The definition and example of phantom shares:
Phantom shares are a type of compensation offered to employees by some large companies. This type of compensation gives employees some financial benefits of owning shares without actually owning the company’s real shares. Employees are compensated with profits realized from any increase in the share value at specified dates.
Phantom shares have become increasingly popular as part of comprehensive employee compensation packages. They are not limited to just tech companies. Some companies tie the award to performance goals.
How do phantom shares work?
The number of phantom shares granted to an employee or manager often depends on that individual’s perceived value to the company. The more valuable the employee is perceived, the greater the number of shares they are likely to receive.
The “delayed mechanism” is activated when phantom shares are granted. The actual financial payment occurs long after, such as two to five years, but this depends on the agreement reached between the company and the employees.
Companies use phantom shares as an incentive tool to reward employees and give these employees a “stake in the game.” The goal is to increase workplace productivity and generate more profits for the company.
Types of phantom shares
Companies tend to use either “discretionary only” phantom shares or “full value” phantom shares.
Discretionary Only
Discretionary shares prevent recipients from receiving the current value of the phantom share. Instead, recipients receive any profit the phantom share achieves over a defined period, such as an increase in the share price.
Assuming that the current value of the company’s share will be $20,000 if Employee “A” receives 1,000 phantom shares, and the price of one share is $20. It is assumed that according to the terms of the agreement, the employee must remain with the company for five years to fully benefit from the deal. This timeframe is known as the “vesting period.”
The company’s share price rises to $40 per share at the end of the vesting period. Employee “A” will receive the difference between the share value of $20 at the time of the agreement and the share price of $40 at the time of earning any profits from the share. The increase in this case is $20 per share, resulting in a profit of $20,000 for the phantom shareholder.
Full Value
The recipient receives both the current value and any increase in the share price once the vesting date for the full value phantom share agreement is reached.
In this case, Employee “A” will receive a $20 increase in the share price after five years. They will also receive the increase in price of the shares since the start date of the agreement.
Advantages and disadvantages of phantom shares
Advantages
Employees benefit from the rising share price: Phantom shares are a strong incentive tool to keep key employees in the company for the entire vesting period. They enhance employee productivity. The recipient also benefits when the phantom share price increases.
Employees do not need to take action to purchase shares: These employees do not need to purchase the company’s phantom shares in the same way that ordinary shareholders must acquire them in the open market. Instead, phantom shares are granted to employees without any cash transaction. This is a significant benefit for employees. They participate in the profits of the share without needing to pay for it.
The company maintains control over the shares: The company’s control over phantom shares is beneficial for employers. The company can define the structure of the agreement within a charter or standard phantom share contract. It can control the level of equity participation in the form of profits disbursed to employees. Companies can also include a clause in the phantom share agreement that eliminates any benefits of phantom shares if the concerned employee leaves the company before completing the agreed-upon vesting period.
Disadvantages
Employees
They have no options or control if the stock price falls: the company controls all decisions in the phantom stock arrangement, giving employees little control or ability to act if the stock price declines. Taxes also affect phantom stock arrangements. Companies must comply with the tax rules of the Internal Revenue Service (IRS), which limit the company’s options for executing distribution dates. They also prevent employees and managers from accelerating phantom stock payments if they believe the company may be in severe financial distress.
Employees can lose benefits if they are terminated: being laid off before the deal is activated, even if the reason is beyond their control, leaves them without a chance to collect any cash benefits from the phantom stock.
Phantom stock plans can incur additional costs for companies: companies that implement phantom stock plans may incur additional costs, especially if any stock valuation review must be conducted by an external accounting firm.
Source: https://www.thebalance.com/what-is-phantom-stock-4173886
Source: https://www.thebalancemoney.com/how-phantom-stock-works-4159362
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