Phantom Stock Plans for Employee Compensation & Retention

Most businesses in the world believe that granting equity to employees leads to greater motivation, enthusiasm and employee retention. However, the biggest risk involved here is the dilution of the company’s stock. An early stage business may struggle between a choice of saving equity for future rounds versus empowering current employees with ESOPs. What if we told you there was an alternative that allowed your business to grant all the stock benefits without diluting any equity?

In this post, Compliance Calendar traces the latest developments on ‘Phantom Stocks’, an innovative tool that gets you all the benefits of owning stock without transfer of actual shares.

Phantom stocks - A simulated stock ownership with real benefits

A phantom stock plan, also known as a phantom equity plan is a type of incentive compensation plan designed to emulate all the real benefits of a stock issue such as - rewarding employees based on the actual performance of the company’s stocks, granting bonus and making them a part of the financial gains made, but with one crucial difference.

Employees in a phantom stock own what may be called mock shares or simulated shares, whose indicated prices move in tandem with the actual stock issued in the capital market. Thus, employees are granted hypothetical or "phantom" units that are tied to the value of the company's stock. These units typically mimic the value and performance of actual company shares, but they do not represent any real ownership or voting rights.

What are the benefits to the company issuing phantom stocks?

Here’s a list of the possible advantages in using phantom stocks in place of conventional methods like ESOPs:

1. Total equity retention and control : By issuing phantom stocks which have zero impact on the actual shareholding of the company, an early to mid sized business can save up a lot of equity and preserve value. Having fewer shares also means lesser interference in taking decisions.

2. Employee performance : Phantom stock plans are often used by companies that want to provide their employees, directors, developers or key stakeholders with a stake in the company's performance and align their interests with those of the shareholders, without actually granting them ownership in the form of stock options or actual shares.

3. Sense of ownership and commitment: The issue of Phantom stock plans indicates a company’s commitment towards its employees. This can be a useful tool for attracting and retaining key employees, fostering a sense of ownership, and motivating employees to contribute to the company's growth and success.

4. Highly flexible instruments: Unlike shares and debentures, the issue of which is heavily regulated by laws, Phantom units are largely flexible. Their issue and other terms and conditions can be designed by the management.

The two models of Phantom Stocks offering

The offering of phantom stocks is usually done in two different ways. Your company can choose between an ‘appreciation only’ model or a ‘full value’ model

» In an appreciation only model, employees receive the benefits of any increase in the underlying share value. For instance, a stock valued at $100, with a 20% increase would yield $20 appreciation for every share held. In this case, employees receive only the value of the appreciation.

» In a ‘full value’ model, the employees receive value of not just the appreciation but also the underlying share price. In the above example, the same $20 increase would entail a final payout of $120.

The payout is usually calculated by multiplying the number of phantom units held by the employee by the increase in the stock price during the measurement period. The amount is then paid out in cash, often subject to certain vesting requirements or other conditions.

Steps involved in issuing phantom stock plans

Here's how a phantom stock plan for employee compensation typically works:

1. Granting of Phantom Units: The company grants phantom units to eligible employees. The number of phantom units awarded to each employee is a flexible choice, and may be designed by the senior management based on variables such as their position, performance, or length of service.

2. Valuation of Phantom Units: The value of the phantom units is determined based on the company's stock price or a predetermined formula tied to the stock's performance. The base value, or the reference value of existing shares can be decided by the management.

3. Measurement Period: The phantom units' value is measured over a specific period of time, known as the measurement period. This period may be defined as a fixed number of years or tied to certain performance goals or milestones.

4. Vesting Schedule: The plan typically includes a vesting schedule that outlines when employees become entitled to the value of their phantom units. Vesting may be time-based (e.g., gradual vesting over a number of years) or performance-based (e.g., vesting upon achieving specific targets or milestones).

5. Payout Calculation: At the end of the measurement period or upon meeting the vesting requirements, the payout for each employee is calculated based on the increase in the value of the phantom units. The calculation is typically determined by multiplying the number of phantom units by the increase in the stock price or a predetermined formula.

6. Cash Payout: The payout is made to the employee in cash, reflecting the value of their vested phantom units. The payout may be subject to applicable taxes, deductions, and any withholding requirements.

7. Additional Terms and Conditions: The phantom stock plan may include other provisions such as dividend equivalent cash payout, change of control provisions (addressing what happens to the phantom units in the event of a merger or acquisition), and rules for termination or retirement of employees.

Taxation of Phantom Stocks in India’s tax laws

A Phantom stock qualifies as a perquisite in the year in which benefits are received. Thus, it is taxable in the hands of the employees. An employee can use benefits of regular deductions to reduce their final tax liability.

It's important to note that the specific details of a phantom stock plan for employee compensation can vary depending on the company's objectives, industry norms, and legal requirements. Consulting with Compliance Calendar’s legal and financial professionals can help you design and implement a phantom stock plan that suits the needs of your company and complies with relevant regulations.

Here are some frequently asked questions (FAQs) about phantom stock options

What is a phantom stock option?

A phantom stock option is a form of employee incentive plan that grants employees the right to receive a cash payout tied to the increase in the value of simulated company shares. It does not grant actual ownership in the company.

How do phantom stock options work?

Employees are awarded phantom stock units that mirror the value of actual company shares. The value of these units fluctuates based on the company's stock price or performance. Upon a triggering event, such as a sale or IPO, employees receive a cash payment equivalent to the increase in the value of their phantom stock units.

What are the benefits of a phantom stock option plan?

Phantom stock options provide employees with a financial incentive tied to the company's performance without granting them actual ownership. They align employee interests with company goals and can help retain and motivate key talent.

Are phantom stock options only for publicly traded companies?

No, phantom stock options can be used by both publicly traded and privately held companies. They are often employed by private companies that want to provide employees with equity-like benefits without going public or diluting ownership.

How are phantom stock option payouts determined?

The payout amount is typically based on the increase in the value of phantom stock units over a specified period. The calculation methodology and specific terms are outlined in the phantom stock option plan.

Are phantom stock option payouts subject to taxes?

Yes, typically, the cash payout from phantom stock options is subject to taxes, including income tax and potentially other applicable taxes. It's essential to consult with tax professionals to understand the tax implications in your jurisdiction.

Can non-employees participate in a phantom stock option plan?

Yes, in some cases, non-employees like consultants or advisors can be included in a phantom stock option plan to align their interests with the company's success. The terms and eligibility criteria can be customized accordingly.

Can phantom stock options be transferred or sold?

The transferability of phantom stock options depends on the terms of the specific plan. In most cases, phantom stock options cannot be transferred or sold and are generally not transferrable upon the employee's death.

How are phantom stock options different from actual stock options?

Phantom stock options do not grant actual ownership in the company, whereas actual stock options provide employees with the right to purchase company stock at a predetermined price. Phantom stock options are purely cash-based and reflect the value of simulated shares.

Can a company have both phantom stock options and traditional stock options?

Yes, a company can offer both types of options. The choice between phantom stock options and traditional stock options depends on the company's goals, structure, and desired incentives for employees.

Note- Remember, it is important as a company to understand the compliance involved in the phantom stock option, and therefore; it's crucial to consult with legal and financial professionals to fully understand the implications and specifics of implementing a phantom stock option plan. Feel free to reach out in case of any query.