Being able to offer substantial remuneration packages is essential to attract the best and the brightest, especially for pivotal management roles. One way you can achieve this is by creating a phantom share option plan, otherwise known as an incentive compensation plan.

Far from being slightly dodgy (as the name may imply), a phantom share option plan is attractive because it gives key employees a stake in the financial success of the company, without the need for the company to make the person a formal shareholder.

The company and employee enter into a contractual relationship, whereby the employee can receive the economic benefit of share ownership, without actually owning shares. Provided that certain triggering events are satisfied, which would be set out in the share option agreement, the employer will be obliged to issue a cash bonus to the employee, which is linked to the increase in the company’s share value. No actual shares are transferred under a phantom share scheme; therefore, the employee does not become a minority shareholder, nor have any voting rights.

There are a number of advantages in providing phantom share option plans to employees, including:

• since no shares are transferred to the employee on the triggering event, the shares in the company are not diluted;
• phantom share option plans are relatively free from regulatory controls. This allows the board to draft the scheme to fit the commercial objectives of the company, including provisions such as the achieving key performance indicators, good and bad leaver provisions, and change of control provisions;
  the amount of the bonus is linked to the performance of the company, which helps ensure that the objectives of top executives are aligned with that of the company’s shareholders;
• for the company, a tax deduction may be available for the cost of payments under the scheme as the amount paid could be offset against the company’s profits;
• as the scheme is discretionary, it does not have to be offered to every employee;
• employees are not taxed on the value of shares nor are they obliged to pay tax on the company’s income. Although, if paid out under the scheme, said payment will be subject to income tax and National Insurance Contributions (NICs) on the full value of the bonus; and
• the company is able to incentivise employees by offering certain economic benefits that come from share ownership, without giving the employees voting and inspection rights.

Some of the key considerations in relation to phantom share option plans include:

• for employees, the cash bonuses are subject to income tax and National Insurance Contributions (NICs) on the full value of the bonus;
• lack of eventual share ownership means once an employee triggers the option and the bonus is paid out, there is no potential for further gain on the employees’ side. Therefore, from an employee’s perspective, it may be worthwhile to negotiate a phantom share option that pays out in stages, potentially reflecting the longevity of the employee’s role within the company;
• as the bonus scheme takes effect on a triggering event, the organisation will need to have the cash reserves available for when payment is due. This can cause cashflow issues in smaller companies. Although, most companies will add limitations of the amount paid out or agree a notice period with the employee in order to allow the company to factor the bonus into its cash flow;
• without actual share ownership, the employee does not have the right to inspect the books and records of the company. Therefore, in a private company, the employee should negotiate a mechanism to verify the market value of the shares;
• the long-term impact of phantom share options on a company’s valuation and balance sheet should be reviewed by an accountant.

The key difference between a phantom share option plan and a cash bonus is the former is directly linked to the company’s rising share price. Using a phantom share option plan assures shareholders that any large bonuses paid to senior executives are justified as they are in direct correlation with the rise in the value of the company.

Because phantom share schemes are linked directly to the increase in the value of the company, they are not generally suitable as an employee-wide incentivisation scheme since not all employees have direct influence over the share value. In addition, few companies are ‘cash-rich’ enough to support such a wide-ranging scheme, as there is always the danger of multiple employees satisfying the triggering event all at once.

As such, phantom stock should be used to protect the company’s investment in its key employees, by sharing the success of the company. Therefore, phantom share option schemes can provide a strong incentive to senior executives whose role puts them in a position to directly affect the value of the company.

Saracens Solicitors is a multi-service law firm based opposite Marble Arch on the North side of Hyde Park in London. We have years of experience in advising private and public companies on various share option schemes. For more information, please call our office on 020 3588 3500.

Do you have any comments to make on this article? Please feel free to add them in the section below.