Phantom share schemes have uses for both private and publicly-listed companies, says Sonia Speedy

While company share plans can be a rewarding way to incentivise staff and improve retention rates, not all businesses can, or wish to, issue shares to employees. But there are ways to gain similar results without issuing or transferring a single share.

Phantom share option plans act like traditional stock market-based share schemes, where options are issued and exercised, and staff benefit from upward movement in the shares’ value. The only difference is that no shares actually change hands. The plans are effectively long-term cash bonus schemes.

Kiki Stannard, tax director at accountancy and financial services firm Smith & Williamson, explains: “All you’re trying to do is replicate the profit element as if [the employees] had real share options.”

Sid Singh, managing director of employee share scheme specialists ESS Consultants, adds that the option price is generally equivalent to the market value of a share in the firm at the time that the option is granted.

“What would normally happen is the [organisation] would grant an option at a fixed price. That option will vest subject to the normal conditions such as performance criteria and time,” he explains.

Most phantom share option plans have performance conditions linked to the company, such as total shareholder return or earnings per share, rather than personal or individual performance criteria.

The time period before options can be exercised within a phantom arrangement is similar to any other share option plan - typically between three and five years. They can also be used on a discretionary basis for senior executives or for all-employee schemes. “Once the option vests, the share price is measured, and the increase determined on the option and a cash payment made,” Singh says.

Stock appreciation rights
A variation on the phantom theme is stock appreciation rights. These are similar to phantom schemes, however, in order to try to create better tax efficiencies than a phantom scheme, share appreciation rights can be implemented using rights over real shares such as options or share awards.

While generally not the first choice for most employers when it comes to share plans, there are a variety of reasons why a private or public organisation may decide to use a phantom arrangement.

As Singh points out, doing so means there is no dilution of share capital, which is particularly relevant within a privately-owned business, where the shareholders or private equity owners may be reluctant to dilute their shareholding. But this can also be relevant for listed companies.

Phantom schemes involve no risk to employees and are easy to administer. As IfsProShare consultant, Sally Russell, says, they are very straight forward. “It’s a record keeping exercise at the end of the day.”

Furthermore, according to Sue Bartlett, senior executive reward consultant at Watson Wyatt, the playing field has been levelled for phantom schemes under International Financial Reporting Standard 2 (IFRS2).

Previously, accounting advantages existed for “real” share plans that granted share options over new shares, as these schemes did not incur an accounting cost, while cash remuneration did. However, now both incur a charge.

But, David Pett, head of share plans at law firm Pinsent Masons, believes the playing field has not been completely levelled. Under the accounting rules IFRS2 and Financial Reporting Standard 20, the rules for cash-settled share-based payments differ from those for share-settled share-based payments. “One has to recalculate the appropriate charge on an annual basis [for phantom schemes]. That can be more complex and also can result in overall higher charges,” he explains.

Nevertheless, Bartlett adds that phantom plans can also be useful for stock market-listed companies that have been taken private by a management buyout or private equity investment. These firms may previously have been running a stock market-based share option plan and so will be keen to continue this. If they cannot or do not wish to issue further shares, then a phantom scheme can help mirror the benefits.

Similarly, listed companies keen to extend their all-employee arrangements into overseas branches may decide to implement a phantom share option plan due to the legal impediments faced. The hassle and cost in using a more traditional scheme in this situation may also be too onerous, again making a phantom arrangement more attractive.

Phantom schemes can also be used on top of existing stock market-based plans, particularly for more senior executives. This may be necessary due to restrictions on the number of shares that can be issued through share plans as a percentage of a company’s overall share capital.

But, like anything, there are downsides. “The main downside is that the [settlement] doesn’t give [employees] any ownership of the company. It can give people the same economic effect, but they’re still never going to be shareholders,” says Bartlett.

She believes there is a “fundamental, philosophical and real” difference between phantom schemes and the traditional stock market-based equivalents.

Rashree Chhatrisha, senior consultant at pay and reward specialists MM&K, adds: “Employees will still be looking at the share price as they will be looking at the increase, but they’re not getting real shares in the business, they’re just getting a cash settlement.”

Such schemes can also create a potentially unknown cash liability for the business, and employers should consider placing a cap on the bonus payable to combat this.

Cash liability
With phantom schemes, the cash settlement has to be borne out of the organisation’s own resources, while, in the case of share options, the benefit realised by the employee is borne by the market.

Another major consideration is the tax status. “HM Revenue and Customs has a range of approved share plans that offer tax relief but there is no tax relief associated with phantom shares,” Russell says.

Stannard adds the complexity of performance-based formulae used to calculate cash settlements for phantom schemes varies widely and can affect staff buy-in to the scheme. This is because they may not be able to directly see how the share price movement affects what they receive.

“When you’re looking at some of the more complicated formulas, you’re going to end up with more of a ‘disconnect’ with the employee, as they need someone to tell them at the end of the year how much money they are going to get. The more complicated the formula, the less of an incentive it is,” she explains.

So while a phantom scheme may not appeal to many firms, it can meet a real need for some.

Case study: Saatchi in campaign for phantom shares
Saatchi & Saatchi ran a phantom share option scheme from the late 1990s to 2002.

The advertising giant was then in the process of implementing a savings-related share option scheme for its employees, but found that the complexities of securities laws or exchange controls in some parts of the Far East made it too difficult to implement the same scheme there.

Working with David Craddock Consultancy services, it set up a phantom share option scheme catering for around 300 staff in countries such as China, India, Vietnam, Malaysia and Thailand.

David Craddock, director of the reward consultancy, says: “Individuals had to save just as the employees in the countries where we were working with real shares did, and they had to show evidence of that saving. They were [then] given a payment which equated to the rise in the share value at the point the option was granted and the phantom price.”†

To prevent the firm having to fund the cash bonuses from its own coffers, an employee share trust was set up to sit behind its phantom scheme, allowing the market to “do the work” in creating the necessary value that would be passed on to employees.

When scheme members began exercising their options between 2000 and 2002, the trust held enough shares within it that could be then sold to cover the value of the employees’ cash payments, without staff ever receiving the shares themselves.

“The phantom scheme went down extremely well, but particularly [so] in China and India. People made significant sums as many saw a substantial rise in the share price,” says Craddock.

When phantom share plans may prove useful:

For private companies… †

  • That want to prevent dilution of the company’s shareholdings.
  • For listed companies which have been taken private and are reluctant to create a surrogate market for their shares. These firms may want to use a phantom scheme instead to mirror the ‘real’ share-based plans offered previously.

For publicly-listed companies…

  • That also want to prevent dilution of the shareholdings in the company.
  • For global firms with staff in locations where it may be impractical to offer traditional share option plans.
  • To go on top of existing traditional schemes when a company is concerned about nearing share issue restrictions for share plans as set by institutional investors.