Phantom Stock
Introduction to Phantom Stock
What Is Phantom Stock?
Phantom stock is a type of incentive compensation that provides employees with benefits similar to equity ownership, but without granting them actual equity in the company. Phantom stock is relatively rare, but the most frequent use case is for privately owned companies that don't want to issue equity or dilute corporate ownership but still want to incentivize employees to grow the value of the company.
How Phantom Stock Works/Key Components
Phantom stock units track the value of company stock and pay the employee based on that value. However, phantom stocks are not actual company stocks, and grantees do not receive voting rights or dividends.
Number of Phantom Shares
The phantom stock grant specifies the number of shares applicable to the grant.
Phantom Stock Type: Appreciation-Only or Full-Value
Phantom stock is primarily one of two types. Appreciation-only is somewhat similar to a stock option, and Full-Value is somewhat similar to an RSU:
Appreciation-only. Employees receive payment only for the increase in stock value from when phantom shares were granted. If the stock value declines or stays flat, employees receive nothing. This limits costs for the company but provides less incentive and security for employees.
Full value. Employees receive the full market value of vested phantom shares, regardless of whether the stock value increased or decreased. This provides more motivation and security for employees but requires the company to pay the full share value even if the stock declines in value.
Phantom Share Value
A fair company value is critical for phantom stock. Companies typically determine the firm value periodically through an independent valuation (typically called a 409a Valuation); less commonly this is done via other approaches (e.g. internal metrics). As the stock appreciates in value, so does the estimated worth of an individual's phantom shares.
Vesting Start Date
The vesting start date is exactly as it sounds; the date the vesting begins.
For new-hire grants, vesting typically starts on the employee's start date.
For existing employees (getting new/additional grants), the vesting start date can vary, but is usually somewhat close to the grant date.
Vesting Schedule
The vesting schedule determines when an employee receives ownership of a portion of the shares. The key sub-parts of this are: Vesting Start Date; Total Length; Vesting Frequency; Cliff or No Cliff; Single/Double Trigger.
IMPORTANT: Vesting schedules can (and frequently do) vary in many ways. For more information and examples see: Vesting Schedules
Cliff Vesting ("Cliff")
A cliff is built into the vesting schedule, functionally modifying it so that no phantom stock will vest until a minimum amount of time is met (i.e. the cliff time period).
Why do companies use cliffs? Stock-comp is intended to incentive employees to add value to a company. Cliff's help ensure a long enough tenure to add such value.
Single- or Double-Trigger
Phantom stock can be both single-trigger or double-trigger; double-trigger is much more common:
Single-trigger. Phantom stock vests when time-vesting requirements are met.
Double-trigger. Phantom stock only vests when two criteria are met: (i) time-vesting and (ii) a liquidity event happens.
Why is double-trigger the most commonly issued type of phantom-stock for VC-backed companies?
Because phantom stock is not equity, it typically needs to be settled in cash. If a company is not cash-flow-positive (or just wants more predictability and control over cash outflows), single-trigger phantom stock presents a challenge.
With a double trigger, shares only vest when both (i) shares have time-vested and (ii) a liquidity event occurred. This gives most private companies more comfort -- as a liquidity event would be anticipated to provide an influx of cash (allowing the company to pay out individual's earned value on Phantom Stock).
Note: this is relatively similar to Double-Trigger RSUs
How Phantom Stock Provides Employees With Value
Companies grant phantom stock to give employees (or other individuals) the opportunity to financially participate in the equity appreciation of the company, but without explicit equity ownership of the company. With phantom stock, an individual typically has the right to receive a payment when the company has a liquidity event (either on the full value of shares, or the appreciation since grant -- depending on the type).
Phantom stock may also have a maximum payout cap
Make sure to fully read and understand your phantom stock. Some plans cap the maximum amount of payout that may be made
Exercising Phantom Stock
Phantom stock that can be exercised is rare. But if you have it, exercising would typically involve the following steps:
Notify the company. When an employee wishes to exercise, they must notify the company (according to the procedures outlined in the phantom stock plan). This often simply involves submitting an exercise notice to the appropriate department.
If any restrictions exist, ensure those are not violated. The company, the individual, or both need to make sure the exercise request is within the company's guidelines. Otherwise, it may need to be amended, or otherwise be rejected.
Receive payment (net of tax). After notifying the company, the employee will typically receive a cash payment for the exercised phantom stock within a set time frame. The payment amount will be contractually determined, based on the type of phantom stock, associated rules, and change in the company's stock price over time. Phantom stock compensation is taxed as ordinary income and tax withholdings are required; as such, the payment to the employee would be net of withholding tax.
Phantom Stock Has Unique Features (and Potential Restrictions)
Phantom stock is paid out in cash. To prevent unexpected cash outflows, phantom stock plans may specify some rules or restrictions (we suggest you read your grant carefully). Examples of items to be aware of include:
Double-trigger grants may not be exercisable. Rather, its paid if/only upon a liquidity event.
Double-trigger may be forfeited in some situations. If a liquidity event does not occur within a specified period of time, or if an employee leaves the company prior to the event occurring -- some plans specify that the grant is forfeit.
Single-trigger grants may have rules and/or restrictions. When you're allowed to exercise, and how many shares you're allowed to exercise at that time may have limitations or restrictions.
Phantom Stock Benefits, Drawbacks, and Less Common Elements
Economic exposure without equity ownership. Phantom stock allows employees to benefit economically from increases in company value without actually owning equity.
Flexibility for companies. Phantom stock plans are very flexible for companies to design and implement. Companies have significant control over details like vesting schedules, payout timing, and triggers for payouts or accelerated vesting.
Potential to reduce risks for employees. Employees get the rewards of stock price gains without the risks of holding equity.
No dilution. Unlike actual stock grants, phantom stock does not require issuing additional shares, so it does not dilute the ownership stakes of other shareholders.
Phantom Stock Tax Implications
Most Phantom stock is double-trigger, and thus taxation is typically associated with a liquidity event:
Non-taxable at grant. Phantom stock grants do not trigger any tax implications when they are granted.
Non-taxable when time-vesting. Assuming a double trigger, shares will not have met all vesting criteria when time-vesting, and thus it is not a taxable event.
Ordinary income tax treatment when vesting. Upon a liquidity event (double trigger), an employee vests their phantom stock. The payout value is treated as ordinary income (including withholding requirements and FICA taxes).
For more information see: Phantom Stock Taxation
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