Phantom Stock Plans: What Are They, And How Do They Work? | Ledgy

Offering your employees phantom stock means your team are not just taking home a salary each month – their compensation is tied to the long-term growth of the business.

But setting up a phantom stock plan means answering many key strategic questions. What should the vesting schedule be for phantom stock holders? Should the phantom stock allocation come out of the founder's equity stake, or not? And what happens when phantom stock holders leave the company?

Read on for answers to all these questions, and many more!

What is phantom stock?

Phantom stocks (also known as phantom shares or virtual shares) are used around the world as a way to reward employees for their contributions to building early-stage businesses. Unlike actual stock, phantom stock does not give the holders any ownership of the business. Instead, phantom stock translates to a cash value the employee will receive when there is an exit event like a public listing or acquisition.

Like any type of equity stake, each phantom share has a nominal value, which is paid by employees when their company exits and they exercise their right to their cash settlement (more on this later). The value of team members' phantom stock is tied to the company’s stock price. Assuming your company grows in value over time, their phantom stock will increase in value too.

Phantom stock is particularly popular in certain markets, especially Germany. In our State of Equity and Ownership report, we found that more than three quarters of German companies used phantom stock:

While some countries use phantom stock more than others, it's vital for finance and operations leaders to understand the ins and outs of a well-run phantom stock program.

What's a phantom stock plan (PSOP)?

Phantom shares sit within a phantom stock plan (PSOP). Companies can set up phantom stock plans that sit alongside other types of stock plan: take a look at this example Ledgy dashboard, which shows the high-level employee stock option pool split out into share options (ESOP) and virtual/phantom shares (VSOP):

When designing their phantom stock plans, companies need to consider their approach to a few key principles, including how vesting and devesting works, and how to handle cash settlements. We'll also talk about how companies can communicate about tax.

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Vesting

People earn the right to their phantom stock over time, just like regular stock options. It’s becoming normal for all types of stock, including phantom stock, to vest over a period of four years with a 12-month cliff at the start of the vesting schedule.

Phantom stock also comes with a cliff. The cliff is the period of time you have to work before being granted rights over any of your phantom stock options. The cliff is designed to prevent people qualifying for equity without making a significant contribution to the growth of the business.

Devesting

Devesting is a process where employees lose their rights to their phantom stock over time after they leave the company. This normally happens at the same rate the phantom stock vested: i.e., if the phantom stock vested over four years, the employee's shares would gradually devest over the subsequent four years after they leave the business.

Cash settlements

The payout to employees who own phantom stock when the company exits is known as a cash settlement.

When a liquidity event (such as an IPO or acquisition) occurs, employees are normally paid the cash they’re due through payroll. Then, they need to report their phantom stock gains to the tax authorities the next time they file their taxes.

Taxation

Phantom stock is taxable once a liquidity event takes place and the gains for employees are realised. Of course, how much tax employees pay on their cash settlement varies by country.

In Switzerland, for example, the government gives a tax ruling on the nominal value of phantom stock, which reduces the taxable amount. In the UK, phantom stock is treated as income rather than capital gains, which could leaves employees with a larger tax bill (up to 45%).

In Germany, probably the country where phantom stock is most popular, employees with stock options are taxed twice: when the options convert to shares, and when the shares are sold. In contrast, the only time tax is due on phantom stock is when there is a liquidity event.

Tax works differently in every country, and it’s important to consult with a legal advisor and/or tax professional when you’re thinking about your virtual shares. But companies must be up front with team members and communicate about the consequences for their tax bills depending on which market they're in.

Other types of phantom stock

Phantom stock comes in different shapes and sizes. In particular, it's worth understanding the difference between phantom shares and stock appreciation rights (SARs).

Stock Appreciation Rights (SARs)

As the name suggests, stock appreciation rights give employees the right to the gains from an appreciating company share price, without directly owning any actual stock. Under the terms of SARs, though, employees may be allowed to 'exchange' the value of any appreciation for stock in the business.

SARs are usually treated very similarly to phantom stock when it comes to tax, vesting and cash settlements.

Phantom stock and stock options: what's the difference?

Stock options give employees the right to buy a set amount of shares at a fixed price at some point in the future. They’re often part of an employee stock ownership plan (ESOP). When the time comes for employees to exercise their share options, they own shares in the company. It’s then up to them when they cash out their equity stake.

Learn about our employee stock ownership plan management software.

There are three major differences between virtual shares and share options:

Ownership

Phantom stock does not give employees direct ownership stakes in the company: they simply represent your right to benefit from the cash value of your virtual shares when the company sells or lists publicly. In contrast, employees who own actual shares have a direct stake in the business, with the benefits (and potential risks) that entails.

Why potential risks? Well, when employees own the company's actual stock, they are exposed to upward AND downward fluctuations in the stock price. While there is always the chance that phantom stock could be worth nothing if the company's stock price does not increase, owning share options heightens the risk that shareholders may lose money if the price per share decreases below the level employees paid to convert their options into company stock.

Cashing out

Holders of phantom stock have no choice over when they receive their cash settlement. They have to wait for a liquidity event, when phantom stock holders are usually 'cashed out' automatically. In contrast, people who hold shares as part of an ESOP can elect when to cash out. They can hold on to their equity stake after a liquidity event, for instance, if they think the share price will increase further.

What you pay up front

It doesn’t cost anything to acquire phantom stock, while it will always cost money to buy shares in a company. Employees are usually asked to pay to exercise their share options and convert them into company stock, but with phantom stock ownership, the only payment you’ll need to make is the tax due when a liquidity event happens and a cash settlement takes place.

Is phantom stock right for your business?

For organisations seeking to give employees access to the economic benefits of the company's performance, without distributing actual ownership stakes, setting up a phantom stock plan could be the way to go.

Phantom stock allows companies to align everyone behind the core mission of the business. Offering phantom shares gives employees a sense of ownership and a focus on results. To learn more about how to handle phantom stock on Ledgy, head to our help centre.

FAQs

1. Why would a company choose phantom stock over share options for employees?

Companies have many reasons for opting for phantom stock. In some countries – for example, Germany – phantom or virtual shares are the dominant form of employee equity, so new joiners might expect phantom stock. Companies may also be attracted to the lighter admin workload involved in granting phantom stock, particularly if the infrastructure around granting share options is cumbersome.