M&A Vocabulary – Understanding the Experts: “Phantom Shares”

Introduction

Phantom shares or fictitious stock options are sometimes also referred to as shadow stocks, synthetic shares, or equity appreciation units. They are often used as a compensation component for senior executives for meeting time- or performance-based conditions in private companies. This compensation component is usually granted as part of a phantom stock option plan, which represents a separate agreement between the employer and the employee. This can be freely structured so that the exercise of the employee’s rights to the compensation component can be linked to rules approved by management. Phantom shares grant their holder a cash bonus calculated with reference to a stock option plan.

The calculation of the cash bonus is based on the potential profit the beneficiary could have achieved if they had instead exercised an option to acquire a certain number of shares. The profit from the option to acquire shares, to which the cash bonus refers, is determined by the market price of the shares at the time the phantom stock option is granted. The characteristics of phantom shares can be similar to those in real stock option agreements, such as performance conditions to be met, requirements regarding continued employment, and vesting periods.

The tax treatment of phantom shares corresponds to the treatment of a normal cash bonus. The cash payment from a phantom share as a compensation component is subject to income tax and social security contributions. However, if employees exercise options on real shares of a private company that are not readily convertible, income tax may be collected via self-assessment and social security contributions may not be applicable. The value from phantom shares is not taken into account when determining the employee’s private pension entitlements and can therefore be excluded. It should therefore be examined whether or not it is more efficient to grant real shares in terms of tax implications.

As a rule, the payout made by the company for a phantom share is deductible for corporate tax purposes according to general principles. However, it is not possible to claim a deduction for a provision for liabilities arising from the granting of phantom shares. The deduction is usually deferred until the actual payout.

Benefits

Phantom shares are a good way to avoid changing the shareholder structure. In private companies, articles of association can contain carefully formulated regulations that protect the interests of their investors. To protect these interests, phantom shares can be granted to avoid granting real shares that could jeopardize these interests.

Furthermore, granting phantom shares is less complex than granting real shares because the number of shareholders is not increased. This means that there is no additional burden on shareholders regarding general meetings, corporate transactions, or issues related to shareholders leaving the company.

Additionally, the value of a phantom share can be calculated differently from the actual market price of the company’s shares. For example, while further investments by the company are included in the valuation of the market value of real shares, the calculation of the value of a phantom share could only take into account the growth of the company in which the employee works.

Application

Regarding the time-limited conditions for exercising phantom stock options, once phantom shares have been granted, the employee has the option to choose when to exercise the right to the cash bonus payment from the phantom shares. It is recommended that the terms of the phantom stock option plan specify the earliest and latest dates for exercising the phantom stock option, as well as certain circumstances under which the option holder cannot exercise their option.

To ensure that the company’s capital is not jeopardized by the exercise of phantom stock options, it is advisable to provide for a maximum number or management confirmation of the number of phantom shares for which rights can be exercised. This ensures that the company is able to bear the value of the phantom shares without risks regarding the capital to be used for this purpose. In order to keep the administrative costs for exercising the rights from phantom shares at a reasonable level, a minimum number of shares should also be specified in the option plan to be used when calculating the value of the phantom shares in the option plan.

It would also be useful to have a rule whereby, upon termination of employment, the option to exercise the right from phantom shares expires after 30 days. In this case, management would be authorized to approve the exercise of the options during this period. Furthermore, it is important to include conditions in the option plan that either exclude an employee’s heirs or allow a window of, for example, 12 months for exercising the options after their death, apart from certain exceptions that can be included in the option plan.

It is also advisable to include a provision in every share program that excludes option losses due to claims arising from termination of employment or leaving office as far as possible. It is recommended to include a similar provision in the corresponding employment or service contract to ensure comprehensive protection. This ensures that potential losses from options in the event of termination are appropriately considered and mitigated.

A clause clarifying the timing and conditions for exercising phantom stock options following a change of control should be included in the option plan. For example, a 30-day exercise period following a change of control during which phantom share holders can exercise their options. After this period, any remaining unexercised rights from phantom shares would lapse. Management would be authorized to determine the proportion of phantom shares for which rights can be exercised, as long as it is not below the minimum proportion. It is recommended to include such a clause that determines the exercise period after a change of control and gives management discretion in determining the proportion of phantom shares for which rights can be exercised.

Naturally, the respective legal framework must be observed in all structures, and consistency and non-discrimination are important when deciding on the exercise of the option.

Conclusion

Phantom stock options are a means of enabling employees to participate financially in the company’s performance. At the same time, they offer flexibility in calculating the amount of the payment to be granted and do not affect the company’s existing shareholder structure.

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