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A phantom equity is a legal strategic compensation plan that awards employees the cash equivalent of a fixed number of shares multiplied by the current price. This award mirrors the stock price, often tracked as fictitious units or 'phantom' shares. These plans, designed with high flexibility, are primarily aimed at senior executives and key personnel.

Pros and Cons of Phantom Equity

Phantom plans can boost employee motivation and tenure by using a "golden handcuff" clause to deter important employees from leaving the company.

Phantom stock-based compensation plans have many benefits that exceed the drawbacks, like any business endeavor. However, there are a few possible issues.

Relative Shortcomings

Any employer considering implementing this type of equity-sharing plan should consider a few of these issues.

  • Need for Sufficient Funds: When vesting occurs, employers must ensure sufficient funds to distribute the money to employees when the vesting period expires. Overlooking the fact that there could be adverse implications, it is important to remember that giving more phantom shares than you can afford to pay out would have some drawbacks.
  • Expensive Process: The DOL and the company's shareholders must be informed of phantom stock plans. Completing an annual third-party valuation is important for the participants to comprehend and monitor the value of their accrued equity more effectively. Although it can be done affordably, there will always be expenses involved.
  • Less Control: Employees have less control over the program than in the scenario where they receive stock options and voting rights as shareholders.
  • Cannot Claim Bonus: Employees cannot claim this bonus as capital gains on their taxes because they only receive the cash equivalent of the number of shares.
  • High Risk: Investors in appreciation-right plans could lose everything if the stock declines or does not rise.

Rewards

Businesses and the employees they choose to grant phantom equity undoubtedly benefit from it, even though there may be drawbacks for employers and workers.

  • Highly Flexible: Employers can also use phantom equity plans, highly flexible compensation options, to retain and incentivize key personnel while encouraging them to behave and think more like owners. Phantom stock, also called synthetic equity, is used any way the organization sees fit and has no inherent limitations or requirements. Additionally, the phantom stock may be modified at the leadership's option.
  • Succession Plan: Although these plans are not intended to be a succession planning solution, they can have features that eventually make a phantom equity plan seamlessly integrate into the firm's overall succession plan.
  • Equity Distribution: Another advantage for the employer is that equity can be distributed without requiring the sharing of earnings, decision-making authority, or the company's financial records.
  • Meeting Objectives: Employers can ensure that specific objectives are met in return, and they will not have to buy back actual shares if an employee quits or is fired before the vesting period ends.

Types of Phantom Equity Plans

An effective tool for upper management is a phantom equity plan, also known as "shadow stock." This type of pay gives the advantage of having company stock without requiring any shares to be transferred or owned. Because of this special characteristic, management can match shareholder interests with their own without reducing equity.

There are two primary categories of phantom equity plans:

  • Appreciation Plan: The plan participant receives a cash payment for the difference between the issued price of the phantom equity and the company's stock price at redemption. Assume, for instance, that the phantom equity's issuance price is $20. The company's share price was $50 at the time of redemption. The cash payment per phantom equity would be $30.
  • Full Value Plans: A cash payment equivalent to the phantom equity's underlying asset's (common stock) value is made to the plan participant upon redemption in a "full value" phantom equity plan. For instance, the company's common share price was $40 at the time of redemption, while the phantom equity was issued at $10. There would be a $40 cash payout for each phantom share. Phantom equity ensures that ownership is not diluted for other investors. This mechanism demonstrates the company's dedication to equity distribution and fairness by simulating stock ownership without actually granting it. However, large cash payments to employees may occasionally interfere with the company's cash flow because they are taxed as ordinary income rather than capital gains to the recipient. Instead of receiving real stock, the employee is given mock stock. Despite not being real, the phantom equity pays out any profits from tracking the price movement of the company's stock.

Knowledge Tip: For detailed information on the phantom equity plan, watch this video.

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SARs vs. Phantom Equity

SARs and non-qualified stock options are similar in many ways, including how they are taxed. However, stock option holders are not given shares of stock; instead, they are given stock shares, which they must sell and use the proceeds to cover the amount they were originally granted. SARs are always awarded in the form of actual stock shares, but the quantity of shares awarded is only determined by the total gain realized by the participant between the grant and exercise dates. Similar to various other types of equity compensation, SARs are transferable and frequently governed by clawback clauses.

Phantom stock-based programs resemble stock appreciation rights (SARs). They are a type of bonus payment made to staff members equivalent to the growth in company stock over a predetermined period. Employee stock options (ESOs) and stock-based rewards (SARs) benefit employees when stock prices rise.

The main distinction between the two is that employees with SARs do not have to pay the exercise price; instead, they receive the full increase in stock or cash.

  • SARs can serve as a retirement plan component and are typically provided to upper management. As the company’s worth goes up, it increases its incentive packages. Also, this can help retain employees, especially when there is internal turmoil, such as a change of ownership or a personal crisis.
  • Typically, employees find comfort in the fact that phantom stock programs are usually supported by cash. This could result in higher selling prices for a company if a potential buyer thinks that the upper management team is stable.

Key Terms for Phantom Equity

  • SRAs: Stock appreciation rights are a kind of remuneration for employees based on the price of the company's stock for a set amount of time. Employees benefit from SARs when the company's stock price increases.
  • Clawback: A clause in a contract requires money that has already been given to an employee to be returned to the employer or beneficiary, sometimes with interest.
  • Benefactor: A benefactor is a person who contributes funds or other aids to somebody, a group, or an organization.
  • Golden Handcuffs: These are some money incentives aimed at persuading workers to remain within the same organization for a specified period.

Final Thoughts on Phantom Equity

Phantom equity refers to a kind of compensation award where the recipient is not granted actual ownership in the company but rather is referenced to equity. These awards go by many names, but the secret to comprehending them is realizing that they are nothing more than cash bonus plans, the amounts of which are set by the company's stock. Although phantom equity can have substantial value, employees may view it less favorably due to the contractual nature of the promises. Owning a portion of something is more appealing than purely discretionary bonus plans, which is how phantom equity plans can be set up.

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ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.


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