By Rohan Kazi
Phantom stock, sometimes called simulated or shadow stock, or a phantom share, is a form of employee compensation that provides access to the value of a company’s equity without issuing any actual shares. Just like real stock, phantom stock can be worth real money, and its value fluctuates with changes in the value of the company.
- Phantom stock is issued under a Phantom Stock Plan, which typically specifies a vesting period before the shares can realize any benefit. The Plan also provides detail about the type of phantom stock issued and the trigger for any payout.
- Usually, a holder of vested phantom stock only receives value upon a liquidation event or sale of the company. Since the holder does not own actual stock, they generally do not receive dividends or vote on corporate matters.
Form and Structure of Phantom Stock
The two types of phantom stock are appreciation only and full value.
Appreciation only (also known as Stock Appreciation Rights) provides the recipient with stock price appreciation as profit where the stock value increases over time.
- For example, assume an employee receives 1,000 shares of phantom stock valued at $10 per share (a total initial value of $10,000) with a 4-year vesting schedule. At the end of year 4 when the shares vest, if the company’s actual stock is worth $50 per share, then the total value of the phantom stock would be worth $50,000. However, a recipient of appreciation only phantom stock would be entitled to receive the amount the value appreciated, or the difference between the current value and the initial value. The phantom stockholder would be entitled to $40,000.
Full value provides the recipient with the full value of the shares at the time of vesting.
- Using the example from above, the full value phantom stockholder with 1,000 shares would be entitled to the full present value of the shares upon vesting, or $50,000.
Since a phantom stockholder does not receive any payout until a liquidation event or sale of the company, a vested phantom stockholder must wait for the appropriate triggering event.
- Assume the company has also issued 4,000 shares of actual stock. Let’s say at the end of year 6, an acquiror decides to purchase the company for $400,000. Upon the sale of the company, the $400,000 would be distributed to all of the actual and phantom stockholders pro-rata. In other words, the $400,000 would be divided by 5,000 (the sum of 4,000 shares of actual stock and 1,000 shares of full value phantom stock).
- The actual stockholders would receive $80 per share. The vested full value phantom stockholder with 1,000 shares would also receive $80 per share for a total payout of $80,000.
- If the phantom stock were appreciation only, then the employee would receive the difference between the present value and the initial value; or $70 per share for a total of $70,000. The actual stockholders would receive the remainder pro-rata, or $82.50 per share ($400,000 minus $70,000, then divided by 4,000 actual shares).
Benefits of Using Phantom Stock
- Simplicity for Company. Due to the vesting schedule and requirement for a liquidity event, phantom stock is only paid out if both conditions are met. If a recipient of shares leaves the company before the shares have vested, the rights can terminate automatically. On the other hand, if the company had issued actual shares, those shares would have to be repurchased. Phantom stockholders also typically have no voting rights. This is because there is not actual equity and those shares do not carry the same rights as actual shares.
- No Taxation Until Maturity. Unlike actual stock, receipt of which results in taxable income (even if the shares are subject to vesting). A holder of phantom stock does not incur taxable income until the holder receives an actual payout.
- Employee Incentive. Although phantom stockholders typically do not receive dividends and have no voting rights, the value of their benefit depends on the value of the share price. This aligns employees’ incentives with those of the stockholders.
- Flexibility. Can be used in both small and large private and publicly traded companies, and in limited liability companies and corporations.
Costs of Using Phantom Stock
There are some downsides to using this type of compensation, which include the following:
- Taxed as Ordinary Income. A payout to a phantom stockholder would get taxed as ordinary income and capital gains treatment is not available.
- Little or No Control for Employees. Because a phantom stockholder does not have voting rights, the company can make decisions without the phantom stockholder’s input. The company could enter into transactions and even terminate the Phantom Stock Plan without recourse for the stockholder. Also, the employee may not be able to participate in partial liquidity opportunities prior to a sale of the company.
- Liquidity May Be Required. For cash deals, it is important for the company to have enough cash to pay stockholders when the time comes. This may influence the price at which a company can trigger a liquidation event. This concern does not apply to non-cash deals.
- Regulatory Issues. Phantom shares may be problematic under the Employee Retirement Income and Security Act (ERISA) which need to be addressed. Companies should also ensure the plan complies with Internal Revenue Code Section 409A, which prohibits indefinite deferral of compensation.
Overall, phantom stock can be a great motivation tool for companies and a good cash incentive plan for the employees.
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