Written by Shubhika Sundriyal 02 February 2023 | 4 min readPhantom stock plans can be a valuable tool for businesses looking to retain top talent. Understand how it can offer & benefits to both employers and employees.
Have you ever given thought to the rising attrition rate among top-performing employees? The trend is fueled by skilled professionals looking for something additional to the traditional compensation structures. Traditional employment structures often confine them to fixed salaries, with incremental raises being the sole reward for outstanding company performance – a far cry from genuine motivation.
Enter stock plans as a part of compensation. Though there are multiple ways to do it. Let’s discuss phantom stocks today.
These innovative employee benefit programs empower workers to partake in the company's success, reflecting the advantages of Employee Stock Ownership Plans (ESOPs) without some of the complexities of ESOPs. Through phantom stock plans, employees enjoy comparable benefits to ESOP holders and gain eligibility to capitalize on profits when the company goes public.
A phantom stock plan is an employee benefit plan that gives selected employees (especially the senior management) cash payment that is equal to the appreciated stock price after a specific period. These are also called phantom shares, simulated stocks, or shadow stocks.
In this, rather than getting physical stock, the employee receives mock stock. Even though it's not real, the Phantom stock is worth money, and its value fluctuates in sync with the actual company stock.
Let’s look at the key features of phantom stock options to understand them better.
The key features include:
Companies use phantom stock as an innovative incentive tool to attract and retain key employees without diluting the actual equity of founders or investors on the cap table. It's particularly beneficial in privately held firms, where real stock options might be impractical. Thus, phantom stock plans provide a flexible alternative to traditional stock options, allowing companies to tailor incentive programs to their specific needs and circumstances.
Setting up a phantom stock plan involves creating virtual shares, aptly named phantom shares, reflecting the company's actual stock.
Appreciation plans align with the company's market value i.e. the increase in the share value over a period of time, while Full Value plans emulate the complete stock value i.e. a cash payment equal to the value of the stock.
Both drive motivation by granting employees a slice of success without diluting ownership. It's the ultimate win-win, driving your team towards excellence while preserving your company's equity structure.
Oh, and when gains arrive, can taxes be far behind? Not really!
The gains on phantom stock plans are considered as ordinary income and the employer shall be liable to deduct tax on the same as a tax on salary income. Tax liability centers around the total stock price at deal closure. Notably, phantom stock lacks preferential tax treatment, denying any deferral advantages.
Given that there are multiple types of stock compensation plans, you might wonder what the key differences between them are. Eg. the difference between RSUs & Phantom stocks. To resolve this, here is a table that clearly outlines the key differences between a phantom stock plan a traditional stock option plan, and a restricted stock plan across various parameters like ownership, value realization, etc..
| Feature | Phantom Stock Plan | Stock Option Plan | Restricted Stock Units |
| Ownership Rights | Phantom stocks represent notional shares; employees don't own actual shares. | Employees receive actual stock options, providing direct ownership after vesting. | Employees receive actual shares, providing direct ownership. |
| Cash vs. Stock Distribution | Employees receive cash equivalent to the value of hypothetical shares. | Employees exercise options to acquire actual company stock. | Employees receive either actual shares of the company's stock or the cash equivalent of the stock's value upon selling the shares in the stock market. |
| Dividends | Typically, employees receive cash equivalent of dividends on phantom stocks. | Employees holding stock options may receive dividends if specified in the plan. | Employees receive dividends or dividend equivalents, depending on the plan. |
| Exercise Price | No exercise price; employees receive the appreciation value in cash. | Employees must pay the exercise price to acquire the stock. | No exercise price; employees receive the stock outright upon vesting. |
| Value Realization | Employees realize value upon a triggering event, like a sale or IPO. | Value realization depends on stock market performance, exercise decisions & liquidation events. | Value is realized upon vesting, determined by the market value of the company's stock at the time of vesting. |
| Taxation | Taxed at the time of payout as ordinary income. | Taxed upon exercise as ordinary income and capital gain tax at the time of sale of exercised shares. | Taxed upon vesting as ordinary income. |
Frequently termed as 'shadow stock' phantom stock plans are exciting compensation plans for highly skilled upper management teams without actual ownership or transfer of any company shares.
By simulating stock ownership, without actually providing it, organizations ensure that equity does not become diluted for other shareholders.
Also, phantom stock enables companies to maintain confidentiality and control over ownership while providing employees with a sense of ownership and potential financial gains tied to the company's prosperity. This strategic approach enhances employee engagement, driving collective efforts towards shared goals.
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