Disadvantages of Phantom Stocks

Phantom stocks, also known as shadow stocks, are a kind of employee incentive and compensation plan that mimics an actual company share but without ownership rights. While it is an excellent way to encourage and appreciate employees, it comes with a handful of disadvantages, including a lack of actual ownership, increased tax burdens, lack of liquidity, dilution in a company’s equity structure, and much more. 

Over the years, founders and companies have embraced phantom stocks as an easy way to compensate their employees when they begin to do some good numbers in the growth of their startups. For instance, a founder could have a financial projection to be worth $5 million in Q4 of 2023, and as that upside is achieved, they could consider motivating their employees to put in the work needed to scale the company higher.

Essentially, it is a way to tell employees that when they put in the required work, and the company scales up further, they have a share in the company that offers them some financial benefits. This makes employees committed to working and growing the company to ensure it reaches the valuation and completes the vesting schedule for them to be eligible to own their financial compensation.  Also, companies issue phantom stocks when they are not willing to issue additional shares to prevent further dillution.

Overall, phantom stocks differ from traditional stock options as they are virtual stock options issued to company employees to be redeemed only when the company achieves a certain valuation. Usually, shares are issued to employees and investors for the company to raise capital. For phantom stocks, the goal is not to raise capital but to motivate employees to work hard to get the company to where it wants to be. 

Typically, issuing phantom stocks often seems like a win-win situation for companies in that they create financial compensation and motivation for employees, which translates to improved performance and productivity in the company. The company grows to achieve its financial projections while employees are rewarded handsomely for their efforts for company growth. However, there are disadvantages to phantom stocks that make it not so much of a great strategy to adopt for companies. We’d go over these disadvantages of phantom stocks. 

Disadvantages of Phantom Stocks

The following are the disadvantages of phantom stocks to employees and employers alike:

1. Lack of Actual Ownership:

The issuance of phantom stocks does not come with a stake in the company’s ownership. Phantom stocks are only issued to provide future financial dividends. Employees with phantom stock have a contractual right to cash payout when the company hits a certain valuation and there’s no stake in ownership with this arrangement

2. Limited Voting and Decision-Making Rights

Moving on from the lack of actual ownership disadvantage of phantom stocks, we have limited voting and decision-making rights. Usually, when issued stock options come with no stake in the company’s ownership, they are not often provided with voting rights or control too. This is the case with phantom stocks. There’s no decision-making right given to holders and when there are voting rights, it comes with a limit. 

3. No Financial Dividends 

Phantom stock units do not entitle owners to receive dividends like regular shareholders do. Employees participating in phantom stock privileges only get a financial benefits when the company hits a valuation and after that nothing follows. Only regular shareholders continue to receive additional financial benefits as the company grows. 

4. Tax Implications

Cash payouts received by employees upon vesting of phantom stock units are generally taxable as ordinary income. The company may also be required to withhold taxes on the payout. This can result in increased tax burdens for both the employees and the company.

5. Cash Payout Risks

The financial guys are quick to make projections and convince people of the possibilities which can motivate employees to work in order to help the company grow for their phantom stock privileges to materialize. However, market forces and trends can take unprecedented turns which make projections impossible. 

Since the benefits of phantom stocks can only be contingent upon the company’s performance or predetermined benchmarks, employees with phantom stocks will not get the cash payout if the company does not meet the benchmark. 

6. Lack of Marketability 

Phantom stocks cannot be freely traded or transferred. This makes it difficult for people in phantom stock arrangements to not know how much their stocks are worth. If you desire immediate access to the value of your phantom stocks, you’ll not be able to get it. 

7. Complexity and Administrative Burden 

Implementing and administering a phantom stock plan can be complex and require additional administrative efforts. The company needs to track the performance of the underlying stock, calculate the value of phantom stock units, monitor vesting schedules, and process cash payouts. This administrative burden can be time-consuming and may require dedicated resources.

Having understood the disadvantages of phantom stocks, it is clear that the negatives outweigh the positives. We’d discuss some alternatives that can help employers provide employees with the compensation they deserve other than the issuance of phantom stocks. 

Alternatives to Phantom Stocks

Companies can employ the use of stock options, restricted stock options (RSUs), and employee stock ownership plans (ESOP) to make up for the privileges they want to accord employees with the use of phantom stocks. 

When compared with each other, both phantom stocks and these suggested options have their merits and demerits. I have analyzed them below:

Stock Options

Stock options give employees the right to purchase company stock at a predetermined price (the exercise price) within a specified period. Here are the advantages and disadvantages of stock options compared to phantom stock.

Advantages:

1. Potential for substantial financial gain if the company’s stock price increases significantly.
2. Aligns employee interests with shareholders, as employees benefit directly from stock price appreciation.
3. Provides employees with the opportunity to become actual shareholders and participate in voting rights and dividends.

Disadvantages:

1. Stock options have an exercise price, and if the stock price does not exceed this price during the exercise period, they may end up worthless.
2. The potential financial gain is contingent on stock price performance, which can be volatile.
3. Stock options require the employee to invest personal funds to exercise them, which may be a barrier for some employees.

Restricted Stock Units (RSUs)

RSUs are actual shares of company stock that are granted to employees, subject to certain restrictions and vesting schedules. Here are the advantages and disadvantages of RSUs compared to phantom stock.

Advantages:

1. Employees receive actual ownership in the company, including voting rights and the potential to receive dividends.
2. RSUs provide a direct link between employee compensation and the company’s stock performance.
3. Simplified taxation compared to stock options, as RSUs, are typically taxed at vesting based on the stock’s fair market value.

Disadvantages:

1. RSUs may have restrictions on the immediate sale, limiting liquidity for employees.
2. Employees may face tax obligations upon vesting, even if they have not sold the shares.
3. The value of RSUs is tied directly to the company’s stock performance, which can be volatile.

Employee Stock Ownership Plans (ESOPs)

ESOPs are employee benefit plans that provide employees with ownership in the company through the allocation of company stock. Here are the advantages and disadvantages of ESOPs compared to phantom stock. 

Advantages:

1. ESOPs foster a sense of ownership and employee engagement in the company’s success.
2. Employees have the potential to accumulate significant wealth as the company grows.
3. ESOPs can provide tax advantages for both the company and its employees.

Disadvantages:

1. Establishing and maintaining an ESOP can be complex and costly.
2. ESOPs require ongoing administrative efforts, including valuation and compliance.
3. The liquidity of ESOP shares may be limited, making it challenging for employees to sell or access the value of their shares.

How to Mitigate the Disadvantages of Phantom Stocks

There are ways employers and founders can help reduce the impact of the disadvantages of phantom stocks. The following are suggestions that can help them do so:

1. Clear Communication: 

It is important for employers to explain how phantom stocks work to employees. Their employees need to understand the mechanism behind phantom stocks and how dividends are earned. 

2. Adopt performance-based vesting criteria: 

Rather than provide a benchmark in the company’s financials to redeem phantom stocks, companies should tie the vesting of phantom stock units to specific performance goals or metrics. By aligning the vesting with the company’s performance, you can reinforce the link between employee efforts and the company’s success. This approach ensures that the payouts are tied to achieving specific objectives, which can contribute to the company’s overall success.

3. Develop a comprehensive cash flow management strategy: 

It is necessary to develop a comprehensive cash flow management strategy to cushion phantom stock payouts’ effect on the company’s financials. Consequently, consider setting aside funds or establishing reserve accounts to ensure the company can fulfill its obligations when the phantom stock units vest. 

4. Regularly evaluate the plan and make necessary adjustments:

As often as possible, the company should periodically evaluate the issuance of the phantom stock to ensure they align with the company’s values and goals. Where needed, the company should make adjustments to the provisions of the phantom stock issuance. 

5. Educate employees on tax implications:

Employers should provide clear information regarding the tax implications of phantom stocks upon payout and any tax withholding requirements. 

6. Seek professional guidance 

Phantom stocks and their issuance is a complicated venture, and companies must consult professionals and experts before attempting to take any step. Professional Guidance includes seeking Guidance from professionals with expertise in compensation and equity plans. Additionally, consulting with legal, tax, and financial professionals can help ensure compliance with applicable regulations, optimize plan design, and address any specific challenges or considerations related to phantom stocks.

Bottom Line 

Phantom stocks help companies to improve employee productivity. In addition, companies enjoy a non-taxable income window until the phantom stocks issued grow to maturity. However, phantom stocks come with a considerable amount of disadvantages that can diminish participants’ perceived control and influence, strain company liquidity, require extensive administrative efforts, introduce tax complexities, create disagreements, and subject participants to volatility in financial benefits tied to stock performance.

However, by adopting a couple of mitigation hacks noted in this article, companies can cushion the impact of the disadvantages of phantom stocks. 

FAQs

What is another name for phantom stock?

There are three common synonyms used to refer to phantom stocks. They include “ghost shares,” “shadow stock,” and “stimulated stock,” etc. 

What is the difference between phantom stock and stock appreciation rights?

While phantom stock and stock appreciation rights (SARs) are forms of equity-based incentives, there is a slight difference between the two. Phantom stock grants employees hypothetical or notional units that mirror the value of actual company shares. Upon payout, employees receive a cash amount equivalent to the increase in the stock’s value. 

On the other hand, SARs give employees the right to receive appreciation in the value of a specified number of shares over a predetermined period. Unlike phantom stock, SARs are settled in actual company shares rather than cash.

What is the vesting schedule for phantom stock?

The vesting schedule for phantom stock is determined by the company and outlined in the phantom stock plan. It specifies the timeline and conditions under which the phantom stock units granted to employees become eligible for payout. Depending on the company, vesting schedules can be from three, four, five years after issuance.