What Is Phantom Stock?

Definition and Example of Phantom Stock

Phantom stock is a form of employee compensation that gives employees access to stock ownership without actually owning the stock. Like any genuine stock, phantom stock's value rises and falls in line with the underlying company stock. Staffers are compensated with profits incurred from any company stock appreciation on specific dates.

Phantom stocks are becoming increasingly prevalent as part of a total compensation package. They're not restricted to tech companies. Some companies tie the award to performance goals.

• Alternate name: Shadow stock

How Phantom Stock Works

The number of phantom shares given to an employee or manager often depends on that person’s perceived value to the company. The more an employee is valued, the greater the number of shares they're likely to receive.

A “delay mechanism” kicks in when phantom stocks are awarded. The actual financial payout is made after a long period, such as two to five years, but it depends on the agreement made between the company and the employees.

Types of Phantom Stock

Companies tend to use either “appreciation only” phantom stocks or “full value” stocks.

Appreciation Only

An appreciation stock will bar recipients from garnering the current value of the phantom stock. Recipients instead earn any profit that the phantom stock might earn over a specific period, such as stock price appreciation.

The current value of the company stock would be $20,000 if employee “A” were to receive 1,000 shares of phantom stock, with each stock worth $20. Suppose that under the terms of the agreement, the employee must stay with the firm for five years to benefit fully from the phantom stock deal. This time frame is known as the “vesting” period.

The company’s stock has risen to $40 per share at the end of the vesting period. Employee “A” would receive the difference between the $20-per-share value of the stock on the date when the deal was struck and the $40 share price on the date when they become entitled to any profits from the stock. The appreciation in this case is $20 per share, which would give the phantom stockholder a profit of $20,000.

Full Value

The recipient earns both the current value and any stock price appreciation once the due date is reached under a full value phantom stock deal.

Employee “A" would receive the $20-per-share price increase after five years in this case. They would also earn the current price appreciation on the shares since the date when the deal commenced.

Pros and Cons of Phantom Stock

Pros Explained

• Employees benefit as the stock price appreciates: Phantom stocks are a solid motivational tool to keep key employees on board for the entire vesting period. They boost employee productivity. The recipient benefits, too, when the phantom stock price appreciates.
• Employees don’t have to take any action to purchase stocks: There’s no need for these employees to purchase phantom stock shares the way regular stockholders must acquire them on the open market. Phantom shares are instead given to employees, with no money changing hands. That’s a big benefit to employees. They share in the stock's profits without having to pay for it.

• The company gets to retain control of the stocks: Company control of phantom stocks is advantageous to employers. A company can dictate the structure of the agreement under a typical phantom stock charter or contract. It can control the level of equity participation in the form of dividends that are paid out to employees. Companies can also include a provision in a phantom stock agreement that “forfeits” any phantom stock benefits if the employee in question departs the company before the agreed vesting-completion date.

Cons Explained

• Employees have no options or control if the stock price plummets: The company calls all the shots in a phantom equity deal, giving employees little control or maneuverability if the share price goes south. Taxes factor into phantom stock deals, too. Companies must strictly adhere to the Internal Revenue Service’s (IRS) tax rule 409A, which limits a company’s options in instituting distribution dates. It also blocks employees and managers from accelerating phantom stock payouts if they think the company might be in severe financial stress.
• Employees can lose benefits if they’re terminated: Termination before the deal triggers, even over issues outside the employee’s control, leaves them out of luck on collecting any phantom stock cash benefits.
• Phantom stock plans can incur additional costs for companies: Companies that implement phantom stock plans can incur additional costs, particularly if any stock valuation overview must be completed by an outside accounting company.