Phantom Stock Plans: How This Alternative to Real Equity Works

March 16, 2022

What’s a form of equity compensation that’s not actually equity compensation? This may seem like a riddle intended to baffle startup founders, many of whom already have a hard enough time keeping their equity terms straight. But the answer is a type of employee compensation that has become increasingly common in recent years: phantom stock. 

Phantom stock plans, otherwise known as shadow stock plans, are a creative way to compensate key employees without granting them actual shares of company stock. Just as a phantom might mirror the outline of an actual figure, phantom stock is a type of employee compensation that tracks the value of actual shares of company stock. Employees who are granted rewards of phantom stock are thus able to benefit from the rise in value of the underlying company stock, without owning any actual stock.

In this guide, we’ll cover everything you need to know about phantom stock plans—including the situations in which they might make more sense than granting actual shares of company stock.

  • What is a phantom stock plan
  • How phantom equity works
  • The main types of phantom stock
  • Pros and cons of phantom stock plans
  • How to think about phantom stock as a startup founder

What is a phantom stock plan?

A phantom stock plan is an employee compensation plan in which an employee is offered “phantom shares” that track the value of the company’s actual stock. It’s important to highlight that phantom shares are not actual equity, though their value does rise and fall in accordance with the value of the company’s stock.

Phantom stock plans can be a powerful motivational tool for key employees, including those who already may be highly compensated or top performers. They also have some very attractive benefits for the employer, who typically controls the terms and structure of the plan and may include provisions that incentivize the employee to stay with the company for a longer term. Existing shareholders may also benefit from phantom stock plans, since granting shares of phantom stock does not require the issuance of new shares and thus does not result in the dilution of shareholder equity.  

The result may sound like a win-win-win situation for employees, the company, and existing shareholders—and in some cases, it is! But phantom stock has some complexities and potential downsides to understand as well. We’ll get to those in a bit. For now, let’s take a deeper look at how phantom stock works.

How phantom equity works

The basic idea behind phantom stock is simple: reward a key employee with the financial benefits of stock ownership without giving them actual shares of company stock. The specific number of shares granted to the employee may vary depending on factors like seniority and performance, and in some cases, additional shares may be granted if certain performance goals are met.

Phantom stocks aren’t technically equity, but they do share a few things in common with traditional forms of equity compensation. For example, a 409a valuation may be required to determine the fair market value (FMV) of a share of phantom stock—just as it would be required to determine the price of stock options offered to employees.

As with other types of equity compensation, phantom stock programs also usually include a vesting schedule to encourage employee retention.

How phantom stocks vest

“Vesting” means that the employee doesn’t get all of the phantom stock upfront. Instead, they earn the cash value of their phantom stocks based on a specific delay mechanism—such as time requirement or performance milestone—that’s specified in the terms of the grant. 

The full value of the phantom stocks may not vest until the full vesting period is up. In some cases, the employee may see their shares partially vest over the course of the vesting schedule. In other cases, the employee won’t see any cash payment until they’re fully vested—a period that may be up to three, four, or five years.

How company performance affects the value of phantom stocks

Assuming the company is successful and continues to grow, the employee stands to benefit from the appreciation in the company’s stock price. 

But here’s a wild thought: what if the company stock price doesn’t appreciate over the full course of the vesting period? What if it actually declines? Does the employee get anything in this case?

Well, it depends on the terms of the grant and the type of phantom stock the employee is granted. Different types of phantom stock can result in different reward valuations at the end of the vesting period. To illustrate this point, let’s take a look at the two main types of phantom stock.

The main types of phantom stock

The two main types of phantom stock are full-value phantom stock and appreciation-only phantom stock. 

Full-value phantom stock

As its name indicates, full-value phantom stock grants the full value of the underlying share of stock. At the end of the vesting period, the employee receives not only the value of how much their stock appreciated since the time of the grant, but the full value of the stock.

Here’s an example to make this more clear:

  • An employee named Sally is granted 100 shares of full-value phantom stock. At the time of the grant, each of these shares is worth $100.
  • Sally’s phantom stocks vest over a period of five years. In the course of that time, the value of one share of company stock rises from $100 to $150.
  • When she is fully vested, Sally receives a cash bonus of $15,000 (100 shares x $150). 

It’s worth noting that, with full-value phantom stock, the employee will end up with some money even if the price goes down. Let’s look at the example above. If the value of one share of company stock goes down from $100 to $50 in the same time period, Sally will receive a cash bonus of $5,000 (100 shares x $50) when she is fully vested. That’s a lot less than what she’d earn if the value of the stock rises, but it’s still something.

Appreciation-only phantom stock

Unlike full-value phantom stocks, appreciation-only phantom stocks only have value if the underlying stock’s price increases over the term of the vesting period. The employee typically receives a cash payout equal to the appreciation in the stock price from the time of the grant to the end of the vesting period. 

If there’s no appreciation in the stock price, it’s possible that the employee won’t receive any cash bonus at all. This is obviously not a great outcome for the employee! If it does end up being the case, the company may provide some other type of cash bonus or incentive as consolation—but this is not guaranteed if it’s not spelled out in the terms of the grant. 

Let’s look at an example of how appreciation-only phantom stock works:

  • An employee named Steven is granted 100 shares of appreciation-only phantom stock. At the time of the grant, each of these shares is worth $100.
  • Steven’s phantom stocks vest over a period of five years. In the course of that time, the value of one share of company stock rises from $100 to $150.
  • When he is fully vested, Steven receives a cash bonus of $5,000 (100 shares x $50).

Pros and cons of phantom stock plans

Phantom stock awards can be a solid basis for an employee benefit plan, but they don’t always make the most sense. Before you determine whether a phantom stock program makes sense for your company, here are some advantages and disadvantages to consider. 

Advantages of phantom stock plans

  • Phantom stock doesn’t dilute shareholder equity. If you’re a founder, you probably care about limiting the dilution of equity ownership across your cap table. Your company’s other shareholders probably care about this a lot, too! Phantom stock can be a great way to give employees exposure to the rise in your stock’s price without granting them equity that would dilute the value of your shares. 
  • It can help your employees feel bought-in to company success. At many public companies, an employee who wants to own stock must purchase that stock on the open market or in an employee stock purchase plan (ESPP). In the absence of other equity compensation, phantom stock is a way to give employees a “stake” in your company’s future without requiring them to buy their own shares.
  • It can supplement other, more restrictive types of equity. It’s not always easy to grant additional equity incentives to top-performing employees. Sometimes the shares just aren’t there, or the regulatory requirements are too onerous. Phantom stocks may offer a more flexible, less restrictive way to reward employees with something close to equity.

Disadvantages of phantom stock plans

  • Phantom stock may create outstanding liabilities that affect the value of your company. While phantom stock doesn’t dilute shareholder equity, it can still create outstanding liabilities that decrease the value of your company. This is assuming that the payout is in cash and not shares.
  • Taxes may be a pain for employees. The cash payout on a phantom stock plan is taxed at ordinary income tax rates in the year in which the phantom shares vest. Ordinary income rates are typically higher than the long-term capital gains rates an employee might qualify for with other types of equity, so they may be giving up more to the IRS than they otherwise would.
  • Less appreciation in the share value means less of a payout. This is basically true with any type of equity, including ordinary stock options. Still, employees with appreciation-only phantom stocks may be extra-bummed if they make it to the end of their vesting period and end up with no reward because the stock’s price didn’t rise. On the other hand, at least the employee doesn’t stand to lose any money from the transaction.

How to think about phantom stock as a startup founder

In the right scenario, a phantom stock incentive plan can benefit both the company and the employee. But there are other types of employee compensation you may want to consider as well, whether it’s traditional equity or something like Stock Appreciation Rights (SARs), which work similarly to appreciation-only phantom stock.

How much (and what type) of equity to offer can be a fine line to walk. You need to think about your company’s financials as well as your employees’ motivation and wellbeing. If you’re interested in learning more about equity and your options as a startup founder, schedule a call with a Pulley expert today.

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