Phantom stock options: an emerging trend in employee compensation - key distinctions from stock option programs
Stock options have become an integral part of corporate culture in the current business environment, specifically within IT companies. It is one of the most in-demand win-win solutions for long-term motivation, linking employee interests to company success.
For companies, stock options serve as an effective tool for motivation and retention of key employees, while providing employees with an opportunity to participate in the business and receive a “piece of the pie” upon achieving success.
There are various types of stock options, whereas the practice of their granting depends on jurisdiction and internal corporate policies. Nonetheless, all stock option programs (regardless of type) share a common principle: employees acquire the right to exercise their stock options (i.e. receive compensation for the contribution) upon fulfillment of specified conditions (e.g., KPI achievement, Exit, IPO, employment for X years in X position). The form of compensation depends on the type of stock option – phantom stock option or stock option.
Recently, companies have increasingly opted to grant phantom stock options to employees. In this article, we will delve into key features of this type of stock option, as well as the fundamental distinctions between stock options and phantom stock options.
What are the differences between stock options and phantom stock options?
The distinctions between stock options and phantom stock options can be made on the following criteria:
1. Employee status
Employee status is linked to the option exercise event.
Upon exercise of stock option, the employee becomes a stockholder with corresponding rights as set forth in the company's bylaws or stockholders' agreement.
As a matter of actual practice, a special class of stock is allocated under options, which provides a limited scope of corporate rights to their holders. For instance, the holders of this stock class may not have voting rights and the right to participate in corporate governance, but they may receive dividends and possess information rights (for more details on information rights, see the REVERA material at the link). This approach allows balancing the interests of the company and employees while preventing excessive employee influence on the company’s corporate governance.
In contrast, phantom stock options do not grant employees stockholder status and any corporate rights. Instead employees receive cash compensation linked to the value of the company’s shares. This approach significantly simplifies administrative procedures for the company, as it eliminates the need to register employees as stockholders, pay registration fees and undergo banking KYC procedures.
2. Compensation form
Upon exercise of stock options, employees receive the right to purchase a specified number of stock at a predetermined price. Subsequently, they may sell the stock at market value and thereby receive a cash benefit.
As a matter of actual practice, corporate documents impose certain restrictions on an employee's sale of stock following option exercise, in particular:
- right of first refusal (i.e., preemptive right of existing stockholders or the company to purchase stock);
- lock-up period (i.e., prohibition on stock transfer for a specified period or before the occurrence of specified events (such as an Exit or IPO).
As for phantom stock options, employees receive cash compensation, the amount of which is calculated based on the appreciation in value of notional (phantom) stock, as if the employee actually held equity .
As a matter of actual practice, the formula for compensation calculation is set forth either in the option program (in case it is the same for all option holders) or in the option agreement with a particular employee (if it varies by employee).
3. Capital dilution
The grant of stock options involves the stock issuance and, consequently, dilution of existing stockholders' equity interests.
As a matter of actual practice, when implementing a stock option program, an option pool (i.e., a maximum number of stock allocated to employees under options) is reserved in order to avoid dilution of existing stockholders' equity interests. Therefore the impact of granting options to employees on the stock capital can be determined at the outset.
Phantom stock options do not affect the capital structure since no stock is issued. In essence, phantom stock options constitute a debt obligation of the company to pay compensation to the employee at a specified time and upon occurrence of specific conditions (such as KPI achievement or an IPO).
4. Taxation
While calculating the tax burden when selecting a particular type of stock option program, it is important to consider that the tax consequences of granting and exercising stock options depend on numerous factors, but primarily – on the tax residency of both the company and the employee.
The receipt of stock options by an employee may result in tax liabilities arising in the following circumstances (depending on the tax residency of the option holder):
- upon the employee's purchase of stock as a result of option exercise (since the stock will be deemed benefit in kind);
- upon the employee's receipt of dividends;
- upon the sale of stock.
As for phantom stock options, only the cash compensation received by the employee is subject to taxation (as a rule, subject to personal income tax) since the compensation under the phantom stock option is not classified as dividends or benefit in kind, but essentially constitutes a bonus / incentive payment.
It is important to take into account that if the employee and the company are tax residents of different jurisdictions that do not have a double tax treaty in place, the overall tax burden on options (phantom or stock) may increase significantly.
When selecting between different types of stock options, aforementioned nuances should be carefully considered, and companies should remember that it is always better to consult with a specialist once again in order to avoid unexpected costs.
Authors:
Ekaterina Yakoltsevich, REVERA lawyer
Veranika Hrazheuskaya, REVERA lawyer
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