In the world of equity compensation, startups are often on the lookout for ways to reward employees without diluting ownership or complicating their capital structure. One option that’s gaining traction is phantom stocks. While they sound like real shares, phantom stocks are a clever workaround that mirrors the value of actual company stock without giving employees any actual ownership. In this blog, we'll take a deep dive into what phantom stocks are, how they work, and the benefits and drawbacks for both startups and their employees.
What Are Phantom Stocks?
Phantom stocks are essentially a promise from the company to pay employees a cash amount that mirrors the appreciation in the company’s stock price. Unlike stock options or restricted stock units (RSUs), phantom stocks don’t involve issuing real shares. Instead, they represent the value of the company’s stock on a specific date.
Imagine you are granted 1,000 phantom stocks at a price of $5 per share. After the vesting period, the stock’s value increases to $15 per share. When you exercise the phantom stocks, the difference—$10 per share—gets paid out to you in cash, giving you a payout of $10,000 (1,000 phantom stocks × $10 gain per share). This allows you to share in the company’s success, but without receiving actual equity or becoming a shareholder.
How Do Phantom Stocks Work?
Here’s an example to make it clearer:
- Grant Date: You’re granted 1,000 phantom stocks when the company’s stock is valued at $5 per share.
- Vesting Period: Over time, these phantom stocks "vest," meaning you earn the right to exercise them.
- Exercise Date: After a few years, the company’s stock has appreciated, and now each phantom stock is worth $15.
- Payout: You exercise your phantom stocks and receive a payout based on the $15 value, for a total of $15,000 (1,000 phantom stocks × $15).
That payout, however, is taxed as ordinary income because you’re receiving a cash payment based on the stock’s value at the time of exercise.
The Pros of Phantom Stocks
- Non-Dilutive: One of the biggest advantages of phantom stocks is that they don’t result in any dilution of ownership. The company doesn’t have to issue additional shares, which means the ownership percentage of founders and other shareholders remains unaffected.
- Cash Payouts: Since phantom stocks are typically settled in cash (not actual shares), employees don’t need to worry about the complexities of stock sales or the volatility of the market. This gives employees immediate access to financial benefits without any risk associated with owning shares.
- Flexibility: Phantom stocks can be customized to align with a company's goals. For example, you can tie payouts to key milestones or growth metrics, which helps incentivize employees to focus on long-term success.
- Simplicity: Compared to stock options, phantom stocks are often simpler for both employers and employees. There’s no need to worry about exercising options, determining strike prices, or dealing with complex tax issues related to actual equity ownership.
The Cons of Phantom Stocks
- Taxable Income: While phantom stocks come with great flexibility, there’s a catch. When you exercise phantom stocks and receive the cash payout, it’s taxed as ordinary income. This means that even though you’re not receiving any physical shares, you could end up with a hefty tax bill depending on how much the stock price has appreciated.
- No Ownership: Unlike stock options or restricted stock units (RSUs), phantom stocks don’t grant you ownership in the company. This means no voting rights, no dividends, and no control over the company’s future decisions. Employees can benefit financially from the company’s growth, but they won’t have the same privileges as actual shareholders.
- Cash Flow Issues for Companies: Although phantom stocks are a great way to reward employees without diluting ownership, companies need to ensure they have the cash available to make the payouts. In cases where the company is not yet profitable or is growing rapidly, coming up with the necessary cash could be challenging.
When Should a Startup Consider Phantom Stocks?
Phantom stocks are ideal for startups or businesses that want to offer equity-like compensation but don’t want to dilute ownership. They are especially useful for companies that are not yet ready to issue shares or don’t have the liquidity to do so. Startups can use phantom stocks to incentivize key employees and align their interests with the company’s growth, without giving up actual equity.
Conclusion
Phantom stocks are an innovative tool in the equity compensation toolkit, offering startups a way to reward employees without the drawbacks of issuing actual shares. While they provide employees with financial benefits tied to the company’s success, they don’t come without trade-offs, such as taxable income and the lack of ownership. For many startups, phantom stocks provide the right balance of incentives without compromising control over the company’s ownership structure.
If you’re considering phantom stocks as part of your employee compensation strategy, it’s important to weigh both the pros and cons carefully to ensure they align with your company’s goals and financial situation.
.svg)
.svg)