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:

Appreciation only

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.

Full value

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.

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.

Liquidity events

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.

How to

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.

Quick-fire Q&A

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.