1. What Is a Phantom Stock Plan?
2. How Do Phantom Stock Plans Work?
3. Why Issue Phantom Stock Instead of Actual Equity?

A phantom stock agreement, also called a phantom stock plan, is an employee benefit plan that provides certain employees many of the advantages of owning stock in the company without giving them actual stock.

What Is a Phantom Stock Plan?

Phantom stock is also known as shadow stock or synthetic equity.

Phantoms stock plans are contractual agreements between the following:

  • The employee
  • The company
  • An advisor
  • Any collaborator the company wishes to reward

Each unit of phantom stock equals one share of common stock.

In general, only selected employees are chosen to receive phantom stock, such as senior management. Phantom stock plans are deferred compensation agreements that award employees based on the value of the company stock. The award, since it's not actual stock, doesn't give employees any ownership rights in the company.

The agreement outlines a monetary reward at an agreed upon date or event in the future. The amount of the reward is tied into the company stock's market value at the moment of vesting. After a set time, participating employees receive the monetary value of the phantom stock.

Although the stock isn't real, phantom stock still follows the company stock's price movements, and payments will come from resulting profits. This type of stock experiences the same price changes as real stock and pays dividends.

There are no inherent restrictions or requirements on the use of phantom stock, so the company can use it in whatever way it chooses. The company may also change its phantom stock at its discretion.

How Do Phantom Stock Plans Work?

The phantom stock plan should outline how many units of shadow stock is granted to each participating employee. The company may choose to grant a percentage interest or a certain number of units. Either of these can be increased in installments.

For instance, the company might give an employee an initial five percent and then increase it to 10 percent after the employee works for the company for five years. The company may also include special forfeiture provisions in the plan to eliminate its obligations to pay out in certain circumstances, such as the employee committing a breach of non-compete or being terminated for cause.

As an example, consider the following:

A company gives an advisor phantom stock units with a four year vesting period. The value is equivalent to 1000 shares. When issued, the value of the shares is $1. In four years, at execution, the value is now $5.

The company doesn't want to make the advisor a shareholder with his 1000 shares, so it pays him the economic value of the shares. While the economic value is $5000, he receives $4000 as a final amount because he has to purchase the shares to receive the payment.

Why Issue Phantom Stock Instead of Actual Equity?

Providing employees with actual equity has some drawbacks when compared to issuing phantom equity. Companies may issue shadow stock for the following reasons:

  • They don't want to give employees shareholder rights, which may grant voting rights or other unforeseen minority rights, depending on state law.
  • They want to avoid the complexity and legal fees that may come from additional agreements, like shareholder agreements.
  • They're concerned about what happens to company shares given to employees that leave the company.

It normally costs less in accounting and legal fees to implement a phantom stock plan compared to a formal stock plan.

Having phantom stock plans is one way to share a stake in the company while avoiding the need for new “owners” to suffer taxable income or be required to invest cash. Mainly, however, it avoids the risks that come from having additional shareholders in the company. Key individuals in management may appreciate having an economic stake in the business, but they might not have any interest in being a company shareholder and all of the rights and obligations that come with the role.

Businesses choose various ways to reward employees, particularly those who serve important positions and/or have been with the company for a long period of time. If you're unsure if a phantom stock plan is right for you — whether you're the employer or employee — you can consult with financial professionals for advice.

If you need help with phantom stock agreements, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.