In the first post, How To Create A Stock Option Plan For Your Startup, we covered what Stock Option Plans (SOP) are, how they work, and how to use them to reward your employees and collaborators who take the leap of faith in your early stage project.
It all seemed very nice and easy, right? But what happens if we want to award SOPs to our “helping hands” but we don’t want to dilute our shareholders stock? Please allow me to introduce to you SOPs’ little cousin:
PHANTOM STOCK OPTION PLANS (Phantoms)
As well as SOPs, Phantoms are a contractual agreement between the company and the employee, advisor, mentor or whatever collaborator the company decides to reward. Phantoms grant a right to a monetary payment at an agreed future time or event as expressed in the Plan and tied to the market value of the company’s stock at the moment of vesting. The same way as it was explained for the SOPs, the payout will increase or decrease linked to the value of the companies stock, but in this case the collaborator will not receive any actual stock but the cash value of it.
How do Phantoms work?
The main principle of vesting period, cliffs, and organization of the Plan is equal to that of the SOPs. Then, why do we use Phantoms? As expressed above, is an easy way to reward those people around the company without diluting the existing shareholders. Phantoms are linked to the monetary value of the shares. Once the vesting period finishes and the options have matured, the grantee has the option to execute the Plan and exchange the options for the monetary value of the shares he had been granted in the Plan.
Let’s use a simplified example: You grant an advisor Phantom options with a standard 4-year vesting period at a value equivalent to 1000 shares . The economic value of those shares at the moment of issue is €1 each. Let’s imagine that in four years the value of those shares is €5 per share at the execution moment. Your company, rather than making him a shareholder with 1000 shares of the company, pays him the economic value of the shares, meaning €5.000. The final amount received by the collaborator would be €4.000 since he has to buy the shares in order to receive the amount. Sometimes this option is eliminated and the final reward is paid in full.
Usually companies link the cash out of the Phantoms to an exit event. Collaborators may have vested all the Options but may not be able to receive the cash. This is a way to protect the company’s cash flow. Receiving cash during an exit event prevents the company from running out of funds by collaborators cashing out. Remember to always mention the Phantoms to the potential buyer; maybe you can even have them include and increase the payout to make them take the cashing out of the collaborators.
For those receiving the Phantoms: For accounting purposes, phantom stock is treated in the same way as deferred cash compensations. Phantom stock payouts are taxable to the employee as ordinary income and deductible to the company. Please bear that in mind when accepting them as compensation and have your tax accountant make sure to include those when you talk to the IRS.
To the early stage companies out there: keep believing in these options to help you grow. Your budget may not allow for market salaries and phantom stock options are a great way to offer a high-reward compensation to attract top talent. Just remember, if you grant too many options you may find yourself without sufficient cash for your business when the vesting period ends.