Motivating and inspiring employees involves various strategies. One emerging approach gaining popularity is the use of phantom shares, also known as virtual stock options. These phantom shares offer similar financial benefits to traditional stock options but don’t grant actual ownership in the company. Let’s explore what phantom shares are and how they work.
Understanding Phantom Shares:
Phantom shares, also called phantom stock or virtual stock options, are becoming increasingly popular in the startup world. These compensation tools are designed to reward, retain, and motivate employees. Here’s how they operate:
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Non-Ownership: People who receive phantom shares don’t actually own any part of the company. Unlike traditional stock options, they can’t buy shares or become shareholders.
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Tied to Company Value: Phantom shares are linked to the real-time value of the company’s stock. So, the compensation tied to phantom shares depends on how well the company’s stock performs.
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Sharing in Growth: Phantom shares give employees a chance to benefit from the company’s growth. When the company’s stock value goes up, the potential compensation also increases.
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No Need for Real Equity: Unlike traditional equity compensation plans, startups don’t have to set aside real shares as assets when using a phantom stock plan.
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Triggered by Events: Phantom shares usually become “liquid” when the company is acquired, goes public, or as specified in buyback agreements.
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Tax Considerations: Gains from phantom shares are reported as ordinary income when they vest and are subject to taxation.
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Dilution Effect: Phantom shares become part of the company’s capitalization table, and their vesting can dilute existing stakeholders during acquisitions or IPOs.
How Phantom Shares are Paid Out:
Phantom shares are typically paid out when the company is acquired or goes public. Employees receive a cash payout equal to the value of their phantom shares. In acquisition scenarios, the acquiring company deducts the amount designated for employees with vested phantom shares from the total acquisition cost.
During an acquisition, shareholder dilution only occurs based on the number of vested phantom shares, taking into account potential acceleration rights. For example, if a company granted 10,000 phantom shares but only 5,000 were vested by employees at the time of acquisition, only those 5,000 vested phantom shares would dilute existing shareholders.
Companies can also choose to buy back phantom shares from employees at a predetermined discount, a provision often outlined in the initial contract. Buybacks are a way to provide employees with liquidity while maintaining control over the company’s capitalization table without increasing dilution.
Creating a Phantom Shares Plan:
Establishing a phantom shares plan involves several key steps:
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Plan Design: Define critical plan elements such as the size of the plan (pool size), vesting period, vesting schedule, cliff, acceleration clauses, liquidity event triggers, repurchase or buyback terms, and good and bad leaver definitions.
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Plan Approval: The plan must be approved by the company’s executive body, usually the council.
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Plan Launch: Launch the plan by sending employee invitation letters, conducting informational meetings, and effectively communicating plan details to ensure its success.
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Plan Management: Legal professionals will create the necessary documents, but ongoing management includes handling employee grant letters, vesting calculations, ownership tracking, and plan maintenance. Tools like Syndicately can simplify these processes.
Advantages of offering phantom shares to employees include:
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Performance-Based Incentives
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Cash Flow Flexibility
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Employee Engagement and Loyalty
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Long-Term Alignment
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Simplified Cap Table Management
In summary, phantom shares offer a compelling alternative to traditional equity compensation plans, helping startups incentivize and retain employees. However, careful planning, communication, and legal guidance are essential to maximize their benefits while minimizing potential drawbacks.
