Phantom stock (aka “shadow stock”) is a convenient way to reward and incentivize employees without issuing any equity to them or diluting other stockholders. Phantom stock plan can be beneficial to both the startup and its employees for reasons outlined below.
What is phantom stock?
Phantom stock is very similar to a regular stock option plan but the main difference is that under a phantom stock plan, the grantee does not receive any actual stock. Instead, they receive cash at a designated future time or event (usually liquidity). The amount of the payout is tied to the market value of the company’s stock at the moment of vesting (e.g. the sale of the company). A typical Phantom Stock Agreement may, thus, provide for a payout of “an amount equal to ____ percent of the net amount received for the assets or stock of the Company upon the sale of the Company.”
So, the company can issue phantom stock to key employees without actually giving them any stock. At the time the company is sold, the grantee receives a cash payout equal to an agreed upon percentage of the company’s stock. Phantom stock plans may also provide for dividends, or not. The payout is usually subject to the grantee’s continued employment with the company and/or achievement of certain milestones.
Benefits to the company
For businesses, the main benefit of phantom stock is that its recipients do not become shareholders of the company. They do not get voting rights, they cannot petition for involuntary dissolution (like shareholders can) of the company. At the same time, employees are motivated to contribute to increasing the value of the shares because that will increase the employees’ payout. Phantom stock agreements are not difficult to draft and there are less tax complexities involved. A properly drafted phantom stock plan will be exempt from subjection to Section 409 of the Internal Revenue Code, which regulates conventional non-qualified plans, deferred-compensation plans.
Benefits to employees
Grantees benefit from phantom stock plans because phantom stock can be non-taxable until it is actually paid out. Receiving real (not phantom) shares in exchange for services, on the other hand, is taxable income at the time the shares are granted. For tax purposes, phantom stock is treated as deferred cash compensation. When the recipient actually receives cash, the payout is then taxed as ordinary income to the recipient but deductible to the company.
“Appreciation only” vs “full value” plans
The two main kinds of phantom stock plans are “appreciation only” plans and “full value” plans. Appreciation only plan only pays out if the shares increase in value after the phantom stock has been granted. Otherwise, grantee does not receive any cash. “Full value” plan pays regardless of whether the stock value goes up or down.