Phantom stock is a contractual agreement between a corporation and recipients of phantom shares that bestow upon the grantee the right to a cash payment at a designated time or in association with a designated event in the future, which payment is to be in an amount tied to the market value of an equivalent number of shares of the corporation's stock.
Phantom stock is a form of compensation that gives selected employees the benefits of stock ownership without actually giving them any company stock¹. It is also known as shadow stock or synthetic equity. Phantom stock can be used to incentivize and retain employees, align their interests with shareholders, and avoid diluting the equity of other shareholders². Phantom stock can also be used by startups to reward prospective contributors to their success without issuing actual shares².
One possible scenario when phantom stock can be used is when a company wants to reward its senior management for increasing the value of the company over time. The company can grant phantom shares to the managers that are tied to the market value of the company's stock. The phantom shares will vest over a period of time or upon meeting certain performance goals. When a payout event occurs, such as a change of control or a liquidity event, the managers will receive a cash payment equal to the value of their phantom shares at that time².
This way, the managers are motivated to grow the company and share in its success, but they do not have to deal with the tax implications or the risks of owning actual stock. The company also does not have to issue new shares or dilute its existing shareholders¹.
Some of the advantages of phantom stock are:
- It can provide financial gain to employees without issuing actual shares or diluting the equity of existing shareholders¹.
- It can increase employee productivity, loyalty, and alignment with the company's goals¹².
- It can offer an easy exit mechanism for employees who leave the company or retire, as they can receive a cash payout for their phantom shares¹.
- It can be non-taxable for employees until the payout event, such as vesting, retirement, or change of control¹².
- It can be flexible and customized to suit the needs and preferences of the company and the employees²³.
Some of the disadvantages of phantom stock are:
- It can create a cash flow problem for the company when it has to pay out large amounts of cash to employees at the payout event²⁴.
- It can be taxed as ordinary income for employees rather than capital gains, which may result in higher taxes²⁴.
- It does not give employees any voting rights or ownership stake in the company, which may reduce their sense of involvement or commitment²⁴.
- It may not be as attractive or competitive as actual stock options or other forms of equity compensation for employees who seek more tangible rewards⁴.
(1) Phantom Stocks: All Pros and Cons Analyzed - trica equity blog. https://www.trica.co/equity/blog/phantom-stocks-pros-and-cons/. (2) Introduction to Phantom Stocks and SARs - Investopedia. https://www.investopedia.com/articles/stocks/12/introduction-phantom-stock.asp. (3) Phantom Stock – What exactly is it and How does it work?. https://eqvista.com/phantom-stock/phantom-stock/.
(4) Phantom Stock Plans vs. Equity: How It Works | Pulley. https://pulley.com/guides/phantom-stock-plans.
(1) Phantom Stock Plan: What It Is, How It Works, 2 Types - Investopedia. https://www.investopedia.com/terms/p/phantomstock.asp. (2) Phantom stock - Wikipedia. https://en.wikipedia.org/wiki/Phantom_stock.