Phantom stock is a very interesting concept and is emerging strongly as a powerful tool of Employee Benefits, especially for Startups. It can be described as a type of employee benefit plan whereby employees or advisors of an Organization get various benefits of stock ownership without actually having real ownership of Stock, in exchange for their services.
It is also often known by names such as shadow stock, simulated stock or phantom shares.
Why Companies use Phantom Stock?
Providing employees with a stake in the ownership of the Organization is a very common practice adopted by Companies. ESOPs and Sweat Equity have been a conventional mode of a deferred reward plan for employees. On the contrary, Phantom Stock is a conventional, performance-based incentive plan which entitles an employee the right to receive cash payments after a specific period of time or upon fulfilment of specific criteria and is directly linked to the valuation and the appreciated value of the share price of the company.
Phantom stock gains advantages above real stock on the following points:
- To prevent diluting the stake of promoters and voting rights as providing voting rights with phantom stock is not mandatory and completely at the discretion of the Company.
- There are very little complications associated with phantom stock. They are generally paid if employees meet certain terms. If the conditions are not met, there is no responsibility on the part of the companies to pay the same.
- Setting up a phantom stock plan is much less expensive as compared to setting up ESOPs,
- It is less time consuming and easy to execute.
It is prudent to carefully plan out the terms and conditions for the phantom stock plan as per the requirements of the Organizations to make the plan effective and profitable for both the parties.
How does it work?
The employer enters into an agreement with employees or advisors for issuing phantom stock in exchange of services. The Agreement should contain all the terms and conditions related to the plan such as:
- Price of the stock
- Payout ratio
- Criteria for eligibility
- Voting rights associated with the stock
- Tasks or Goals, if any, that need to be accomplished in order to exercise the option
- Such other conditions at the discretion of the Company
The Agreement also sets out the mode of redemption of the phantom stock plan. They are usually redeemed in cash. But if the Agreement allows, the payment obligation can also be fulfilled by distributing actual stock to the employees.
Based on the mode of redemption, Phantom Stock can be of two types viz.
- Appreciation only– In this case, the phantom stock holder receives the difference in the value of the stock at the time of issue and the value at the time of maturity. This means they receive anything above and beyond what the phantom stock was worth when it was granted.
- Full value– In this case, the phantom stock holder receives the full value of what the stock is worth for, at the time of maturity, instead of the stock appreciation amount as in the former type.
Unlike ESOP’s and Sweat Equity, which can be taxed as Income on the basis of the value of shares issued, Phantom Stocks are not taxed at the time of grant. These are taxed only when there is actual outflow of cash at the time of redemption or maturity of the Stock. This helps in deferring the tax and paying the same only when there is actual benefit arising out of increase in the value of Company’s Shares.
Phantom Stock is a smart scheme to provide benefits without diluting the shareholding and at the same time satisfying employees, advisors and permanent consultants, who wish to gain out of the growth in the Company. It’s a Win-Win for all!