Derivative trading started in India in 2000. If we had told you then, there could be a Derivative-style incentive plan for the Employees as well, would you have believed us?
I wouldn’t have believed us either. But the growing popularity of Phantom Stock Options is proving otherwise.
Phantom Stock Options, also referred to as Shadow Stock Options belong to Stock Appreciation Rights (SARs) family and are a performance based, long term incentive plan for employees. A particular number of Phantom Stock Options are issued to the employees with an attached reward in the form of cash or equity shares of the Company. The employees are eligible to reap benefits of this reward at the end of the term of Phantom Stock Options. Unlike other Stock Options, these do not form part of the Share Capital of the Company, nor do they grant any share in the ownership of the Company. Instead Phantom Stocks are linked to the valuation of the Company and their value is derived based on the valuation of the Company at the time of expiry of their term. Hence, like derivatives their value fluctuates with changes in the valuation of the Company
There are 2 types of Phantom Stock Options. Those which have ultimate reward in the form of Cash and those which provide reward in the form of equity shares of the Company. The first kind is known as Appreciation Only Phantom Stock Option and the second kind is known as Full Value Stocks.
Growing Popularity of Phantom Stock Options
Phantom Stock Options are gaining popularity with Employers because of their unique trait whereby companies can share a portion of their profits or increased valuation with their employees – driving & motivating employees, but in a way that doesn’t conclude in dilution of shareholding. This motivational tool helps in keeping the employees engaged with the Company for the entire vesting period. Moreover, it uplifts efficiency and productivity in employees because when Company’s valuation increases, they stand to gain too. A feeling of unity is induced amongst employees as well as between employees and the Company.
Employees favour this form of incentive too. To start with, it’s a zero-payment investment because unlike the Stock Market, here they don’t need to pay to gain monetary benefit from the Company’s appreciating value. For Company, this means the employees are not eligible to vote like other shareholders of the Company, neither are they eligible to receive dividends. Hence, the issue of Phantom Stock Options is usually approved without resistance by the investors of the Company.
Amongst both types, Appreciation Only Stock Options are favoured more by the employees (and most of the times, by employers as well) because of tangible cash reward, directly linked with the valuation of the Company, payable at the time of pay-out. Talking about pay-out, this period is usually 3 – 5 years, although this can be determined as per mutual understanding of the employee and the Company. This delay mechanism helps in keeping employees motivated for a long term and focused on merging individual goals with that of the Company’s. Each employee’s contribution ultimately results in higher profitability which in turn affects the valuation positively.
In other words, Phantom Stock Options are win-win for the Company as well as the employees.
How are Phantom Stock Options issued?
The Company and the employee execute a legally valid agreement defining terms of issue of Phantom Stock Options.
The terms usually contain a vesting period of 3-5 years, post which the employee will be eligible for cash pay-out or Equity Shares. This agreement also needs the employee to be engaged with the Employer Company for the entire vesting period and complete given goals to be eligible for pay-out. However, the entire agreement can be structured as per mutual understanding between the Employer Company and the employee. There are no fixed legal rules.
Legal and Taxation aspects
In terms of legal framework related to Phantom Stocks in India, at present the Securities and Exchange Board of India has issued guidelines governing Full Value Phantom Stocks for listed companies. As for private and closely held companies, the law is silent at the moment.
On the Taxation front, for Appreciation Only Stocks, the final cash benefit is to be considered as income for employees and will accordingly be subject to income tax. As for the Company, it is responsible for deduction tax as per Withholding Tax (Tax Deducted at Source) laws before releasing the payment.
For Full Value Stocks, taxation laws come into picture when an employee tries to sell/transfer the Stocks. Depending on whether the employer company is a listed entity or not, Full Value Stocks will be given the same treatment as the other shares of the Company.
To conclude, in current times, with lockdown in place in several parts of the World on account of Covid-19 pandemic and slow growth-rate prevalent almost globally, it has become necessary for the companies to have a long-term incentive policy in place, especially for their key employees. Phantom Stock Options are perfect for such times: the pay-out is delayed, they encourage long-term association and rank high on motivation factor scale. Like derivative trading, if rightly structured, Phantom Stock Options could be a suitable choice for all involved.