Phantom Stock: Everything You Need to Know
Phantom stock is an employee benefit where selected employees receive the benefits of stock ownership without the company giving them actual stock. 8 min read
What is Phantom Stock?
Phantom shares (phantom stock agreements) are an employee benefit where selected employees receive the benefits of stock ownership without receiving actual stock from the company. While not stock in the company, phantom stock is worth money just like real stock— its value rises and falls with the company's actual stock (or what the company is valued at, if it's not a publicly traded company). Employees are paid out profits at the end of a pre-determined length of time.
Also known as ghost shares, shadow stock, simulated stock, or phantom shares, phantom stock is often provided as a bonus for employees’ hard work and longevity. One form of phantom stock is Stock Appreciation Rights.
There isn't one exact one-size-fits-all definition of what phantom stock is or how companies use it. The term “phantom stock” can apply to any reward that takes time to mature. Usually, the award is for a specific number of units, or phantom shares, that follow the price of the company's actual shares — going up as the company is worth more and down as it's worth less.
Each phantom stock plan has a plan charter. This charter dictates the vesting schedule. If there are goals or tasks that participants must accomplish in order to vest, the charter outlines what these are and what the participants will receive. The charter also states voting rights, if any. If the phantom stock can be converted to actual shares in the company upon payout, the charter will outline how this is done. Having a well drafted plan charter is imperative for companies.
Why Do Companies Use Phantom Equity?
Awarding employees company stock can provide many benefits, including motivation to work harder because if the company is successful, its stock prices will go up. This system also encourages loyalty to a company: employees feel invested, which makes it less likely that they'll seek new opportunities elsewhere.
However, even with these incentives, phantom stock might be a better option for employers in certain situations:
- When there are legal concerns.
- When the company is unwilling to issue additional shares.
- To prevent diluting stock by giving it to many employees, which may influence voting control.
Providing phantom stock allows the company to reward employees for their hard work without worrying about those big problems.
Phantom shares are typically used to encourage senior leadership to produce better results for the company. The number of shares awarded usually depends on the leader’s place in the organization and how well their team has performed. Though the promise of the money is given today, the benefits are long-term—paying out after two, three, or five years, depending on the term that the company sets. As previously noted, the phantom stock can also be contingent on accomplishing a specific goal or task.
Form and Structure of Phantom Stock Agreements
There are two types of phantom stock agreements that most companies use:
- Appreciation only
- Full value
When companies use appreciation-only phantom stock, recipients don't receive the current value of real stock when they cash out their phantom stock. Instead, they receive anything above and beyond what the phantom stock was worth when it was granted.
For example, let's say that Bob was granted 500 phantom shares on June 5, 2020. When the shares were granted, they were worth $60.50 each. In order to receive the benefit of these shares, Bob needs to stay with the company for five years. At that time, on June 5, 2025, the shares are worth $85.25.
For each of Bob's shares, he'll get the difference between the current value ($85.25) and the initial value ($60.50), which is $24.75 per share. Multiply that by 500 shares, and Bob's bonus ends up being $12,375.
Where appreciation-only phantom stock pays out the difference between the shares' initial value and their current value, full-value phantom stock pays out exactly what it's worth.
For example, let's say that Mary is granted 500 phantom shares on June 5, 2020, for the company she works for. Coincidentally, the stock for her company is also worth $60.50 a share, and she also has to wait five years for them to mature. Once those five years have passed, the shares are (strangely enough) also worth $85.25.
However, unlike Bob's phantom shares, Mary's are worth the full value — which means she's paid out the full $85.25 per share and gets a bonus of $42,625. Go Mary!
Why Is Phantom Equity Important?
For employees, phantom stock rewards the time and effort they have invested into their company. When the phantom stock matures, companies will typically pay employees the cash value of the shares or, in some less often circumstances, convert the phantom shares into actual stock.
For company owners, phantom stock can help grow their business offering top employees a reason to stay and help the company succeed for the long-term. Strong leadership is essential to a company's success, and replacing senior leadership can be expensive and time consuming.
Phantom shares could be granted every year, even if they take five years to mature. This means that once leaders have been at the company for five years, they can expect to benefit from these rewards annually. On the other hand, if they leave the company before the shares mature, they will not receive any of those rewards.
Reasons to Consider Not Using Phantom Stock Plans
Phantom stock is not a good idea if the company is planning on issuing it to most or all employees, especially if the phantom shares will be paid out when the employee leaves the company or retires. In that case, phantom shares may be ruled illegal because of the Employee Retirement Income and Security Act (ERISA). Employee stock ownership plans (ESOP) and 401(k) plans are qualified plans that are considered legal under ERISA. However, ERISA prevents non-qualified plans from acting like qualified plans. Sometimes awarding phantom stock, especially if given to a large percentage of employees, may be seen as a non-qualified plan under ERISA.
Companies should also make sure they're in compliance with Internal Revenue Code Section 409A. This addresses executives that might be tempted to accelerate distributions because of knowledge that the company is nearing financial collapse. When setting up a phantom stock plan, Section 409A must be followed, which includes the guidelines for distributions and terms of the plan.
Phantom stock might not always be your best option. Phantom stock only benefits employees if the company grows; issuing phantom shares when you don't foresee growth in the near future could backfire and lower morale. Additionally, some employees may get more excited about having actual shares in the company, which can be kept for years to come, rather than having phantom shares.
Reasons to Consider Using Phantom Stock Plans
Despite some of the challenges associated with phantom stock, it is important to note that phantom stock definitely has its advantages. These advantages include:
- Little to no complications. Phantom shares are only paid out if the employee meets certain terms. If an employee leaves the company before those terms are met, the phantom stocks disappear. If the company had used actual stock, those would have to be repurchased, which would make things more complicated and potentially, more expensive.
- No voting rights. Since phantom shares are not the same as real stock, you don't have to worry about employees voting down key decisions, such as selling the company or changing leadership roles.
- Invested employees. Even without voting rights, employees will still be invested in the company because typically, when the company succeeds, stock prices (and therefore the value of phantom shares) will rise.
- Less expensive. Setting up a phantom stock bonus plan is much less expensive than setting up an ESOP, and when you're running a business, anything that saves you money is a good thing.
- More flexibility. Phantom stock plans can be used in privately held companies and public ones, in small and large companies, in LLCs and C Corporations, and even in non-profit organizations to some extent.
- No taxes are owed till the stocks mature. When company stocks are given to an employees, even if they have to hold onto them for a specific term, it's considered taxable income. Phantom stock doesn't have this issue and is not considered income until the bonus is paid out.
As long as phantom shares are created according to the applicable laws, including ERISA and IRS Code 409A, they bring a lot of advantages with them.
Frequently Asked Questions About Phantom Stocks
- What are the differences between phantom stocks and an ESOP? An ESOP is a qualified retirement program, similar to a pension plan. Though stocks are involved, the employee doesn't usually gain ownership of the shares. Instead, a specific number of shares are awarded to each employee, when that employee is ready to retire, the shares are cashed out. The value of those shares increases and decreases as company stock increases and decreases, because they are actual shares. All employees in a company are eligible for this plan, similar to a 401(k). Having an ESOP in place is like having a second set of owners that need to approve key decisions, which is not the case with phantom shares. Phantom stock is only given to a small percentage of employees. Most commonly, this group is the core leadership team. Here, the employee never actually owns shares, because the shares don’t actually exist. There is also more flexibility regarding how and when phantom stock can be cashed out. Until that point, phantom stock is not actually equity.
What are the differences between phantom stocks and stock appreciation rights? Stock appreciation rights (SAR) and phantom shares are very similar, but there are some key differences you should be aware of:
- SARs are for the amount of money equal to the increase in value of a specific number of shares over time.
- They may or may not have a specific date when they pay out.
- If they don't, employees can choose when they want to cash out once the shares vest.
- SARs don't offer dividend-equivalent payments.
- They are often granted along with stock options in order to help finance the purchase of options or to pay tax if any is due.
There's a lot of flexibility when it comes to SARs, which means that there are also a lot of decisions to make with things like vesting rules, eligibility, and who gets how much. The main difference between SARs and phantom shares is that phantom shares have the possibility of offering dividend-equivalent payments. Additionally, phantom shares can be dependent on performance criteria.
What companies should consider a phantom stock program? If you're unsure whether a phantom stock program is right for your company, here are some key things to consider:
- Does your company expect growth? The only way that this program will work is if growth is expected in the coming years.
- If there is projected growth on the horizon, will it work to share 5 to 15 percent of that growth with employees?
- Will the amount of money that you are able to share be enough that it is meaningful to your employees?
- Are there key employees who are essential to the successful growth of your company?
Once you've considered the answer to these questions, you should have a better idea of whether a phantom stock program would benefit your company.
- What happens to phantom stock if the company is sold? If a business is sold, employees that own phantom stock receive money that is equal to the amount they would have received had they owned actual stock in the company. For that reason, it's financially beneficial to employees to own phantom stock, as they don't need to worry about dilution.
- Do phantom stocks take dividends into account? It depends on how the phantom stock plan is set up, but they definitely can include dividend payments to phantom shareholders, which is a great benefit to owners of said phantom stock.
If you need help with creating a phantom stock program or just have questions about how phantom shares work, post your question or concern on UpCounsel's marketplace. The lawyers at UpCounsel come from law schools that include Yale Law and Harvard Law and have an average of 14 years of legal experience. These lawyers are the top 5 percent of lawyers, and have worked with or on behalf of companies such as Menlo Ventures, Google, and Airbnb.