Phantom Stock or ESOP: Which is better?
This article will cover phantom stock and ESOPs and what makes them different.
Many companies these days find ways to hold on to their best employees. And one of these ways is by offering better employee benefits and compensation packages. With more employee compensation packages in the market, companies have numerous options to choose from such as ESOPs, stock option plans, SARs, phantom stock plans, and many more.
Understanding Phantom stock
Phantom stock is a kind of employee compensation that offers employees with access to stock ownership without them actually owning the company shares. Just like other common shares, the value of phantom stock rise and fall with the underlying stock value. And employees are compensated with the profit gained from the increase in share value over a period of time.
Normally, the number of phantom shares offered is based on many factors. Usually the higher that employee is valued, the more shares of phantom stock they are likely to receive. The moment a phantom stock is awarded to an employee, a “delay mechanism” kicks in, where the actual financial payout is made after a long period. Two to five years is common for a phantom stock payout. Nevertheless, it depends on the agreement made between the company and the employee.
This means that companies normally use phantom stock both as a motivational tool to reward employees and to also offer them “skin in the game” to increase workplace productivity and earn the company more profit. This formula drives the company’s stock price higher as well.
How Phantom Stock Plans Work
There are two kinds of phantom stock plans that a company can choose from:
- The “Full value” plans where the complete value of the share is offered, including the value of the underlying shares and the appreciation.
- The “Appreciation only” plans – This plan does not include the value of the actual underlying shares themselves. They usually pay the value of any increase in the company stock over a certain period of time that begins on the date the plan is granted.
Both of these plans are somewhat similar to traditional non-qualified plans in a lot of ways. This is because these plans can be discriminatory in nature and are also typically subject to a substantial risk of forfeiture that ends when the benefits are paid to the employees. And at this time, the employee recognizes income for the amount paid and the employer can take a deduction.
While phantom stock may be hypothetical, it still can pay out dividends and it experiences price changes just like its real counterpart. After a period of time, the cash value of the phantom stock is distributed to the participating employees. Phantom stock, also known as synthetic equity, has no inherent requirements or restrictions regarding its use, allowing the organization to use it however it chooses. But these stocks can be changed at the leadership’s discretion.
These stocks qualify as a deferred compensation plan. A phantom stock program must meet the requirements set forth by Internal Revenue Service (IRS) code 409(a). This means that the company must perform a valuation to find the common share price for tax purposes.
Understanding ESOP (Employee Stock Ownership Plan)
ESOPs, also known as an employee stock option plan, is an employee benefit plan that offers employees with ownership interest in the company. Through ESOPs, the company offering the plan, the selling shareholders and the participants (employees) of the plan get many tax benefits. Companies normally use ESOPs as a corporate-finance strategy to align the interests of the employees to that of the shareholders.
In fact, an ESOP is created to promote succession planning in a closely held company by offering the employees the chance to purchase stocks from the company. ESOPs are all set up as trust funds and can be funded by borrowing money through the entity to buy company shares, putting cash in to buy existing company shares, or by companies that are adding newly issued shares into them. ESOPs are used by companies of all sizes, including a number of large publicly traded corporations.
Upfront Costs and Distributions
A lot of the companies normally provide employees with ownership through ESOPs with no upfront costs. This means that the employees do not have to purchase the shares to become the owner, and they are offered them for free. But the company may hold the given shares in a trust for safety and growth until the employee retires or resigns from the company. Companies normally tie the distributions from the plan to vesting-parts of the shares that are earned for each year of service.
Once the shares have been vested completely, the company buys the vested shares from the retiring or resigning employee. This amount then goes to the employee in a lump sum or in equal periodic payments based on the plan. The shares that the company gets back are then redistributed or considered as void. Just to be clear, the employee that leaves the company cannot take the shares with them, just the cash payment. Employees that have been fired only get the shares vested in the plan, up to the company’s discretion.
Phantom Stock vs ESOP – Major Differences
Although both stock types are used to offer equity compensation to employees in a company, these two plans are different from each other. Let us look at this table below to understand their difference.
Phantom Stock vs ESOP Table
|No dilution of the company’s ownership.||Ownership of the company gets diluted.|
|Employees do not participate in the management of the company.||Employees as shareholders get a say in the management of the company.|
|Cost of the shares is borne by the company.||Price of the shares is borne by the employees in this plan.|
|Greater flexibility as no legal obligations are attached to it.||Rigid in frame as it is regulated by the SEBI and Companies Act, 2013.|
|One point taxation - This means that the tax is imposed only at one time from the day it is granted till the sale of the shares. Phantom stock payouts are taxable to the employee as ordinary income and deductible to the company.||Double point taxation - The shares are taxed twice from the time the shares are granted till the final sale. At the time of exercise - income tax, and at the time of the sale of the shares - capital gains tax.|
From these points it seems that phantom stock offers a lot more advantages than ESOPs. Another benefit of the phantom stock program is that it is far less costly than creating an ESOP. Then why is ESOP even an option?
The next section will explain just that.
Which one should you choose?
Both plans have the same goal, which is offering employees with the share ownership value in the company. But both plans work differently and offer different outcomes.
ESOP is a qualified retirement program just like a pension plan. This plan has to follow non-discrimination rules, unlike phantom stock plans. The employees do not get the actual ownership of the shares in this plan as well. Instead, the shares under their name are normally cashed out at their retirement. And since the employee’s retirement account grows if the company does well, it does motivate them to do better and improve the company results. Basically, an ESOP is a great plan for companies that want to involve their employees in ownership accountability and value sharing. They are a growing and effective employee benefit.
On the other hand, a phantom stock plan varies in a number of ways. They are usually adopted mainly for a selected group of employees, usually ones in leadership roles in the company. Due to this, phantom stock plans offer much more flexibility than ESOPs. Nonetheless, employees do not actually get the stock in this plan, but receive the economic value instead. The value earned by employees under the plan is almost always settled in cash.
After comparing phantom stock plans and ESOP plans, we can see that both have different advantages and are used based on different goals and situations in the company. You just need to see what your goals are and choose the plan you want to implement. But as you do that, remember to keep track of the plan. The best way to do this is by using a software app like Eqvista.