What is a Phantom Stock?
Phantom stock is incentive compensation or an employee benefit where the employee receives the benefit of owning a stock without the company giving them the stock in reality. It is an amount that the employer promises to pay to its employees in the near future.
- The near future can be treated as a certain number of years or retirement of an employee, employee attaining a certain age, or by changing the ownership of the company.
- These stocks are similar to actual stock, where its value rises and falls as compared to that of actual stock of the companies;
- Companies use it as a motivational tool for retaining its employee or its top-level executive by promising a cash benefit to the employee at some point in the future, where it is subject to a substantial risk of forfeiture in the meantime.
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Types of Phantom Stocks Plan
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#1 – Appreciation Plans
Companies use this particular plan when the employee doesn’t receive the current value of the stock. Instead, they receive the appreciated value of the stock. Companies are, therefore, able to negotiate with the employee for their working tenure in this particular plan.
Consider the following Example:
Let say Aindrilla was granted 700 shares on May 5, 2013. These shares were worth $43.50 each. Cinderella was asked to stay in the company for the next 6 years. Thereby she will be able to rip the benefits of these shares. On May 5, 2019, the value of these shares was $55.30 each. For each share of Cinderella, she will get the difference of the current value ($55.30) and the initial share value ($43.50), which is $11.8 per share. Multiply the difference with 700 shares. So Cinderella ends up with a bonus of $8,260.
#2 – Full Value Plans
Full Value plans pay out the exact value of the share i.e., the exact worth. Whereas an appreciation plan of phantom stock payout the difference between the initial shares and their current value.
Consider the following Example:
Alex was granted 700 shares on May 5, 2013, form the company where he works. The value of the stock was $43.50 per share. Alex was asked to be with the company for 5 years. After Alex completed his tenure with the company as the five years passed, the share value rose to $55.30 each. The amount that Alex holds now in full value phantom will be $33,180 as he is paid out the full amount.
Advantages
- It is a motivational tool and fostered retention as well as there is no investment need for the employee’s side.
- The ownership of shares for the employer is not diluted.
- It is inexpensive to implement, administrate, and it is structured to meet any number of company needs.
- If necessary, plans may contain a conversion feature that enables employees to receive actual shares of stock instead of cash.
- Companies can control the equity participation of employees through dividends paid out to employees. Companies can have a “forfeits” agreement towards the stock allotted through the phantom stock plan to the employee if he/she depart early before the agreement.
Disadvantages
- During due time employers must have sufficient cash on hand to pay benefits.
- Employers can incur an additional cost if the overview of stock valuation is needed to be completed by an outside company.
- To all true shareholders and the SEC, if the company is publicly traded, employers must report the status of the phantom stock plan at least annually to all participants.
- All benefits are taxed as ordinary incomeOrdinary IncomeOrdinary income refers to an individual's or business entity's earnings that are taxable at the regular rates. Such earnings include salary, wages, rent received, royalty, commission, interest received, profit, etc. It excludes all incomes with tax deducted at source and capital gain.read more to employees – as the benefit is paid in cash, capital gains treatment is not available.
- Participants who are in “appreciation-only” plans may not receive a thing if the company stock does not appreciate it at a price.
- For employees, the employer can take a call in the phantom equity deal by giving little control to the employee if the shares drop in price. They may also terminate the deal.
Limitations
- Companies need to make sure that they comply with Internal Revenue Code Section 409A
- A phantom stock plan is a costly form of long-term incentive in that it requires a charge against the company’s income statement.
- It is potentially an “uncapped liability” to the company.
- For executives, phantom stock rights do not represent a true ownership position in privately held companiesPrivately Held CompaniesA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. read more that do not have publicly traded shares.
- Phantom equity shares do not carry voting rights or similar rights associated with stock ownership.
Conclusion
Phantom stock plans can be both a good employee motivation tool for the company and a solid cash incentive plan for employees. Even if an event goes otherwise and the stock price doesn’t appreciate, neither employer nor employee loses any money directly in the deal.
It provides more upside than downside for phantom stock plans, an increasingly valuable financial tool at a time when employee retention is vital, and when the stock market is on a general upward trend.
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