How Phantom Equity Drives Employee Engagement

As a business owner, you want your employees to bring excellence to the table. You want them to drive business goals and deliver their innovative best. Essentially, you want them to take ownership of their domains.So, is there a way to inspire employees to act like owners without giving away equity ownership? The answer is “Yes”. Issuing phantom equity to existing and potential employees is an effective way for companies to motivate employees (to bring their best to work and enjoy a share of the profits).

What Is Phantom Equity?

Fresh recruits often come on board with a lot of enthusiasm. But after spending two to five years, employees seek more value from companies. Besides compensation and employee benefits, they also want to benefit from the company’s overall profitability.Traditionally, companies have offered stock options as a way to get employees invested in the long term. This meant giving away equity and ownership. But that’s neither always possible nor in the interest of founders & investors.Phantom equity (also known as shadow equity, mock stock, or synthetic equity) is a unique benefit where select employees are issued “phantom shares,” which mirror the value of the real stock. However, phantom equity is not real equity.

Features of Phantom Equity

Here’s a rundown of how phantom equity works:

  • Employees with phantom equity are not shareholders in the companies. But at a designated time in the future, cash payments amounting to the market value of an equivalent number of shares of the company’s stock will be made to the employee.
  • Though a phantom share is not an actual stock, its value rises and falls based on the company’s market share price, or valuation, if it is not publicly traded.
  • The vesting period (i.e. the predetermined time frame for paying out phantom shares) can be immediate or after one to five years. If the vesting period is fixed, this option becomes attractive enough to hire, retain and inspire employees to deliver their best performance.
  • Details such as the number of phantom stocks, vesting period, and payment options are laid out in individual contracts shared with each employee. The terms can vary for different employees.
  • Payments are issued in the form of cash bonuses. They can also be paid like a dividend, mirroring the value and timeline of when shareholders receive their dividends.
  • When employees receive payments, they do not get the capital gains tax benefits. The amount must be added to their income and will be taxed as per their income slab.

Phantom Equity vs Stock Options

Companies need to weigh the pros and cons of offering phantom equity versus stock options. Here’s a look at some of the advantages of going the phantom equity route:

  • With stock options, employees become shareholders. On the other hand, with phantom shares, equity ownership continues to lie with founders and investors.
  • When a company goes the stock option route, the legalities are far more complex. Several guidelines by the Internal Revenue Service (IRS), such as the 409A valuation, must be followed. However, with phantom equity, the process is much easier & contracts are typically no more than a page long.

Who Gets Phantom Equity?

It is completely at the business owners and management’s discretion to decide ‘which employees receive phantom shares’ and ‘what are the terms & conditions of the agreement.’Typically, phantom shares are offered to highly valued employees and those who play a lucrative role in the business. The future pipeline of leaders, who resonate with the work culture, is often considered for offering phantom shares by the owners. Additionally, those employees who have stood by the business in a time of crisis can also be rewarded with phantom shares.

Triggering High-Value Employee Engagement

Just as shareholders track the value of their stock market holdings, employees who receive phantom equity can track their phantom shares as they grow in value. Watching the value of phantom shares grow can be a great motivator for employees to be more invested in their work.However, it’s not just about excelling in one’s job role. Once an employee sees themselves as having a stake in the company's growth, they tend to make driving profitability a personal goal. They take a deeper interest in the company's revenues. It may also nudge them to contribute with creative ideas to reduce overheads.There is a shift from seeing oneself as ‘doing a job’ to ‘taking ownership of how the business can thrive’. The prospect of receiving phantom shares works as a great incentive for employees.Some businesses encourage employees to attend weekly open-book staff meetings as a way to engage them. It also sends the message that phantom equity must be earned.

Factors Influencing Phantom Equity

When rolling out a phantom equity plan, company management should be aware of the following factors:

  • When and if you decide to sell the company, then every phantom equity share will be valued at the transaction price of an actual share.
  • If an employee leaves the company with vested phantom shares, then they will need to be paid a cash compensation worth their value.

Hence, it is best to lay out the terms and conditions of the payout clearly in the agreement. For instance, a company can decide to pay it in installments over a predetermined period to avoid cash flow issues for the business.

The Takeaway

Today, many businesses are considering phantom equity as a legitimate strategy to incentivize employees. The goal is to get them to stick around and play an instrumental role in the success of the business.The key to the success of this model is to design the terms and conditions with a realistic, long-term view. In addition, you also have to ensure that payment schedules do not financially drain the business.trica is a state-of-the-art stock options management tool leveraged by startups to build a sound structure for running stock options programs. This end-to-end solution is an excellent investment for businesses looking to hire and retain the best talent, with stock options as an offering.Book a demo today to know more!

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