If you’ve got a successful business or a start-up, you’ll want to make sure you attract (and hold onto) top talent to help your business grow. Many successful companies, including start-ups and early stage businesses, use employee share schemes as part of their overall packages to attract new employees.
One type of scheme particularly popular with fast-growing companies is the Enterprise Management Incentive or EMI scheme, where employees are awarded options to buy shares at an attractive price. These schemes are highly-advantageous, tax-wise, but have some other implications, mostly in relation to diluting existing shareholdings when they’re exercised.
If you’re a founder of a business who wants to attract talent but not give away shares, a popular alternative to an EMI or other share option scheme is a phantom share scheme. Phantom shares are not shares at all but fictional shares that rise and fall with the value of the shares they represent. Read this FAQ to find out more about phantom share schemes, and whether this might be right for your business.
Jump to:
- What is a phantom share scheme?
- How does a phantom share scheme work?
- What are the benefits of phantom share schemes?
- Because your employees will only get a bonus if the company shares increase in value, they are highly incentivised to help you grow your business
- Phantom share schemes will protect you and your shareholders from share dilution
- You can have the upside of an employee share scheme without potential downsides like dealing with minority shareholders
- You can tailor the scheme to suit you
- Why might a company want to award phantom equity rather than actual equity?
- How are phantom share schemes treated for tax?
- Can I set up a phantom share scheme if my business is a partnership?
- What else do I need to think about when setting up a phantom share scheme?
What is a phantom share scheme?
Many employers, particularly SMEs and start-ups set up incentive schemes like share plans that offer employees the chance to participate in company ownership. Often these are linked to employee performance, company growth or an exit event. While these types of schemes are popular with employees, they can have some challenges. For example, some need a special class of employee share to be created, employees can come and go, requiring complex provisions in the scheme dealing with good and bad leavers and there will be potential for dilution of founder shares. A simpler approach may be to create a phantom share plan, where the employee doesn’t get actual shares at all, but ‘fictional’ shares. These fictional shares normally have a notional value equivalent to real shares, which will rise and fall with the value of the real shares underlying them. So, the staff member doesn’t hold any equity, isn’t entitled to attend company meetings or vote on company decisions but is entitled to cash payments tied to share value – often payable on an exit. Phantom share plans also sometimes entitle participants to ”dividend equivalents”, i.e. cash bonuses equivalent to the dividend they would have received if they owned real shares.
How does a phantom share scheme work?
The company sets up a phantom share account on their books and draws up rules relating to participation and allocation. If a trigger event occurs such as an IPO or a company sale, you’ll pay them an additional bonus equivalent to the market value of the company’s shares at the time of the event.
This way, the employee is incentivised to help grow the company, as the ‘value’ of their holding will rise with the company’s value, and they will receive bonuses tied to the company’s value. These schemes can be easier to set up and run than other share option or share acquisition arrangements, and there’s no risk of share dilution (although there will be financial dilution and a lack of tax efficiency).
What are the benefits of phantom share schemes?
Here are some of the main benefits of phantom share schemes:
Because your employees will only get a bonus if the company shares increase in value, they are highly incentivised to help you grow your business
Research has shown that companies that allow employees the right to participate in equity are more productive and better performing than those that don’t. With a phantom share scheme, you can achieve a similar effect on your business performance, without issuing actual shares.
Phantom share schemes will protect you and your shareholders from share dilution
This contrasts with employee share option and share acquisition schemes, where you need to part with some of the equity of your company to achieve the benefits associated with such schemes. When you set up a phantom share scheme, your team will be motivated to increase your company’s value, but you won’t have to part with shares. However, there will be financial dilution resulting from the requirement to apy out cash and there is no opportunity for tax efficiency
You can have the upside of an employee share scheme without potential downsides like dealing with minority shareholders
While employee share schemes are attractive, they require ongoing administration, including reporting to HMRC. Phantom share schemes can be more straightforward to set up and administer.
Phantom share schemes are highly flexible and you can set them up so they suit your needs – they don’t need to meet specific legal requirements since they don’t come with tax advantages. They’re simpler to operate and your company doesn’t need to meet certain conditions to qualify.
You can tailor the scheme to suit you
Because you’ve a free hand in terms of what the scheme allows, you can structure the arrangements to fit your objectives.
Why might a company want to award phantom equity rather than actual equity?
A company might want to award phantom equity rather than real equity because it wants employees to be incentivised to help the company grow, but not want to issue them with shares or does not qualify for a tax advantaged share option arrangement. This is because employee share ownership will result in dilution of existing shares and more complex administration and compliance.
How are phantom share schemes treated for tax?
When you issue your staff with bonuses under a phantom share scheme, these are treated as salary expenses for corporation tax, so they’ll be deducted from profits making your corporation tax bill smaller.
For your employee, they’ll be no tax to pay when you grant them a phantom share or option. However, they’ll pay full tax and NICs on their bonuses (and you’ll pay employer NICs), so they’re less tax-efficient than some other employee share schemes. For an example, full tax relief from employment income tax and NICs can be available where EMI options are used and a corporation tax deduction can also be available.
Can I set up a phantom share scheme if my business is a partnership?
While partnerships don’t have shares, you can still put in place a scheme similar to a phantom share scheme. Rather than tie your fictional share value to your real shares, you’d tie your phantom some other measure of partnership value.
What else do I need to think about when setting up a phantom share scheme?
If you’re thinking about setting up a phantom share plan, here are some things to bear in mind:
- What am I trying to achieve from this plan? Company growth? High employee performance?
- Are there more tax efficient alternatives available?
- Who will be allowed to join the plan?
- Will participants get the underlying value of the shares, or only the amount by which the fictional shares grow in value once they’re awarded?
- When will the fictional shares vest? And will cash be paid put before an exit occurs?
- Should the employee be forced to give up their fictional shares if they leave on bad terms? And what happens if an employee dies, becomes disabled or retires?
- How will you fund the cash bonuses? Would payment only be aligned with an exit event??
- What are the trigger events that will entitle the employee to receive a bonus linked to share value?
