A Detailed Guide to Phantom Stock And Its Valuation

A Detailed Guide to Phantom Stock And Its Valuation

Several companies offer their senior-level employees extra benefits along with their salaries. These benefits generally include employee compensation in the form of company stock.

Rewarding employees with company stock can offer numerous benefits to employees and employers. Many employee equity plans are used to encourage employees, such as ESOPs, stock options, and phantom stock. Among these plans, the one gaining popularity among companies is Phantom Stock.

With Phantom stock, employees get the benefits of owning shares without the actual ownership of company stock. It’s a great way to attract or retain talent and make employees feel involved by creating them as members of the economic benefits obtained by the company.

If you are ready to learn more about phantom stock, keep reading to find out what phantom stock is, its types, how they work, the pros and cons of phantom stock, and in the end, how to create a successful phantom stock plan.

What Is Phantom Stock?

A phantom stock plan is an employee benefit plan, also known as a shadow stock plan. The plan gives selected senior-level employees numerous benefits of stock ownership without actually issuing them any company stock.

It is due to the fact that employees receive mock stock instead of physical stock. Although the phantom stock isn’t real, it follows the price movement of the company’s actual stock, which provides employees with comprehensive benefits of ownership, like an increase in stock price, dividends, and more.

This stock is mainly offered to employees as a bonus for staying with the company for a long time and for their relentless hard work. It is an incredibly effective employee retention strategy used by companies to compensate employees and retain key talent.

An agreement is made between employees and employers while issuing a phantom stock. The agreement defines the vesting schedule of the plan, outlines rules that need to be followed, and if there are any voting rights, it is also mentioned.

Types Of Phantom Stock

There are two kinds of phantom stock plans offered as employee compensation. These include “appreciation only” and “full value” phantom stock. Below we have explained them in detail:

1. Appreciation Only Phantom Stock
Under this type of plan, the employee only receives a cash payment equal to the difference in stock price between the issue date and the redemption date.

They would not get the current value of the stock and will earn the stock price appreciation as profit where the stock value increases over time.

2. Full Value Phantom Stock
Under this type of plan, the employee receives a cash payment equal to the full value of the underlying stock, and the amount of share has been appreciated on the date of redemption. This includes both the original value and the increase in value.

Phantom Stock Plan Example:
To give an example, let’s say an employee was granted 100 shares of phantom stock in January 2020. At that time, the stock price was 700₹. Let’s suppose that the vesting period is of 5 years, so after 5 years the stock price has appreciated from 700₹ to 850₹.

In the Appreciation Only Method, after the vesting period of 5 years, the employee will receive the appreciated amount per share, i.e. (850₹ – 700₹) X 100 stocks = 15000.

In the Full Value Method, in January 2025, the employee will receive the full value of the shares. That is 850₹ X 100 shares = 85000.

Why Do Organizations Use Phantom Stock?

Giving employees employee compensation can offer a lot of benefits to companies. The most significant benefit is it motivates employees to work harder, creates loyal employees, employees feel involved in the company, and stay with the company for a longer time to receive the phantom stock amount.

Apart from this, phantom stock is great for many situations, such as

• The Company not being willing to issue additional shares
• Legal concerns
• To balance the stock dilution effect

How Does Phantom Stock Work?

To issue phantom stock to employees, both employer and employee need to enter into an agreement. Following the terms of the plan, the company needs to offer an amount of phantom stock to selected employees over a decided period of time.

The agreement includes every detail, such as the payment events, vesting schedule, and other conditions. The payment is offered as per plan and is usually redeemed in cash.

The amount of phantom stock is calculated based on the:

• Number of shares employees hold
• Share value at the payment time
• Phantom stock plan type

Phantom Stock Advantages And Disadvantages

Pros Of Phantom Stock:

• It’s highly flexible and can be used by both private and public organizations.
• It’s cheaper to set up a phantom stock plan; hence it saves the company money.
• Employees don’t need to pay taxes on phantom stock until they mature.
• It is less complicated as the employees are paid only if they meet the set term in the agreement.
• Since the plan involves cash-based payments, the company won’t be in trouble handling half the vested stock.
• Even though voting rights are not offered, the employee stays invested in the company’s growth.

Cons Of Phantom Stock:

• The companies need to have cash in hand in order to pay the employees when they redeem their stocks.
• From the employee’s point of view, if they are part of the “appreciate only” phantom stock plan, they won’t get anything if the company stock doesn’t appreciate at price.
• If the share price decreases, the employer can terminate the agreement or just give a small amount of the stock valuation.

Phantom Stock Taxation

The gain obtained from phantom stock is considered ordinary income and taxed accordingly. The tax rate is on the stock amount received at the time of redemption.

At this time, the employer has the option to receive a deduction in the year the employee reports income. This income is reported in the employee’s W-2, subject to withholding tax requirements.

Moreover, standard rules of tax deduction (TDS) are applied at the time of payout. Employers issuing phantom stock options can claim this as salary (perquisites) expenses in their books.

Phantom Stock Tax Implications:

At the time of the phantom stock issue:
The employee gets the right to receive certain payments at a future date which is subject to several conditions. This means no tax is triggered on the date of stock issued.

At the time of condition fulfillment:
When certain conditions are met, the employee re-affirms the right to receive certain payments at future dates, which are subject to certain conditions. This condition translates to no tax being triggered at the time of vesting.

At the time of phantom stock redemption:
When phantom stock is redeemed, the amount of cash the employee receives is taxed as perquisites under the head income from salaries.

By and large, below are the things that need to be kept in mind when it comes to income taxes:

• No taxation is triggered on the issue date
• No taxation is triggered on the vesting date
• The employee needs to pay tax at the time of stock redemption
• No specific tax obligation is on the company, other than deducting TDS, as the payment is taxed under the head of income from salaries.

Steps For A Successful Phantom Stock Plan

Step 1: Define Goals & Offerings

The first step is to decide the objectives, determine the eligible employees and identify the equity percentage. The vesting condition should be clearly set up, whether time-based or milestone-based or a combination of both.

Make sure the plan you create should align with your company’s culture and long-term goals. Although a phantom stock plan is a deferred employee compensation plan, employers can alter the plan as and when required.

Step 2: Create A Proper Phantom Stock Valuation

One of the most important things is to define the right valuation methodology to determine the value of your business.

Step 3: Plan How To Allocate The Stock

As mentioned above, the phantom stock has two types – “Appreciation only” and “Full Value.” You need to decide which type will meet your organization’s needs and goals.

Step 4: Plan Phantom Stock Payout Schedule

Many companies schedule their stock payout annually, while some might go a long way. You can reward a longtime employee as annual rewards or can go over a predetermined period of years.

Step 5: Draft The Agreement

Design the agreement in such a way that it ensures the correct tax treatment and the desired deferred compensation for employees.

In The End

Issuing phantom shares is an effective way to motivate and inspire employees and create a result-driven culture within your organization. The plan has minimal risks and flexible terms and conditions. However, consider various factors related to such a plan before introducing it in your organization.

If you want to launch a phantom stock plan and need help with its valuation – look no further than My Valuation.

We are IBBI registered valuer helping startups and businesses with objectively accurate valuation services in India. Our valuation experts will help you find the accurate market value of your business and guide you through the valuation and business modeling implications.

Reach out to us today.

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