You may have heard the whispers through the jungle grapevine on “phantom shares” (also sometimes referred to as “shadow equity”). As a startup, your company’s budget may not stretch to paying market salaries, so a phantom share plan may help you attract top talent. Phantom share plans are a form of compensation for employees and are an alternative to more traditional employee share option plans (ESOPs). While they are more commonly seen in jurisdictions with income tax, your common law company may wish to explore using one.
How is a phantom share plan different to an ESOP?
A phantom share plan is a deferred compensation plan that gives the employee the right to receive a cash payment on a future date which is usually linked to an exit or liquidity event. The amount of that cash payment is tied to the value of the company’s shares. However, this right does not give any equity ownership to the employee (i.e. the company does not issue any shares to the employee): it is a contractual arrangement in which the employee is granted units of phantom shares.
If you’d like to know more, Do I need an Employee Share Option Plan? has information on ESOPs.
Why would I want to use one?
Employers use phantom share plans for reasons that are broadly similar to those cited for using ESOPs: to motivate employees to work harder, resulting in a successful company whose valuation increases. Both types of plans are designed to encourage loyalty to the company: if employees feel invested in the company, they are less likely to seek new opportunities elsewhere. Replacing senior leadership is essential to a company’s success and it is expensive to replace those leaders if they leave the business. Phantom shares could be granted every year, perhaps with a five-year maturity period. Once those employees have been with the company for five years, they will benefit from these rewards annually, but if they leave the company before the shares mature, they will not receive any payment for the phantom shares.
Phantom shares are not actual equity, so they avoid some of the downsides of issuing shares in your company. Some of the reasons why you may not want to issue shares to your employees include:
• diluting ownership by issuing shares to many employees, as this may impact on voting rights;
• additional agreements and documentation (e.g. shareholders’ agreement) may be needed, which increases the complexity of the arrangement and involves time, effort and cost;
• introducing mechanisms to deal with what happens to the employee’s shares if their employment with the company ends; and
• the plan may increase the company’s cost of keeping the shares in the company’s possession if the company has a buyout provision which applies to a departing shareholder.
Any reasons why I should not use a phantom share plan?
Phantom share plans benefit employees if the company grows. If your company does not foresee growth in the near future (e.g. you have a long research and development phase ahead), these plans may not have the intended effect and instead lower morale. Some employees may also be more excited by the idea of having real shares in your company rather than phantom ones.
How does a phantom share plan work?
The plan will state the number of units of phantom shares or the participation percentage interest which will be granted to the employee. If the latter, the company may increase the percentage interest in instalments over a period of time (for example, the initial percentage interest may be 5 per cent. and this will increase to 10 per cent. after the employee completes five years of continuous service with the company). The phantom shares may be immediately vested or subject to a vesting schedule. The employee may also lose the entitlement upon the occurrence of certain events (e.g. termination for cause or a breach of a non-compete restriction).
If you’d like to know more, Do we need a Founders’ Agreement? has information on vesting arrangements.
How do I determine the value of a phantom share?
The value of a phantom share unit is measured by the value of the company’s shares and will fluctuate as the value of the company changes. That value may be fixed, calculated using a formula or determined by a valuation exercise. The value will be subject to adjustments e.g. capital investments made by shareholders and dividends paid to shareholders.
When does the employee receive value for the phantom shares?
Payment of the benefits is usually deferred until a specified date, which is usually linked to an exit or other form of liquidity event. The phantom share units are valued and the payment follows, either as one lump sum or a series of instalments over a particular period of time. In its most common form, an employee holding phantom shares will get paid by the company for those shares on a sale of the company.
Two types of phantom share plans are typically used: appreciation only and full value. For appreciation only plans, the employee receives an amount equal to the value of the increase in the company’s share price (e.g. if an employee is granted 100 phantom shares worth US$50.00 each and the value of each share increases to US$80.00 at the time of payment, the difference between the current value (US$80.00) and the initial value (US$50.00) is US$30.00, so the employee will receive a bonus of US$3,000 (US$30.00 per share multiplied by 100 shares)). Under a full value plan, the employee will receive the underlying value of the phantom shares at the time of payment (e.g. using our earlier example, the same employee would receive US$80.00 per share and therefore a bonus of US$8,000).
What do I need to think about?
Phantom share plans offer more flexibility in design than a traditional ESOP. If you aren’t sure whether a phantom share plan is suitable for your company, consider the following:
• Are there key employees who are essential to the growth of your company?
• Do you expect your company to grow? A phantom share plan will only work if you expect an increase in the company’s value in the years ahead.
• If the company is expected to grow, what percentage of that upside are you willing to share with your employees?
• Will phantom shares be a meaningful incentive to them?
I want one. What details do I need?
You will need to think about the following points when developing your company’s plan:
• Who can participate in the plan (both current and future positions)?
• Will employees receive payment on a full value or appreciation only basis?
• How often will the company grant phantom shares (e.g. one upfront grant or annually)?
• When will units vest? If units are awarded annually, will each new grant be subject to a fresh vesting schedule?
• How will the units be valued? Will the company use a formula or an appraisal?
• Should the employee forfeit their phantom shares for any reason (e.g. breach of non-compete restriction)?
• When will the value of the phantom stock units be paid out (e.g. only an exit or liquidity event and/or upon termination of employment)?
• Will the payment be made in a lump sum or in instalments? If in instalments, over how many years?