PHANTOM STOCKS
In the current start-up dominated entrepreneurial world, companies have recognised the heating up competition for talent. With the increase in competition, companies have to ensure that the talented people are retained in the company by offering them incentives. The most common method to offer incentives to the employees is by issuing options under an Employee Stock Option Plan (ESOP). An alternate incentive offered by the companies to the employees is phantom stocks.
Phantom stock is one of the share-based payment methods used by the companies to incentivise key employees in order to retain them. Also known as ‘shadow stock’, phantom stock is, essentially, a written agreement between the company and the employee to receive cash or cash equivalent consideration at a future point in time. The value of consideration is as per the market value of the underlying company stock.
In the practical scenario, phantom stocks do not provide ownership of company’s shares/stock to the employee. However, the employee gets to enjoy the benefits of ownership such as increase in stock price, dividends (if any), etc., depending on the phantom stock plan that the company creates before issuing these stocks.
Generally, there are two methods of issuing phantom stocks: (i) appreciation only; and (ii) full value. The company may choose either of the above two options to provide phantom stocks to its employees. In appreciation only method, the company provides the employee with a cash or cash equivalent consideration which is equal to the amount of difference between the value at which the stock option was granted to the employee and the current/ongoing value of the stock of the company at the time of calculation of the consideration. For instance, a company’s stock value, at the time of issue of phantom stock, is determined to be ₹100 per share. In appreciation only method, each phantom stock issued to the employee will produce value only if the price rises above ₹100. If the redemption is taking place at ₹150 per share, the employee would receive ₹50. However, depending on the terms of the agreement between the company and the employee, the issue price can be set below or above the actual stock price.
Whereas, in full value method, the employee is entitled to receive the full value at which the stock of the company is worth at the time of calculation of the consideration. For instance, assume a company’s stock value, at the time of issue of phantom stock, is determined to be ₹100 per share. If the employee was to receive full value, they will be receiving the ₹100 value plus or minus any appreciation thereon. Thus, if the company stock value increases to ₹150 per share by the exercise date of the phantom stock, the employees would receive ₹150 for each phantom stock they owned.
ESOPs vs. Phantom stocks
An ESOP, as defined under Section 2(37) of the Companies Act 2013, is an option given to the directors, officers or employees of a company or of its holding company or subsidiary company or companies, if any, which gives such directors, officers or employees, the benefit or right to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.
The main purpose of issuing options under an ESOP is to motivate and retain the employees by way of giving ownership in the company through issuance of equity to them. The price, at which the right to purchase or subscribe to the shares of the company, is pre-determined. ESOP, in India, is governed by Section 62 (1) (b) of the Companies Act 2013 and the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021.
A brief comparison between the Employee Stock Option Plan and phantom stocks is as under:
| S. No. | Parameters | Employee Stock Option Plan | Phantom Stocks |
|---|---|---|---|
| 1. | Share Capital Dilution | Options issued to the employees dilutes the share capital of the company. | No dilution of share capital of the company since no actual share/stock is issued to the employee. |
| 2. | Consideration | The price for shares, at the time of exercise, are required to be paid for by the employees. | The company is required to pay the employee cash or cash equivalent consideration as per the value of the shares of the company. |
| 3. | Dividend and voting rights | The employee shall have the right to receive dividends and shall have the voting rights in the company upon exercise of the option and issue of shares. | As there is no actual issuance of shares, there are no voting rights. Dividend maybe payable as per the terms of the agreement. |
| 4. | Flexibility | ESOP is regulated by the SEBI and the Companies Act, 2013 | As there are no legal obligations attached to it, there is a greater degree of flexibility. |
| 5. | Valuation | The issue price of the options is decided by the company in conformity with applicable accounting policies. The issue price shall not be less than the intrinsic value of the shares. | The valuation of stock would be done as per the terms and conditions of the agreement. |
| 6. | Resolution | Special resolution needs to be passed to approve the implementation. | No resolution needs to be passed. These are issued in accordance with the terms laid down in the agreement. |
| 7. | Lock-in and Vesting Period | The minimum vesting period shall be one year from the issue date after which the options can be exercised by the employees. The company shall have the freedom to specify the lock-in period for the shares issued | Lock-in and vesting period shall be in conformity with the agreement. |
| 8. | Transferability | The options are neither transferable nor can they be hypothecated, pledged, mortgaged or encumbered or alienated in any manner. | Usually, phantom stocks are nontransferable. However, the terms of the agreement may provide otherwise. |
| 9. | Disclosure in Director’s Report | The Board of Directors shall disclose details of Employee Stock Options Scheme in the Directors Report. | There is no requirement to disclose the issue of stock in the Director’s Report. |
Phantom stocks in India
The existing Indian legal framework is silent on Phantom Stocks, they are usually governed by the agreement entered into between the employee and the company. The agreement lays down the terms and conditions which include the value, the vesting schedule or any other mechanism applicable for the events of payment of the consideration.
While the Companies Act, 2013 provides guidelines for Employee Stock Option Plan (ESOP) and even sweat equity, neither the Companies Act, 2013 nor the Securities and Exchange Board of India (Share Based Employee Benefits and Sweat Equity) Regulations, 2021 provide any guidelines for phantom stocks.
In 2015, Mindtree Limited, sought advice from Reserve Bank of India (“RBI”) for the applicability of SEBI (Share Based Employee Benefits) Regulations, 2014 on their Phantom Stock Scheme, which involved issuing phantom stocks to the employees of Mindtree Limited. In an informal guidance letter from the RBI to Mindtree Limited, dated July 15, 2015, the RBI said that the SEBI (Share Based Employee Benefits) Regulations, 2014 may not apply to the phantom stocks issued by Mindtree Limited to its promoters since the phantom stocks do not involve any actual purchase or sale of the equity shared of M/s. Mindtree Limited.
Further, from taxation perspective, phantom stocks are usually taxed under the head of salary income as perquisites in the hands of the employee, at the time of redemption. No incidence of tax arises in hands of the company at the time of making payment of the cash entitlement to the employee.
Conclusion
While the concept of phantom stocks is lesser known in India, there are companies like DLF, Birla Sunlife and Bajaj Allianz, Cairn India, which are issuing phantom stocks to incentivise their employees. It has become more relevant around the globe, especially, in this post-pandemic world where uncertainty has taken precedence and retaining key employees has become an uphill task for employers. One advantage of issuing phantom stocks is that there is no dilution of equity and the existing shareholders’ control over the company. Additionally, there is no tax levied during the vesting period. The employees work with renewed enthusiasm which leads to an increase in overall productivity.
However, one disadvantage of issuing phantom stocks is that the company needs to evaluate their stock price on a timely basis which can be a costly process if the company opts for a third-party stock valuation. Additionally, the company needs to have cash in hand at the time of redemption.
Considering the clear use-case of phantom stocks, the advantages that they bring to the table will most certainly make them a popular tool for incentivising and retaining employees in India as well.
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