Phantom stocks are like Schrodinger’s cat – they exist and do not exist simultaneously. Phantom stocks are a type of employee ownership. They are an excellent tool that can be used by startups to provide the upside of valuation growth to their employees while retaining the concentration of ownership and protecting their cash outflow in the form of salaries.
The Essential Questions and Answers on Phantom Stocks
To understand phantom stocks, we found the answers to 7 key questions about phantom stocks and their usage, especially in the startup scene. They are discussed below:
1. What Are Phantom Stocks?
Phantom stocks involve compensating employees without them actually holding any stocks in the company. Such compensation is equal to the appreciation in the company’s stock value. Phantom stocks or shadow stocks mimic Employee Stock Option Plans or ESOPs but do not involve share allotment. The idea behind this is to ensure that the shareholding of the company is not diluted.
Phantom stocks are named so since a phantom refers to something like a ghost that does not exist materially, yet creates an impact. Similarly, the company’s stocks are not actually allotted to employees, yet they are entitled to the increase in share value.
2. How Similar Are Phantom Stocks to ESOPs?
You can think of phantom stocks as a cousin of ESOPs. The similarity between both of these compensation tools is that they incentivize key employees to stick with the company and contribute to an increase in its value.
The difference is that ESOPs give the employee the option of purchasing the shares of the company, whereas phantom stocks do not; the employee gets paid in cash an amount equal to the increase in the value of a stock during a particular period of time.
3. What Are the Benefits of Phantom Stocks?
Phantom stocks do not require you as an employer or owner of a startup to increase the number of shares issued and allotted. The composition of ownership does not change and you can do more with a limited or smaller sized ESOP pool.
Phantom stocks motivate employees to contribute or create an increase in your company’s value. They can work towards this objective by improving business performance, increasing efficiency, and reducing redundancies. Later, they will reap the benefit of their hard work in the form of an amount equal to the appreciation in the company’s share price for a period specified by the company.
The company and its promoters undoubtedly stand to gain since the stock price appreciates and resourceful talent is retained in the company.
4. What Are the Different Types of Phantom Stocks?
Broadly, there are two types of phantom stocks – ‘appreciation only’ and ‘full value’. The differences between the two are explained in the table below.
5. What Are the Regulatory Aspects of Phantom Stocks?
The Securities Exchange Board of India (SEBI) defines phantom stock options as “a form of share-based employee benefits based on the underlying value of equity shares of the employer company. The settlement of such options is made in cash and not in equity shares of the company.”
The cousins of phantom stocks, such as ESOPs and Stock Appreciation Rights (SARs) are regulated by SEBI’s latest guidelines issued on August 13th, 2021, which are a merger of the Issue of Sweat Equity Regulations, 2002 and Share Based Employee Benefits Regulations (SBEB), 2014. These guidelines are silent on phantom stocks. However, the SEBI guidelines on employee equity issued in July 2021 expressly declare the non-applicability of the guidelines to phantom stocks because they do not involve any actual purchase or sale of the shares.
According to Regulation 1(4) of the SBEB Regulations, “one of the applicability criteria for an employee benefit scheme to be covered under the SBEB Regulations is that the scheme actually involves dealing in or subscribing to or purchasing securities of the company directly or indirectly.” The Companies Act, 2013 is also silent on phantom stocks.
Companies need to come up with their own internal policy on the terms and conditions of phantom stocks such as eligibility, grant, vesting, allotment, and payments involved. For ease, these can be aligned with the terms and conditions for ESOPs.
6. What Are the Tax Implications of Phantom Stocks?
For an employee who is an individual assessee, there is no tax impact at the time of allotment of phantom stocks. The receipt of money upon their exercise or sale is seen as a part of salary income and is taxed as a perquisite.
The company does not have to pay any tax when it makes a payment to an employee on account of phantom stocks. However, it has to deduct tax at source for the amount that is paid in cash to an employee.
7. Are Phantom Stocks Right for You?
Some companies cannot offer equity to their employees due to corporate restrictions or to ensure that ownership does not get diluted. At the same time, they would like to incentivize key employees to perform well by linking their compensation to the company’s stock price. For such companies, phantom stocks are a viable option.
Phantom stocks create a win-win situation for both employers and employees. The employee does not have to face the price volatility of the company’s stock. The company can strengthen its liquidity without compromising on rewarding good performance.
Read about the pros and cons of phantom stocks here to decide if phantom stocks fit the bill for your startup.