6 Frequently Asked Questions About Phantom Stocks Answered
Phantom stocks. Sounds strange, doesn’t it? A phantom stock allows employees to share in a company’s success and wealth. Also known as shadow stocks or ghost shares, companies provide them to employees with stock ownership and a retirement plan to ensure future financial security. So, what are these phantom stocks?
Phantom Stocks and All You Need to Know About Them
Scroll down to check out these six frequently asked questions about phantom stocks.
1. Phantom stock: What is it?
The idea of phantom stock plans is to mimic stock ownership without actually handing over the shares. A phantom stock plan, also called equity pay plans, equity compensation plans, or stock bonus plans, falls under the category of employee stock option plans.
Phantom stock options allow employees to purchase shares of a company for a fixed price, called “equity value.” These stock options are part of companies’ incentive strategies.
Phantom shares are issued in many US-based companies for long-term incentive programs intended to reward long-term service or honor retirement.
2. What is the purpose of phantom stocks?
The provision of company stock to employees has many benefits, from motivating them to work harder to increasing stock value (by preventing liquidation). It encourages loyalty to an organization.
Also, employers might prefer phantom stock in certain other circumstances like:
- When legal issues are involved
- A company might not want to issue more shares
- When stock dilution needs to be avoided
A company can reward its employees with phantom stock without fearing the above-mentioned problems. A common purpose of phantom shares is to encourage senior leaders to conduct better business. Shares will be awarded based on the leader’s position and their team’s performance.
Although the money is promised at issuance, the benefit will begin to accrue after two, three, or five years, depending on how long the company chooses. The benefit may be contingent on the achievement of specific goals.
3. What are the types of phantom stocks?
There are two types of phantom stock options:
- Appreciation only
- Fully compensated
In an appreciation-only phantom stock offering, only the increased value of the shares is credited to the participants as cash settlement. The difference between the phantom stock’s original value and the current market value is the amount that the employee receives.
Consider the example of Jane being granted 1000 phantom shares on February 2, 2020. These shares were valued at $70 each at the time of grant. For Jane to become eligible for these shares, she must remain with the organization for five years. As of Feb 2, 2025, the shares are worth $90.
Jane gets the difference between the current value ($90) and the original value ($70) of each of her shares, which is $20. By multiplying 1000 shares by $20, Jane’s bonus becomes $20,000.
As opposed to appreciation-only phantom stock, a full-value phantom stock pays the entire amount of its value at settlement time.
Lisbon, for example, has been granted 1000 phantom shares of her company’s stock on Feb 2, 2020. She also has to wait five years for her company’s stock to mature, which is also worth $70 a share. After five years have passed, the shares will also be worth (surprisingly) $90.
The Lisbon shares, however, are worth the full value, so she gets the full $90 per share and received a bonus of $90,00.
4. What are the benefits of phantom stocks?
- For a startup, the phantom stock system is more cost-effective and saves money when compared to stock option plans
- Phantom stocks are available to both public and private companies
- There is no tax imposed on the employee during the vesting period
- Shares are not issued but are cash-based
- Employees retain ownership in the company, even without voting rights
- There are fewer complications with phantom stock programs since employees only get paid if all conditions are met
5. What are the drawbacks of phantom stocks?
- An employer may terminate the agreement if the stock price decreases
- If the share price rises, the value of “appreciation only” shares is only subject to gain
- Following vesting, taxes are imposed as ordinary income
- Employers who run a phantom stock program must inform all participants of its status annually if the company is publicly traded
- Employees must be paid with cash at the time of payout
- If a third party performs the stock valuation, the employer must pay an additional fee
6. How do phantom stock plans work?
The company signs a formal agreement defining the terms and conditions of the payment plan. It also specifies the vesting schedule, the payment events, and the dividend as part of the plan.
According to the specifications, participating employees would be awarded phantom stocks or units of shares. Upon fulfillment of the plan’s terms, the employees are entitled to cash payments in exchange for their phantom stock units.
The payment is determined by:
- Number of vested units
- Unit value at the time of payment, and
- Categorisation of the plan, if it falls under appreciation-only type or full value type
- Phantom shares are treated as bonuses and are redeemed for cash
Finally, phantom stock options are the safest form of stock options. The risks are minimal, but you can weigh out the pros and cons of your organization’s needs as an employer.
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