Why Are Phantom Stocks Better Than Actual Stocks?

Phantom stocks, also called Shadow stocks, are hypothetical, yet enjoy the same value as actual stock. Shadow stocks are an effective and powerful motivator for higher management employees or top performers who already receive high compensation. These plans are instrumental in retaining employees and inspire and encourage them to strive harder for company growth, as the value of their shadow stock is linked to the better performance of the organization..

This article will explore the key details of phantom stocks and why they perform better than actual stocks.

Phantom Stocks: An Overview

A phantom stock plan is a mode of compensation in which the

employees receive phantom shares that track the value of actual stocks. They are not equity in the true sense; however, their value rises and falls like the company’s equity shares.

Just like phantom mirrors the outline of the real figure, phantom stocks mirror the value of actual shares. Employees who receive phantom shares benefit from the growth of the value of the underlying company stock without owning any stock.

These plans can also be described as deferred employee compensation plans where the owner of these shares receives benefits similar to equity ownership without the company issuing them equity shares.

Shadow stocks share some similarities with actual stocks. Their price fluctuates like actual equity share prices. Shadow stock plans provide participants with no voting rights and offer only financial benefits to the holders after a fixed, agreed-upon term. The phantom stock agreement details the vesting timeline and the goals for the employee before the shares can vest.

Types of Phantom Stocks

1. Appreciation-only stocks

In this variant of phantom stocks, the employee receives cash equal to the difference between the company’s equity price at the time of redemption and the issue price of the phantom stock.

For example, if the issue price of the shadow stock was Rs 100, and at the time of redemption, the share price was Rs 150, the employee will receive Rs 50 per share.

2. Full-value stocks

In the full-value stock plan, the employee receives cash equal to the actual value of the equity at the time of redemption.

For example, if the issue price of the shadow stock was Rs 100 and, at the time of redemption, the share price is Rs 150, the employee will receive Rs 150 per share.

Advantages Of Phantom Stocks Over Actual Stock Plans

Founders can issue different variants of Employee Stock Options (ESOPs), Compensation Plans, Incentive Plans, and Employee Stock Purchase Plans, but shadow stocks are the most popular choice.

Phantom stocks allow founders to share ownership but mitigate the risk that comes with it.They are equally beneficial for founders, employees, and shareholders.

Here is a list of the top advantages of phantom stocks:

1. Zero dilution of founder and shareholder equity

Business founders and shareholders would not want to dilute equity ownership. Phantom stocks allow employees to benefit from growth in equity value without reducing the founder’s or the shareholders’ share value. The issue of actual shares leads to a dilution of ownership for the founders and the shareholders.

2. Lesser formalities and paperwork

The issuance of phantom stocks, unlike actual equity, requires no transfer of shares, which means less paperwork and formalities. SEBI’s Employee Benefits Regulations or the Companies Act, 2013, do not have details or rules regarding phantom stocks; this also reduces the paperwork or  legal tangles.

3. Flexible and less restrictive

Granting additional equity incentives to employees is not always possible due to punishing regulatory guidelines or simply because there are no shares to be given. Phantom stocks are a way to reward employees in a less restrictive and more flexible option compared to real stocks.

4. Founders retain control over decision-making

Employees who are issued phantom shares do not have voting rights, whereas equity shareholders can vote. Issuing phantom shares poses no threat of the founder losing control of the decision-making process.

5. Better employee management

Employees work with enhanced dedication and loyalty as they feel recognized; they know they will benefit if the company does well. Companies can structure the phantom stock plans to motivate the employees to stay longer with the organization.

Entrepreneurs can share ownership with high-performing and critical team members and add to their compensation without adding to the company’s payroll.

6. Benefits employees

Phantom stocks offer benefits for employees as they are contractual agreements and require minimal documentation. With no binding regulations, they pose no legal hassles for employees.

Employees do not have to pay taxes on them annually; they have to pay taxes at maturity. Shadow stocks give a sense of ownership to employees. They become stakeholders in the organization’s performance; the prospect of monetary growth encourages them to stay with the company for longer.

7. Offer easy exit

Shadow stocks allow for an easy exit compared to real stocks. As no actual shares are issued, there is no need to repurchase them from the employees or the secondary market, where the employees may sell their equity.

Conclusion

Phantom stock plans can benefit both employees and founders in the appropriate scenario. Benefits like committed and motivated employees, lesser formalities, non-dilution of equity, and control for founders make it a win-win proposition for all parties.

However, which equity plan to offer employees and how much to offer can be a tricky call for a start-up; trica equity can assist you in your decision-making process.

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