Phantom stock is offered by some companies to senior employees, giving them some financial benefits of owning shares without having actual ownership of company stock.
What Is Phantom Stock?
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 stock's value rises and falls in line with the underlying company stock, and staffers are compensated with profits incurred from any company stock appreciation on specific dates.
Phantom stocks are becoming increasingly prevalent in the employee compensation sector as part of a total compensation package and are not restricted to tech companies. Some companies tie the award to specific performance goals.
- Alternate name: Shadow stock
How Phantom Stock Works
Usually, the number of phantom shares given to an employee or manager depends on that person’s perceived value to the company. The more that employee is valued, the greater the number of 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.
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.
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.
An appreciation stock will bar recipients from garnering the current value of the 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. Let's say under the terms of the agreement, the employee must stay with the firm for five years to benefit fully 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” would receive the difference between the $20-per-share value of the stock on the date when the deal was struck and the $40 share price on the date when they become entitled to any profits from the stock five years later. The appreciation is $20 per share. That would give the phantom stockholder a profit of $20,000.
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.
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.
Phantom stocks are a solid motivational tool to keep key employees on board for the entire vesting period and to boost employee productivity. 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 purchase phantom 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.
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.
Termination before the deal triggers, even over issues outside the employee’s control, leave 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. This rule 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.
- 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 nor employee loses any money directly in the deal.
- Phantom stock plans provide more upside than downside.
- They are increasingly offered as part of employee compensation packages.