editing by Richard Chang
Our Standards: The Thomson Reuters Trust Principles.
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News & Insights
Papa John’s Stock (NASDAQ:PZZA): Options Activity Points to Downside
October 16, 2023 — 09:26 pm EDT
Written by Joshua Enomoto for TipRanks ->
With the prospect of a recession representing a non-zero probability event, investors may initially want to consider a fast-food play like Papa John’s ( NASDAQ:PZZA ). As a provider of cheap but delectable food products, it stands to benefit from the trade-down effect. Unfortunately, shares have been volatile recently, raising concerns about greater pain ahead due to certain options trading dynamics. Therefore, I am bearish on PZZA stock.
PZZA Stock Should Swing Higher, but It’s Not
Based on both the core business undergirding PZZA stock as well as its historical trend, Papa John’s should be a solid performer this year. In terms of bang for the buck, it’s hard to beat the fast-food brand, especially if it offers customer incentives. However, PZZA stock has fallen by 16% year-to-date , pointing to broader risks.
While the Federal Reserve remains committed to tackling the rise in consumer prices that has hurt sentiment across the board, inflation has been stubbornly high . Not only that, but the September jobs report came in hotter than expected, which means more dollars chase after fewer goods. Thus, it’s not unreasonable – it’s perhaps even likely – that the Fed will raise interest rates again.
Of course, rising borrowing costs impose their own distinct challenges. With consumers keeping their wallets closed for as long as possible, demand across multiple industries has waned. In turn, impacted enterprises will likely issue layoffs . Subsequently, people are seeking cheaper alternatives to common goods and services, meaning that the trade-down effect is in full bloom.
Under this scenario, PZZA stock should thrive. Following the initial shock of the 2008 financial crisis, Papa John’s shares eventually marched higher. And after the early outbreak of COVID-19, PZZA came back with a vengeance, especially as the pizzeria marketed its no-contact delivery service.
So, with economic troubles in the air, Papa John’s should benefit as one of the low-cost calorie leaders. However, it’s not, and that may lead to another set of problems.
Options Setup Points to Possibly More Pain for Papa John’s
At first glance, PZZA stock options paint a seemingly bearish picture. Presently, the put/call ratio – or the total number of open put options divided by open call options – clocks in at 3.8. In other words, there are nearly four times as many puts as there are calls. Because puts give holders the right but not the obligation to sell the underlying security at the listed strike price, this ratio seems pessimistic.
However, a face-value interpretation is difficult to make without considering options flow or big block transactions likely made by institutions. If major entities are selling (writing) the puts, the underlying implication is the opposite of buying the puts. Stated differently, put writers have the obligation but not the right to fulfill the contract; as in, they must buy the underlying security at the listed strike price.
Still, if the puts expire worthless, then the put writers get to keep the premium received for writing the options.
Here’s where things get interesting. One of the biggest “exposed” puts is the Nov 17 ’23 67.50 put . Currently, open interest for the option stands at 3,420 contracts. Most of this open interest came from one big block trade involving 3,375 contracts on September 18. At the moment the transaction was made, PZZA stock was trading at $75.27.
Unfortunately for the put writer, the option has now gone in the money (ITM). Therefore, the buyers of the puts can choose to exercise the contract, meaning that the writer would be obligated to buy PZZA stock at a higher price than the open market price.
Further, that’s not the only put option that has gone ITM, and many others threaten to go ITM if PZZA stock continues falling. To mitigate the failed trade, institutional put writers may buy puts (to cancel the sold puts), thus possibly sparking downside.
Is PZZA Stock a Buy, According to Analysts?
Turning to Wall Street, PZZA stock has a Moderate Buy consensus rating based on seven Buys, one Hold, and one Sell rating. The average PZZA stock price target is $93.75, implying 41.1% upside potential.
On paper, economic downturns should cynically benefit PZZA stock because the underlying entity provides low-cost fast food. It’s possible, then, that major traders decided to write put options thinking that PZZA would stabilize. However, its recent downturn leaves many options traders exposed. To correct this apparently failed trade, traders may take actions that could possibly lead to further pain for Papa John’s.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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