Phantom Stock Plans For Private Companies: Should You Use One Instead Of ESOPs?

TL;DR - Phantom stock plan vs ESOP

What is a phantom stock plan?

A phantom stock plan (AKA shadow stock plan) is a deferred cash incentive plan. 

Unlike ESOPs, it doesn’t give away ownership to employees, so the existing shareholders' percentage isn't diluted. Instead of receiving actual shares, the employee is granted mock stock that mirrors the value of the company’s real stock. 

When the stock's value rises, the employee gets a cash payout reflecting those gains. 

This structure is designed to retain and motivate holders while aligning their interests with the business’s performance and growth.

How phantom stock plans work

While ESOPs involve actual equity grants, phantom stock doesn’t. 

It mirrors the outcome of owning shares (rewarding employees when the company value rises) without ownership dilution. Instead, employees get a deferred cash bonus linked to stock performance.

Here’s how it works:

• The company creates a pool of phantom shares that are linked to its actual share price.
• Employees are granted a set number of these phantom shares.
• The company then establishes a vesting schedule, requiring employees to wait a certain period before they become eligible.
• The company can also set trigger events (like an acquisition, IPO, or specific milestones) at which the cash payout becomes due.
• When vesting and triggers are met, employees receive a cash payout based on the current value of their vested phantom shares.
• If the company performs well, its stock value increases, causing the value of the phantom shares to rise, resulting in a larger payout. Conversely, if the company underperforms, the value decreases, leading to smaller payouts.

Note: Companies can also include forfeiture clauses, where employees lose their phantom stock if they violate non-compete agreements or get terminated for cause.

For example, in full value phantom stock plans, an employee is granted 200 phantom shares at $8 per share. If the company’s share value rises to $12, the employee gets $2,400 (200 × $12) at the time of settlement. If the share value drops to $6, the payout falls to $1,200.

Types of phantom stock plans

Phantom stock payouts can be structured in two types:  full value and appreciation-only, each using a different method to calculate how much employees receive.

‍a. Full value plans pay employees based on the complete stock value plus any appreciation. If your company stock is worth $20 per share when granted and rises to $35 at payout, employees receive the full $35 per unit.

b. Appreciation-only plans (much like stock appreciation rights (SARs)) only pay the increase in value. Using the same example, employees would receive $15 per unit ($35 minus the $20 starting value). SARs are a type of phantom stocks.

Most companies choose appreciation-only grants. It creates performance leverage similar to stock options while limiting payout obligations to just the share return, not the initial value.

How do you calculate the value of your phantom stock unit?

The initial value of a phantom stock unit is typically set at the grant date based on the Fair Market Value (FMV) of the company’s stock, which is typically determined by an independent 409A valuation.

There's no locked-in value regardless of vesting schedules, meaning the final value of the phantom stock can change based on the company’s performance or stock price, and employees' payouts depend on this fluctuating value.

Is a phantom stock plan a better ESOP alternative for private companies?

Given phantom stock's simpler structure, many founders consider it as an alternative to traditional employee ownership programs. The most common comparison is with ESOPs. 

What is ESOP?

An Employee Stock Ownership Plan (ESOP) grants employees an ownership interest in the company, whereas phantom stock plans offer cash payments linked to stock value. 

Stock options operate by granting employees the right to purchase company shares at a preset strike price within a specified time period. Once options vest, employees can exercise and convert them into shares. 

When the company's stock price exceeds the strike price, employees profit by exercising their options and selling the shares. This structure keeps employees focused on performance since they benefit directly from stock price appreciation.

Advantages of phantom stocks when compared to ESOPs

Let’s find out when phantom stock plans are more advantageous than ESOPs.

‍a. No equity dilution

‍Phantom stock plans don’t issue actual shares, so there’s no dilution of ownership for founders or existing shareholders. ESOPs, in contrast, allocate real shares, which can affect the company’s cap table over time.

‍b. No upfront cost for employees

‍Employees aren’t required to buy in or pay anything to participate. This lowers the barrier to entry, especially compared to stock options, where employees must exercise shares, often at an exercise/strike price.

‍c. Cost-effective for employers

‍ESOP involves costs related to trust structures, legal compliance, and annual valuations to set up and maintain. Phantom stock plans are typically less resource-intensive.

‍d. Greater flexibility

Phantom stock plans are simpler to administer than ESOPs because they do not involve the issuance of actual shares. They are also subject to less stringent regulatory requirements.

Disadvantages of phantom stocks when compared to ESOPs

Despite its flexibility, phantom stock lacks several aspects that ESOPs possess. Here are the disadvantages.

a. No real ownership rights

‍Phantom stock doesn’t confer actual shares, so employees don’t get voting rights or ownership. ESOP participants, as part-owners, have more engagement.

‍b. No liquidity before payout

‍Unlike actual shares, phantom shares cannot be sold or transferred, meaning employees must wait for a triggering event (such as an acquisition or IPO) to receive their reward. In contrast, stock option holders in private companies often have the opportunity to sell their shares back to the company through buybacks, providing some liquidity even before a liquidity event occurs.

ESOP vs phantom stock: Which one makes more sense for tax treatment?

If you're evaluating ESOPs or phantom stock plans for your company, tax impact is likely a major deciding factor. Here's how to think about it.

A. For founders and companies

a. Incentive Stock Options (ISOs) don’t allow the company to take a tax deduction if holding conditions are met (i.e., it is a qualifying disposition).

But, Non-qualified Stock Options (NSOs) allow companies to take a tax deduction when employees exercise their options. Since NSO earnings are treated as income for the employee, the company can claim a corresponding tax deduction.

b. Phantom stock, on the other hand, also allows for deductions when payouts are made (as compensation), making it simpler but less powerful in long-term tax optimization.

B. For employees

a. ISOs defer taxes until the sale for employees, and the entire gain (FMV at sale minus the strike price) is eligible for long-term capital gains if holding conditions are met. In contrast, NSOs are taxed as ordinary income at exercise on the difference between the FMV at exercise and the exercise price, with any further gain upon sale taxed as capital gains.

b. Phantom stock is purely taxed as ordinary income. 

ESOP or phantom stock option plan: What should you use?

The decision isn't about which plan is superior; they're complementary approaches that can work independently or alongside each other. 

Choose phantom stock if:

• You want broader coverage (employees, advisors, consultants)
• You need maximum flexibility in plan design and administration
• You prefer cash settlements over actual share transfers
• You want to avoid share dilution in your ownership structure
• You don't want to follow non-discrimination rules
• You don’t want long-term tax benefits

Choose ESOP if:

• You want to incentivize only employees
• You want to promote ownership and accountability throughout the organization
• You can handle non-discrimination rule compliance

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FAQs

1. Should I use phantom stock or ESOP?

If you want targeted incentives without share dilution or compliance complexity, phantom stock is ideal, especially for non-employees. But if your goal is employee ownership, ESOPs are the better choice.

2. Is phantom stock good for employees?

Yes, for key employees. It aligns incentives with company performance, offers a simpler setup, and requires no upfront investment. However, holders don’t get voting rights, dividends, or actual equity, so it's best suited for those prioritizing cash rewards over ownership.

3. Is phantom stock taxable?

Yes, phantom stock payouts are taxed as ordinary income when paid, not as capital gains. Employers get a tax deduction at the same time. There’s no tax at grant or vesting, but compliance with Section 409A in the U.S. is essential.

4. What is another name for phantom stock?

Phantom stock has several common names: shadow stock, ghost shares, phantom equity plan, phantom share schemes, and synthetic equity programs.