Phantom Stocks Explained

Did you know that some stocks aren’t real?

Most people don’t, but these shadow stocks exist nonetheless—companies even give them to their employees. Don’t worry, these companies aren’t scamming their own workers. In fact, phantom stocks are more valuable than you may think. 👻 💰

To discover exactly how valuable they are, we have to take these stocks out of the shadows for a moment—no matter how hypothetical, phantom stocks can become real very fast.

For instance, for employers—who often struggle to keep key employees at their company for a long time—a bit of extra worker incentive is always welcome. After the Covid-19 pandemic, almost two-thirds of U.S. workers looked for new job opportunities as part of a trend called the “Great Resignation.”

This just goes to show how big the challenge of employee retention is for companies—and why stock-based compensation plans like phantom stocks are an invaluable addition to the mix of employee benefits.

To keep valued employees aboard, companies can compensate them in a variety of ways—phantom stocks being one of those. With many types of stock-based compensation out there, it’s easy to get lost in a sea of financial acronyms and abbreviations.

Nevertheless, an employee needs to know exactly what’s on the table—what’s all the tough negotiating for, otherwise? Likewise, the employer has to put up a balancing act between attracting the employee and not putting themself at a disadvantage. 

Before we make it sound too much like an episode of Suits, let’s get to the heart of the matter. In this article, we’ll tell you what phantoms stocks are, how they work, and what the different types are. We’ll also look at the pros and cons, alternatives and we’ll even unveil a more disturbing meaning of phantom stocks.

Phantom Stock, What’s That? 🤔

Do you want the financial benefits of having shares to your name without the hassle of actually owning them? Then, phantom stocks might be the answer—if your company offers them to you, of course. 

They might do so as part of the compensation package—the higher your position, the higher the chance the company will offer them to you. Don’t despair if you’re not up there yet, phantom stock compensation is becoming more and more prevalent.

Vesting ⌛

A specific number of phantom shares are granted to an employee—laid down in an agreement. Besides the number of shares, other important things—such as the type of payout and the vesting schedule—are also disclosed in the agreement.

Phantom shares—as with many other stock compensation types—are subject to a vesting schedule. Vesting happens when the shares are distributed to an employee—the first batch usually after one year.

After this “vesting cliff’’ has been reached, the remaining shares typically vest on a monthly or yearly basis until all of the shares have vested. In other words, the vesting schedule indicates when different batches of shares vest.

When phantom shares vest the recipient gets a specific amount of money equal to the value of the shares—depending on the type of plan. It is, however, also possible that the company distributes actual stock instead of cash.

Mock Stocks 💭

These “mock stocks” give an employee stock ownership without the stocks—yeah, you read that right. Although hypothetical, they go up and down in value along with the underlying company stock. 

No, the company is not trying to make you a pro at paper trading—there’s actual cash involved. Depending on the type of phantom stock—as if it wasn’t complex enough—the employee can expect a payout at a specific date or after specific achievements. 

How Phantom Stock Works 🔧

Although the name sounds a bit spooky, the only scary thing about phantom stock is paying the taxes—unless you’re the IRS, of course. So, let’s go ahead and shine a light on the shadow stocks—those are all the word jokes, we promise. 

Loyalty Pays 🤝

How many phantom shares an employee receives depends on the company—a good way to find out how valuable you are to an employer. Each company—that offers phantom stock—has its own phantom stock plan and policy in place.

Don’t expect to cash in right after signing the agreement—a delay mechanism is activated after phantom shares are granted. The actual payout takes place based on a vesting schedule—usually three to five years.

An employer can also choose to grant phantom shares over time in installments—for example, each month or year. The payout an employee can look forward to depends on the type of plan a company has—more on this later.

Why Do Employers Choose Phantom Stock?

Given the fact that there are many different types of stock-based compensation, you might be asking yourself why an employer would choose phantom shares—as opposed to any of the other stock compensation options. 

What all of them have in common is that they reward employees for being loyal and hard-working. As with the other types, phantom shares give employees “skin in the game”—motivating them to be productive. 

Share Issuance 📃

What sets phantom shares apart is that the shares are “fake”—who wouldn’t sign for that?

With the shares being non-existent, the employer doesn’t have to issue any new shares. 

The advantage of this is the lack of equity dilution—a fancy way to say each shareholder’s piece of the pie gets a little smaller after more shares are issued. On top of that, there won’t be any legal concerns that normally come with the issuance of shares.

Issuing shares to employees also means giving them a bigger stake in the company—partially shifting control. Phantom stock lives up to its name here—it gives the employees merely “phantom” control.

Diversification 📚

One of the best ways to lose your wealth is to put all your eggs in one basket—you wouldn’t be the first one to go broke by speculating on one or just a few stocks.  All the more reason to diversify your investment portfolio properly.

Many stock-based compensation options give employees a disproportionate amount of company stock in their portfolio—after the shares have been distributed. Phantom shares, however, don’t have the same effect since the shares don’t exist.

Golden Handcuffs 👮

To keep key—highly-compensated—employees from leaving, companies have the option of giving them golden handcuffs. Don’t worry, it’s not what it sounds like. The benefits employees receive from these handcuffs are strictly financial.

Golden handcuffs are used to get valued employees “locked in a job”—get cozy with your cubicle. To prevent them from running off to a competitor, they can count on a variety of financial incentives.

The catch is that the executives can forget about the benefits if they leave the company before an agreed-upon date. The incentives motivate high-up employees—who are notorious job-hoppers—to stay around longer than they normally would.

The Evaluation of Phantom Shares 📁

So, how much is a phantom share worth? The simple answer is that the value of a phantom share is tied to the value of an underlying company share. Phantom shares go up and down in value together with the company’s “real” shares.

In reality, it’s a bit more complicated—the company often has to hire an external appraiser to determine the value of phantom shares. No, not just by looking at Google stock charts—the parties involved have often agreed upon adjustments for calculating the value.

These could involve leaving out gains or losses in certain cases or adding dividends paid by the company, for example. An appraiser has to take all of this into account—if the value of phantom shares hasn’t been stipulated beforehand by an agreement.

When Do Phantom Shares Become Taxable?

If you think non-existent shares sound like a good way to avoid paying taxes, think again. 

Phantom stock is seen as a form of deferred cash compensation—meaning that employers have to comply with section 409A of the Internal Revenue Code. 

You don’t have to go back to college for a degree in tax law—it’s fairly simple to understand.

Thanks to this piece of tax legislation, there is no tax impact when the phantom shares are granted. That all changes, however, when the shares vest and a payout takes place.

The payout received by the employee is taxed as ordinary income—the company usually deducts a certain amount. Since the value of the shares fluctuates, it’s normal for the liability to change every year during the vesting period.

Different Types of Phantom Stock Plans 💼

There are two types of phantom stock plans that employers normally use to compensate employees—the “appreciation only” and “full value” variants. Conveniently, these plans are exactly what the names would have you assume.

Appreciation Only 📈

As the name suggests, companies that use an appreciation-only plan don’t give employees the full current value when a payout takes place. Instead, they receive the share price appreciation—times the number of shares—relative to when the shares were granted

Let’s say you receive 1.000 phantom shares when the company’s share price is at $10 and the shares vest after four years. Lucky you, the share price has doubled after four years and is at $20 when the shares vest.

After the four-year vesting period, each share is worth $10 more than when they were granted. To calculate the total payout we multiply this $10 share price appreciation by 1.000—the number of phantom shares granted. 

That leaves you with a $10.000 payout—thank you high school calculus. As you’ve just seen, the payout in our example is based on the share price appreciation and doesn’t include the full value of the underlying shares.

Full Value 💰

The full value type, however, doesn’t only pay out the share price appreciation. This phantom stock plan variant pays out the full value of the company’s underlying shares—great news unless you work for Kraft Heinz that has been in decline since 2017.

Let’s say you found a new job—to retain you and your talents the company grants you 1,000 phantom shares. By coincidence, the shares are also worth $10 apiece and the vesting period is four years.

You patiently wait for four years for shares to vest—luckily, your new company does just as well and the share price has once again doubled to $20. In contrast to last time, you now receive the full value of the shares—20 times 1.000 comes down to a payout of $20.000.

Advantages of Phantom Shares 👍

Phantom shares are seen by many as having more upside than downside—sometimes they’re even considered to be better than “normal” shares. Having said that, phantom shares are not all sunshine and rainbows.

To start on a positive note, phantom shares are often described as a “win-win” situation. They motivate employees to stick around for the entire vesting period and improve productivity—leading to a rising share price, in turn benefiting the employees.

What’s in it for Employers? 👔

It aligns the motives of the employer and employees and postpones paying taxes to a later date—a superpower most of us will envy. 

From the employer’s perspective, the absence of share dilution is also an attractive attribute of phantom shares—they’re different from normal company stock, after all. Companies also have full control of phantom stock plans—they dictate the agreement.

If that wasn’t enough, companies also don’t have to worry about giving employees voting rights or dealing with legal issues. Similarly to voting rights, employers won’t have to worry about paying dividends either.

However, employers can choose to pay out “phantom dividends”—these are dividend equivalents. Any dividends the company paid out to “normal” shareholders will also be credited to phantom stockholders after their full value shares have vested.

There is a unique benefit for S corporations—these types of corporations can only have a limited number of shareholders. With phantom shares, there’s no risk of expanding the shareholder base—while employees still benefit from a rising share price.

How About the Employees? 👷

As luck would have it, the benefits employees receive with phantom shares are not merely figments of imagination. With regular shares, investors often lose sleep over another pullback or crash warning—no need to worry about that with phantom shares.

Since employees don’t have to pay for the shares—they are given to them by the company—there’s no initial investment required by the employee. Even if the share price performs badly, all the money paid out to an employee is technically a gain. 

The Downsides of Phantom Shares 👎

So, why wouldn’t every company choose phantom shares as compensation?

Mainly because there are many different types of equity compensation to choose from. 

Some aspects of phantom shares make them less attractive relative to other stock-based compensation—other downsides apply to most equity compensation types.

More Money, More Problems 💵

Phantom shares can hurt a company’s cash flow—the company has to pay out a large amount of cash to employees after the shares have vested. The balance sheet is also affected by the variable liability of share price fluctuation.

Remember the external appraisers we talked about earlier? Well, they don’t work for free. The company has no choice but to incur these extra costs—every year the status of its phantom stock plan has to be disclosed. 

Troubles With 409A 🏢

The IRS’s tax rule 409A can also be to the detriment of both the employer and employee. Thanks to this rule, a company is limited in its ability to choose distribution dates—exacerbating the cash flow issue.

On top of that, it makes it practically impossible for employees to accelerate payouts. Any company not complying with 409A can expect to pay hefty penalties—who would’ve expected that from the IRS?

However, there is a way companies can avoid tax rule 409A—by using the short-term deferral rule. Since a phantom stock plan is a type of written compensation plan it is exempt from section 409A under one condition.

To benefit from this exemption, the payment has to take place shortly after the phantom shares vest. So, companies often pay out the cash right after vesting to avoid 409A—thank goodness for tax loopholes. 

Who’s the Boss Here? 📣

That’s not the only downside for employees—with phantom shares, companies are the ones calling the shots. Phantom shares come with very limited rights for employees—and that’s often intentional, as it’s hard to make key decisions when your employees vote against you.

That’s why employees don’t obtain any voting rights and—dependent on the plan’s structure—might not receive any dividends. There is also little room to maneuver when the share price drops—it’s hard to sell shares that don’t exist, after all.

What Are Some Phantom Stock Alternatives?

The sheer number of stock-based compensation options can make it a tough job for employers to choose the right one. In this section, we’ll describe a few of the most popular phantom stock alternatives.

Stock Appreciation Rights (SARs) 📊

Stock appreciation rights or SARs are again exactly what the name suggests—who said finance was complicated? They are very similar to appreciation-only phantom shares—they also give employees the right to share price appreciation.

However, the main difference is that the employee often gets the payout in shares instead of cash. There also doesn’t have to be a specific payout date—giving employees the flexibility to choose when they want to receive the money.

Phantom shares can be tied to specific achievements—whereas SARs aren’t. For employees interested in dividend investing SAR would be a bitter disappointment—they don’t offer any dividend equivalents.

Stock Options 

SARs are often granted to employees together with stock options—the money to buy the options has to come from somewhere, after all. Options trading is one of the reasons that GME and AMC still make the headlines regularly in the later summer of 2021.

Although it’s not any company’s intention to take its employees on such a wild ride, the options work the same way. By granting stock options, employees get the right to purchase a specific number of shares at a date in the future—with a pre-set price.

Restricted Stock Units

Restricted Stock Units or RSUs are, in essence, a promise of value by the employer to the employee. The employer promises to give the employee shares in the company if the employee stays at the company for a specific amount of time.

As with many of the other stock compensation types, they’re sometimes distributed after certain milestones are achieved. During the vesting period, the shares are usually given on a monthly or yearly basis after the employee has reached a “vesting cliff.”

The main difference here with phantom shares is that vested RSUs are actual shares in the company. This also gives the employee—possible—dividends and voting rights that phantom shares lack.

The Meaning of Phantom Shares in Naked Shorting 📰

You must have lived under a rock if you’ve missed the whole GME/AMC saga that saw an army of retail traders take aim for a couple of big hedge funds. The reason they saw an opportunity to squeeze out the hedge funds was the big guys’ massive short positions.

Luring people into the cinema and selling video games the old school way both have become increasingly difficult over the last decade—no surprise then that AMC and GME became a target for hedge funds. To add insult to injury, these funds shorted more than 100% of the shares in existence.

This happens in a process called naked shorting—it’s less exciting than it sounds. The hedge funds short shares which have “not been determined to exist”—this way they gain more leverage easily. These newly “created” shares are called phantom shares—often compared to counterfeit money.

Final Words 📌

Phantom shares are shares that don’t exist, but the benefits employees can expect are not a fantasy—neither is the role of phantom shares in naked shorting. Understanding what phantom shares exactly are is necessary to take full advantage of them—it also helps you understand the shenanigans going on in the financial markets. 

So, hats off to you for putting in the effort to educate yourself on this topic. You’ve learned what phantom stock is, how they work and what the different types of phantom stock plans are. We’ve also discussed the pros and cons of phantom shares, a few alternatives, and the other meaning of phantom shares.

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