Why Should A Company Issue Phantom Shares?

Andrew Haimdas January 10, 2025

In today’s dynamic business environment, attracting and retaining top talent is crucial, especially among startups and rapidly growing companies. Phantom shares, also known as “shadow” or “synthetic” shares, can be utilised to incentivise staff by offering competitive compensation packages linked to the company’s and the individual’s performance. Unlike EMI options, growth shares, or CSOPs, phantom shares do not require you to issue actual shares but still offers financial rewards for the employees and consultants.

Phantom share options are a form of employee and consultant compensation that provides the benefits of share ownership without issuing actual equity in the company. These shares represent a contractual agreement that grants the employee or consultant the right to receive cash payments based on the company’s share value, these do not confer ownership interest, voting rights, or dividend rights to the holder, but instead mirror the performance of actual shares, allowing companies to reward key employees and consultants, aligning their interests with those of shareholders while avoiding the complexities and risks of issuing actual equity in the company.

This article aims to give you a thorough understanding of phantom shares, focusing on how they work, their benefits, and how they are implemented within the context of UK law. The article will also provide insights into creating an effective phantom share plan.

1. Why consider phantom shares?

These contractual agreements are typically used in long-term incentive plans to reward their contributions to the company’s growth. These can be tailored to meet specific business needs, offering flexibility in terms of performance metrics, vesting periods and payout conditions.

Non-Dilutive nature: they do not affect the company’s share capital, rewarding employees and/or consultants without diluting existing shareholders’ equity.
Employee and consultant retention and motivation: tying rewards to company performance, phantom shares provide significant incentives to retain top talent and motivate performance.

Flexibility: these plans can be customised to be tailored to fit specific business objectives, financial goals and performance metrics. Phantom shares can also be a suitable option for companies that do not have a share capital such as companies limited by guarantee, building societies, mutual insurers, co-operatives and industrial and provident societies.

2. How do phantom shares work?

Phantom shares are created through a phantom share plan, which outlines the terms and conditions under which the shares are awarded. This plan specifies the number of phantom shares allocated to each employee and/or consultant, their performance metrics to be achieved and the payout triggers.

Valuation Methods: the valuation of phantom shares is crucial, as it determines the cash payout employees and/or consultants will receive. Linking the phantom shares’ value to the company’s share price or using financial metrics such as earning before interest, taxes, depreciation and amortization or revenue growth are the most common.
Payout Mechanisms: cash payouts from phantom shares are triggered upon specific conditions, such as the sale of the company, reaching performance milestones, or at the end of the vesting period, based on the initial grant value and the valuation at the relevant trigger event.

3. Advantages and disadvantages of phantom shares for your company

Phantom shares offer several benefits such as preserving equity, however, they also come with drawbacks including financial liabilities. Helping companies weigh the benefits against the potential challenges.

For employers

Advantages:

Equity Preservation: no equity or rights to current equity are provided to staff therefore there is no dilution of the existing shareholders’ equity.

Customisable Plans: companies can design phantom share plans to meet specific strategic goals, enhancing loyalty and incentivising long-term performance, using various metrics and payout conditions.

Employee and consultant retentions: companies can incentivise employees and consultants stay without providing significant salary increases and only paying upon the occurrence of relevant trigger events.

Tax Considerations: companies can benefit from corporate tax deductions for phantom share payouts. Employers must do this while complying with reporting requirements, as well as taking into account PAYE tax and NICs on payouts which are payable once cash is paid to the staff member.

Disadvantages:

Future Liability: obligates the company to make future cash payouts, creating a financial liability on the company’s balance sheet, impacting cash flow and financial planning. Additionally, if there is a significant phantom share liability, then such liability may affect the company’s valuation, which would prejudice the return for shareholders (and phantom shareholders) on an exit.

Complex Administration: designing and managing phantom share plans requires meticulous administration, including performance metrics, vesting schedules, and ensuring accurate and timely payouts.

For employees and consultants

Advantages:

Financial Rewards: employees and consultants can benefit from substantial financial incentives tied to the company’s success, providing a direct link between performance and financial gain, thus offering a way for employees and consultants to share in the company’s growth and profitability.
No Investment Required: employees and consultants benefit from the company’s growth and success without needing to invest their own money, making it an attractive and low-risk option and gaining financial rewards without the associated risks of holding actual shares. These risks include:
being exposed to market volatility fluctuating the price due to market conditions, company performance or economic factors;
facing the risk of dilution which can decrease the value of existing shares; and
the potential tax liabilities upon the sale or transfer of the shares such as capital gains tax.

Disadvantages:

Lack of Ownership Rights: unlike actual shareholders, employees and consultants with phantom shares do not have voting rights or dividends. Albeit in many cases of other similar sweat equity arrangements employee and consultant shares may not benefit from voting rights and dividends.

Tax Implications: cash payouts are treated as income and subject to income tax and National Insurance contributions in the UK. Employees and consultants (and employers) should be aware of potential tax liabilities to manage these obligations.

No funds to make payment: if the company is not in the financial position to make the necessary payments to the employee or consultant pursuant to the exercise of the phantom share options, the board of directors of the company will usually have an overriding power to decline to honour the phantom share options if they consider the pay-out to not be affordable at that time.

4. Legal considerations

Implementing a phantom share involves navigating several legal and compliance issues:

Employment and consultancy Contracts: amendments to employment and consultancy contracts may be necessary, these should clearly outline the terms and conditions of the phantom share awards, including:
vesting and performance metrics (clearly define the vesting schedules and the performance metrics that will trigger the payouts, ensuring the employees understand the conditions under which they will receive their benefits); and
termination and clawback provisions (specifying what happens if an employee leaves the company, including whether the phantom shares are forfeited or if in cases of misconduct or underperformance there are clawback provisions).
Documentation: a ‘Form of Phantom Share Option Certificate’ and a ‘Rules of the Phantom Share Option Plan’ are standard and essential documents. This documentation should cover all aspects of the scheme such as:
scheme rules: detailed rules governing the operation of the phantom share scheme, including eligibility criteria, the basis of award and payout mechanisms;
employee and consultancy agreements: individual agreements with each participating employee, detailing the number of phantom shares awarded, the vesting schedule and the conditions under which payouts will be made; and
long term incentive plans (“LTIPs”): a tool to align employee and consultant interests with company performance, but LTPs often involve granting actual equity or options to purchase at a future date, contingent on achieving specific performance goals over a long period.

5. Compliance

Companies Act 2006: While phantom shares themselves do not require amendments to a company’s articles of association they will still need to be reviewed for any potential restrictions and any associated shareholder approval or board resolutions for payouts will need to be documented clearly to align with corporate governance. Ensuring such resolutions are properly documented is essential for enforceability and compliance.
HMRC Guidelines: adherence to the HMRC guidelines is critical to manage tax implications of phantom share schemes for both the company and the employees. For the company, payments made under the scheme are typically tax-deductible expenses, but they must handle PAYE tax and NICs correctly. For employees, cash payouts from phantom shares are subject to income tax and NICs. It is essential to clearly outline these tax implications in the scheme documentation and provide employees with the necessary information to manage their tax liabilities effectively.

Phantom shares can offer you a strategic tool for aligning employee and consultant incentives with long-term business success without diluting company ownership. By understanding their mechanics, benefits and potential drawbacks companies can implement these plans effectively, fostering loyalty and driving performance.

Conclusion

Here at The Jonathan Lea Network, we have significant experience and expertise with matters involving employee and consultant compensation schemes like phantom shares. We are happy to utilise our skills and expertise to resolve common and uncommon issues that may arise during the process.

If you would like to know more about Phantom Shares and whether your company should adopt Phantom shares, we offer a no-cost, no-obligation 20-minute introductory call as a starting point. Please email wewillhelp@jonathanlea.net providing us with any relevant information ensuring that any call we have is as productive as possible. After this call, we can then email you a scope of work, fee estimate, and confirmation of any other points or information mentioned on the call.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.