Understanding Phantom Stocks
What if you could enjoy the financial rewards of owning company shares without holding a single company stock? This isn’t a financial paradox; it is the innovative concept of phantom stocks. A Phantom stock plan also known as a “shadow stock” or “mock stock”, is a compensation strategy that allows companies to grant their employees the financial benefits of owning shares without actually diluting the company’s equity.
Phantom stocks are hypothetical stocks offered to the employees by the companies as compensation where they don’t receive the ownership of the stocks but only the financial benefits attached to it. This concept offers a unique alternative to the traditional equity-based incentives while still maintaining the motivational and monetary benefits of stock ownership. Phantom stock plans are structured to mimic the performance of actual company shares allowing the employees to reap the benefits from both the initial value of the shares and its appreciation, which is like owning real shares but without the complexities attached with actual share ownership.
How Does It Work?
Phantom Shares operate through a contractual agreement between the company and certain employees or advisors, promising them future cash incentives, based on the market value of the company’s stock. While having similarities to employee stock option plans, phantom stocks differ in the aspect that the employees do not receive actual stocks in the end, instead they receive a mock stock ownership experience that traces the real share value movements.
The company first grants a certain number of phantom stock units to the employees, which do not confer any ownership rights. These phantom stock units follow a vesting schedule already set out in the agreement that determines when employees are entitled to ask for payouts, and whether the vesting schedule is time based, or milestone based. Timelines for vesting can range from specific years to the entirety of the employment, whereas, performance-based incentives, motivates and rewards the employees without diluting equity. This system successfully bridges the gap between the conventional equity compensation and cash-based incentives, creating a win-win situation for both the company and the employees.
There are two ways in which employees are granted phantom stocks:
- Appreciation Only Phantom Stock Option Plan: Under this option, the employee is granted the appreciation amount in the price of stocks from the date of grant till the date of redemption of phantom stocks. For instance, if the price of a stock on date of grant was Rs. 200 and the price of that stock on the date of redemption is Rs. 290, then the employee shall the receive Rs. 90 per stock.
- Full Value Stock Option Plan: Under this option, the employee is granted the full price of the stock as on the date of redemption. For instance, if the price of a stock on the date of grant is Rs. 200 and the price of that stock on the date of redemption is Rs. 260, then the employee shall receive Rs. 260 per stock.
These distinct methods show versatility and flexibility, and companies can adjust phantom stock arrangements in such a way that aligns with their objectives and goals, offering a customizable framework that can be adopted to meet specific targets and compensation mechanisms.
The Indian legal framework surrounding phantom stocks remains undefined and unexplored as this compensation mechanism is still new and emerging in India. The Companies Act, 2013 provides a robust framework for employee stock option plans but is silent on the concept of phantom stocks in India. Due to the absence of legal regulations, companies must tread carefully and structure and manage the implementation of phantom stocks plan by relying on general legal principles.
Employees Stock Options vs. Phantom Stocks Option
An Employee Stock Option Plan (ESOP) is a compensation scheme that allows employees to acquire ownership in the company. Under an ESOP, a company grants equity shares to its employees as a reward for their performance or achievement of a milestone. When employees exercise their option, they become partial owners of the company and receive the same benefits as shareholders.
A Phantom Stock Option Plan (PSOP) differs from an ESOP in terms of their structure and execution. Under ESOPs, employees are granted real shares of the company leading to partial ownership of the company upon exercise, whereas under PSOPs, employees do not receive actual shares of the company, instead they receive cash-based incentives equivalent to the market value of company’s stock prices. They only receive monetary benefits linked to the shares of the company without ownership rights. ESOPs leads to dilution in equity of the company as new shares are issued to the employees. PSOPs on the other hand, avoid equity dilution as not actual share transfer takes place. Employees under ESOPs are involved in the management of the company as shareholders, however, such right is not available to employees under PSOPs.
PSOPs have emerged as a more attractive and flexible alternative to ESOPs since it offers benefits to employees without diluting the company’s equity, creating a favourable situation for both the company and the employees.
Our Opinion
Phantom stocks represent a creative and flexible approach to employee compensation, that bridges the gap between equity compensation and cash-based incentives. Unlike traditional ESOPs, phantom stock plans allow companies to reward employees based on the company’s stock performance without diluting equity or granting ownership rights. This model offers a win-win scenario: companies can retain control and manage equity effectively, while employees gain financial rewards tied to stock value appreciation. The distinction between Appreciation Only and Full Value plans adds a layer of customization, aligning these instruments with specific organizational goals.
While phantom stock plans offer significant benefits, companies must exercise caution and ensure robust agreements are in place to safeguard both the organization and employees. A well-drafted phantom stock agreement should clearly outline the terms and conditions, including the number of phantom units granted, the vesting schedule (time-based or milestone-based), and the method for calculating payouts. It should also address scenarios such as termination of employment, retirement, or mergers and acquisitions to avoid future disputes. Additionally, the agreement must explicitly state that phantom stocks do not confer ownership or voting rights to employees, ensuring no ambiguity about their role.
Authors: Tushar Gulati (VP – Corporate) and Subham Khanna (Senior Associate Corporate & Commercial)
