What Is Phantom Stock and How Does It Work?

There's Nothing Scary About Phantom Stock

Coworkers discussing their employee compensation packages
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Some companies offer senior employees benefits packages that include phantom stock. With these offerings, the employee receives some of the benefits of owning shares without having actual ownership of company stock.

Ghosts roam among the trading pits on Wall Street but not in the form of goblins and specters more traditionally celebrated on Halloween night. No, these ghosts are a different variety of spirits, in the form of so-called “phantom” stocks that are becoming increasingly pervasive in the employee compensation sector.

Companies as diverse as Publix Supermarkets, Saatchi & Saatchi, and Proctor & Gamble offer—or have offered—employees some form of phantom stock ownership as part of their employee compensation packages. Expect more firms to follow as they realize the possible benefits of implementing phantom stock for employee compensation campaigns.

Phantom Stock Defined

Phantom stocks are a form of employee compensation that gives employees access to stock ownership without actually owning the stock. Like any genuine stock, phantom stocks rise and fall in value in line with the underlying company stock, and staffers are compensated with profits incurred from any company stock appreciation on specific dates.

Usually, the number of phantom shares given to an employee or manager depends on that person’s perceived value to the company. The higher that employee is valued, the more shares of phantom stocks they are likely to receive.

When phantom stocks are awarded, a “delay mechanism” kicks in, where the actual financial payout is made after a long period. Two to five years is common for a phantom stock payout. However, it depends on the agreement made between the company and the employees.

In that regard, companies use phantom stocks both as a motivational tool to reward employees and to give those employees “skin in the game” to increase workplace productivity and earn the company more profits—a formula that drives the company’s stock price higher, as well.

Types of Phantom Stock

When implementing phantom stocks as employee stock compensation, companies tend to use either “appreciation only” phantom stocks or “full value” stocks.

Appreciation Only

Appreciation stocks bar recipients from garnering the current value of phantom stock. Instead, recipients earn any profit—such as stock price appreciation—that the phantom stock might earn over a specific period.

For example, if employee “A” were to receive 1,000 shares of phantom stock, with each stock worth $20, the current value of the company stock would be $20,000. Under the terms of the agreement, the employee must stay with the firm for five years, for example, to benefit from the phantom stock deal. This timeframe requirement is known as the “vesting” period.

At the end of the vesting period, the company’s stock has risen to $40 per share. Under that scenario, employee “A”, after the five-year period was up, would receive the difference between the $20 per-share current value of the stock on the date when the deal was struck, and the $40 per share on the date when they become entitled to any profits from the stock—$20 per share. That would give the phantom stockholder a profit of $20,000.

Full Value

Under a full value phantom stock deal, the recipient earns both the current value and any stock price appreciation once the due date is reached.

In the above case, employee “A’ would receive the $20 per share price increase after five years. However, they would also earn the current price appreciation on the shares since the date when the deal commenced.

Using our same example as above, this value would also amount to $20 per share—on a stock that’s trading at $40 per share. At 1,000 shares of stock, that would give the employee $40,000 after the five-year vesting trigger date.

Pros and Cons of Phantom Stock

As the case with any financial investment instrument, there is no shortage of positives and slightly fewer negatives with phantom stock deals.

Pros

Phantom stocks are a solid motivational tool to both keep key employees on board for the entire vesting period, but also to boost employee productivity. After all, when the phantom stock price appreciates, the recipient benefits, too. For employers, that’s a true win-win.

By sticking to the phantom stock script, actual company stockholders don’t see their shares diluted in value, as shadow stocks aren’t the same as regular company stocks.

For employees, there’s no need to actually purchase phantoms stock shares as regular stockholders must do on the open market. Instead, phantom shares are given to employees with no money changing hands. That’s a big benefit to employees, who share in the stock's profits without having to pay for it.

Company control of phantom stocks is advantageous to employers, as well. Under a typical phantom stock charter or contract, companies can dictate the structure of the agreement. For example, the company can control the level of equity participation in the form of dividends paid out to employees. Also, companies can include provisions in a phantom stock agreement that “forfeits” any phantom stock benefits if the employee in question departs the company before the agreed vesting completion date.

Cons

Companies that implement phantom stock plans can incur additional costs, particularly if any stock valuation overview needs to be completed by an outside accounting company.

For employees, the company calls all the shots in a phantom equity deal, giving them little control or maneuverability if the share price goes south. They also may be terminated before the deal triggers, over issues outside the employee’s control, leaving them out of luck on collecting any phantom stock cash benefits.

Taxes factor into phantom stock deals, too. For example, companies must strictly adhere to the Internal Revenue Service’s (IRS) Tax rule 409A statute, which limits a company’s options in instituting distribution dates, and also blocks employees and managers from accelerating phantom stock payouts, if they deem the company to be in severe financial stress.

For employees, phantom stocks come with limits that normally are par for the course for regular company stockholders. For instance, phantom stockholders hold no right to vote, and may not be eligible for dividends, dependent on the deal’s structure.

Key Takeaways

Phantom stock plans can be both a good employee motivation tool for employers and a solid cash incentive plan for employees. If events go sour and the stock price doesn’t appreciate, neither the employer or employee loses any money directly in the deal.

That provides more upside than downside for phantom stock plans—an increasingly valuable financial tool at a time when employee retention is key, and when the stock market is on a general upward trend.