Phantom Stocks: All Pros and Cons Analyzed

Employees are the pillars of every company. And offering benefits to employees like company stocks is a great way to retain talent. Such compensation is mainly beneficial for startups that cannot offer competitive salaries to compensate for the employee’s experience and skill. This comes under the employee equity plans, which also include other schemes like ESOPs.

So if you want to retain some senior-level employees and stop them from eyeing other opportunities, it’s time to understand how you can steer away from the usual salary increment route and opt for phantom stocks.

Phantom stocks could be the bridge to establish a profitable arrangement both for your employee and your company.

What is a Phantom Stock Options Plan?

Phantom stocks are types of compensation that are primarily meant for senior-level employees. Under this plan, employees enjoy the benefits of stock ownership. However, these stocks are hypothetical.

Meaning, phantom stock options have the characteristics of regular stock. It’s worth money, and the price keeps fluctuating according to the market. But employees gain from the profits of the stock price change only after a fixed and agreed-upon tenure. These stocks, also known as ‘shadow stocks,’ do not give the employees voting rights or even a say in the decisions taken for and by the company. They only reap financial benefits.

Each phantom stock plan contains an agreement that outlines the plan’s vesting timeline. Each rule would be outlined in the agreement, including the goals or tasks that a participant must complete before the shares can vest.

It also describes these goals and what is delivered to participants once they have met their objectives.

What are the Different Types of Phantom Stock Options?

There are two types of Phantom stocks: Appreciation Only and Full Value.

1. Appreciation Only

Under this type of phantom stock, the employees only get compensated with the stock’s appreciated value. This means that at the time of cash settlement, they will receive the difference between the current value and the value of the stock when it was granted.

Also read: Experts Discuss: 5 Must-Knows on Incorporating in the United States

2. Full Value

As the name suggests, employees who are given full value phantom stocks get the entire value of the stock as compensation when the cash settlement is released.

It must be noted that both types of plans are similar to traditional non-qualified plans in many ways. Vesting schedules in phantom stock plans are usually dependent on tenure or the achievement of specific goals or tasks outlined in the plan charter.

This document also specifies whether participants will receive monetary equivalents in the form of dividends or voting rights.

So far, we’ve discussed the nature and types of phantom stock options. Now, let’s dive into the pros and cons of employee stock options.

What are the Pros of Using Phantom Stocks?

There are several benefits of using phantom stocks. They are:

1. Financial Gain at Zero Debt

By transferring the value of stocks of the company, employers save a lot on their employee wages. This means they get to retain quality talent without having to drain their financial resources.

At the same time, phantom stocks do not mess with existing shareholders’ control over the company.

Also, under the phantom stock scheme, employees receive the value of the stock as compensation and not the stock itself. Hence, there are no chances of equity dilution.

2. Increased Employee Productivity

Implementing phantom stock pros the company in terms of its human resource in two ways:

• The employees work with renewed enthusiasm which leads to an increase in overall productivity.
• Furthermore, with better compensation, the employees stop looking for other opportunities. This is a rather significant advantage of phantom stocks.

Every company needs experienced, senior-level employees in managerial and leadership-related positions. But financing these talents and retaining them is pretty expensive, and that’s where phantom stocks step in.

The best part here is that when you transfer real stocks to an employee, they also have the right to vote in your organization’s decisions.

However, since phantom stocks aren’t real, you get to increase their productivity and loyalty without giving them the right to vote.

3. Easy Exit Mechanism

Phantom stocks provide an easy exit mechanism in comparison to ESOPs. Since they are not actual stocks, there is no hassle of repurchasing them from the employee or from the secondary market where an employee may sell the shares.

Employees cease to reap the benefits of phantom stocks once they leave. You might feel that this might bother employees, but no, their profits aren’t compromised here.

Also read: What Is the Right Time to Exercise Stock Options?

Unlike ESOPs, phantom stocks are much more flexible, and they do not have to wait till their retirement to access the cash benefits.

They can do so even while they are in the service. Here, the employees are only given financial help if they meet specific requirements. Once they leave, the economic benefits stop, simple.

4. Non-Taxable Before Maturity

When employees hold equity shares for a specific period, it comes under the company’s taxable income. However, when you issue phantom stock to your employees, it will be exempted from tax until the stock matures.

However, even when it matures and you have to release the cash settlement, the tax for the transaction will be governed by the guidelines set for the salary income head.

What are the Cons of Using Phantom Stocks?

Like every other aspect, there are certain drawbacks of using phantom stocks as well. They are:

1. You Need to Have Cash in Hand During Settlement

No matter how things are looking for your company when settling employees’ cash benefits, it would help if you had the financial means to compensate them.

Unlike real stocks, phantom stock options only benefit employees through monetary compensation. And if you fail to pay them, they have all the rights to take a legal course of action against you.

2. You Need to Pay for Third-Party Stock Valuation

In case you need to opt for a third-party stock valuation, you alone will have to bear the charges of the advisory firm. Since your company implements the phantom stock scheme, your entitled employees cannot share the cost.

3. Capital Gains Treatment Does Not Apply to Phantom Stocks

Since phantom stocks aren’t real stocks, your employees will miss out on quite a few benefits with Phantom stocks. Regular stocks undergo capital gains treatment under which you will be required to pay a tax on the profit you made from the sale of the stock.

However, phantom stocks aren’t real and they only benefit the employee financially. Hence, it gets taxed as ordinary income and your employee has to pay that.

The disadvantage here is that capital gains have lower tax rates than regular income. So although you will be saving on capital gains tax, your employee will have to pay a tax on the extra benefit. This might give them second thoughts about the arrangement and reconsider if it’s worth it.

Final Thoughts

You can see that the downsides of phantom stocks are outnumbered by the benefits they bring along. And there is no doubt that they act as an excellent tool to motivate and retain employees.

So if you want to scale your business by compensating your senior-level employees, who hold key positions in your company well, then reach out to us to request a demo and take your business to new heights.

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