What Is Phantom Stock? A Non-Dilutive Equity Alternative Explained
Phantom stock is an increasingly popular compensation tool that allows companies to incentivize and retain employees without giving up actual ownership. For private companies in particular, phantom stock provides many of the benefits of equity-based compensation while preserving control and avoiding dilution. A skilled business attorney or general counsel can help you structure and implement an effective stock program.
What Is Phantom Stock?
Phantom units of stock are essentially a profit sharing device that incentivizes employees and participants to stay with a granting company until certain triggering events occur. Like common stock, phantom units generally increases in value as the granting company increases in value. When stated triggering events occur, such as sale of the company, the holder of phantom stock will receive a payout.
Unlike traditional equity compensation, phantom shares grant no ownership rights, such as voting or dividends. This means founders and shareholders retain full control, making phantom shares especially attractive to closely held or private companies.
Types of Phantom Share Plans
There are two main types of phantom stock plans:
Appreciation-Only Plans
Employees are paid the difference between the current value of the stock and its value on the grant date.
Example: If 1000 units are granted at $1 and the value rises to $10, the payout is $900 (1000 × $9).Full Value Plans
Employees receive the entire current value of the stock units, including the original value and any appreciation.
Example: With the same values, the payout would be $10,000 (1000 × $10).
How Payouts Are Structured
Phantom shares are typically paid in cash when certain conditions are met, such as:
Vesting: Employees must often meet time or performance-based milestones.
Triggering Events: Common triggers include an IPO, acquisition, or a specified payout date.
Note: phantom share payouts are taxed as ordinary income, which may result in higher taxes compared to capital gains from actual equity.
Key Benefits
Phantom share plans offers several advantages for both employers and employees:
- No Dilution: Companies can incentivize employees without issuing actual shares or changing the cap table.
- Alignment with Performance: The value of phantom stock units rises and falls with the company’s valuation, tying rewards to performance.
- Retention & Motivation: Vesting schedules and performance goals encourage long-term commitment.
- Flexibility: Plans can be customized to meet a company’s unique goals, without the legal complexities of issuing equity.
Disadvantages
The primary disadvantages of phantom share plans are as follows:
- No Ownership or Control: Employees don’t receive voting rights or dividends.
- Higher Tax Burden: Payouts are generally taxed as ordinary income.
- Liquidity Risks for the Company: The company must have the cash to make payouts, which can become a financial liability.
- Perception Gap: Because no shares are issued, employees may perceive less ownership or influence.
Is Phantom Stock Right for Your Company?
Phantom stock is ideal for private companies that want to attract top talent without giving up ownership or board seats. It aligns employee incentives with company performance and offers flexibility in structuring compensation packages. However, businesses must carefully plan for future payout obligations and understand the tax implications. Contact a business attorney for more information.
About
Attorney Collier started his own law firm straight out of law school and has been practicing law in Ohio for 5+ years. During that time, Joe focused on business law and litigation, gaining some exposure to intellectual property law. While running his firm in 2021, Joe decided to go back to school and get his patent license. Since then, Attorney Collier has been focusing on protecting innovators and entrepreneurs through his expertise in intellectual property and business law.