How Phantom Stock Works

There's Nothing Scary About Phantom Stocks

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Ghosts roam among the trading pits on Wall Street but not in the form of goblins and specters more traditionally celebrated on Halloween night.

No, these ghosts are a different variety of spirits, in the form of so-called “phantom” stocks that are becoming increasingly pervasive in the employee compensation sector.

Companies as diverse as Publix Supermarkets, Saatchi & Saatchi, and offer (or have offered) employees some form of phantom stock ownership, as part of their employee compensation packages.

Expect more firms to follow as they realize the benefits of implementing phantom stock employee compensation campaigns.

Phantom Stocks Defined

Phantom stocks are just what their name implies—a form of employee compensation that gives employees access to stock ownership without actually owning the stock. Like any genuine stock, phantom stocks rise and fall in value in line with the underlying company stock, and staffers are compensated with profits incurred from any company stock appreciation at a specific date.

By and large, the number of phantom shares given to an employee or manager depends on that person’s perceived value to the company. The higher that employee is valued, the more shares of phantom stocks he or she is likely to receive. When phantom stocks are awarded, a “delay mechanism” kicks in, where the actual financial payout is made after a long period of time—two to five years is a common phantom stock payout, depending on the agreement made between the company and the employees.

In that regard, companies use phantom stocks both as a motivational tool to reward employees and to give those employees “skin in the game” to increase workplace productivity and earn the company more profits—a formula that drives the company’s stock price higher, as well.

Types of Phantom Stock

When implementing phantom stocks as employee stock compensation, companies tend to use either “appreciation only” phantom stocks or “full value” stocks. Here’s how each phantom stock model operates:

Appreciation Only: Appreciation stocks bar recipients from garnering the current value of a phantom stock. Instead, recipients earn any profit (i.e. stock price appreciation) that the phantom stock might earn over a specific period of time. For example, if employee “A” were to receive 1,000 shares of phantom stock, with each stock worth $20, the current value of the company stock would be $20,000. Under the terms of the agreement, the employee must stay with the firm for five years, for example, to benefit from the phantom stock deal (known as the “vesting” period.) At that time, the company’s stock has risen to $40 per share.

Under that scenario, employee “A”, after the five-year period was up, would receive the difference between the $20 per-share current value of the stock on the date when the deal was struck, and the $40 per share on the date when he or she becomes entitled to any profits from the stock (or $20 per share.) That would give the phantom a profit of $20,000.

Full Value: Under a full value phantom stock deal, the recipient earns both the current value and any stock price appreciation once the due date is reached. In the above case, employee “A’ would not only receive the $20 per share price increase after five years, he or she would also earn the current price appreciation on the date when the deal commenced, also $20 per share on a stock that’s trading at $40 per share. At 1,000 shares of stock, that would give the employee $40,000 after the five-year vesting trigger date.

Pros and Cons of Phantom Stocks

As the case with any financial/investment instrument, there is no shortage of positives and slightly fewer negatives with phantom stock deals:

Pros

  • Phantom stocks are a solid motivational tool to both keep key employees on board for the entire vesting period, but also to boost . After all, when the phantom stock price appreciates, the recipient benefits, too. For employers, that’s a true win-win.
  • By sticking to the phantom stock script, actual company stockholders don’t see their shares diluted in value, as shadow stocks aren’t the same as regular company stocks.
  • For employees, there’s no need to actually purchase phantoms stock shares, as regular stockholders must do on the open market. Instead, phantom shares are given to employees with no money changing hands. That’s a big benefit to employees, who only share in the stock’s, without having to pay for them.
  • Company control of phantom stocks is advantageous to employers, as well. Under a typical phantom stock charter or contract, companies can dictate the structure of the agreement. For example, the company can control the level of equity participation in the form of dividends paid out to employees. Also, companies can include provisions in a phantom stock agreement that “forfeits” any phantom stock benefits if the employee in question departs the company before the agreed vesting completion date.

Cons

  • Companies that implement phantom stock plans can incur additional costs, particularly if any stock valuation overview needs to be completed by an outside accounting company.
  • For employees, the company calls all the shots in a phantom equity deal, giving them little control or maneuverability if the share price goes south. They also may be terminated before the deal triggers, over issues outside the employee’s control, leaving them out of luck on collecting any phantom stock cash benefits.
  • Taxes factor into phantom stock deals, too. For example, companies must strictly adhere to the Internal Revenue Service’s 409A statute, which limits a company’s options in instituting distribution dates, and also blocks employees and managers from accelerating phantom stock payouts, if they deem the company to be in severe financial stress.
  • For employees, phantom stocks come with limits that normally are par for the course for regular company stockholders. For instance, phantom stockholders hold no right to vote, and may not be eligible for dividends, dependent on the deal’s structure.

The takeaway? Phantom stock plans can be both a good employee motivation tool for employers, and a solid cash incentive plan for employees. If events go sour and the stock price doesn’t appreciate, neither the employer or employee loses any money directly in the deal.

That provides more upside than downside for phantom stock plans—an increasingly valuable financial tool at a time when employee retention is key, and when the stock market is on a general upward trend.