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FAQ: Phantom share schemes

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 incentive 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 downsides. They can be expensive to set up and run, and also have the effect of 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 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.  

What is a phantom share scheme?

Many employers, particularly SMEs and start-ups, are choosing to set up incentive schemes like share plans that offer employees the chance to participate in company ownership. Often these are linked to employee performance or company growth. While these types of schemes are popular with employees, they can have some downsides. For example, you need to create a special class of employee share, employees can come and go, requiring complex provisions in the scheme dealing with good and bad leavers, as well as the potential for dilution of founder shares. In addition, as a company goes through different funding rounds, having a bank of employee shares can create issues with funders.  

One way of avoiding these difficulties is to create a phantom share plan, where the employee doesn’t get actual shares at all, but ‘fictional’ shares. These fictional shares have a notional value equivalent to real shares, will rise and fall with the value of the real shares, and entitle the holder to cash bonuses equivalent to the dividend they would have received if they owned real shares. 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. 

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. Every time a dividend is paid, the employee will get a cash bonus equivalent to what they would have received if they were actual shareholders. If a trigger event occurs such as an IPO, a company sale, or if the employee leaves on good terms, 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 profits. These schemes are easy to set up and run, and there’s no risk of share dilution. They’re an ideal, no-frills way to reward employees, and they’re a risk-free alternative to traditional employee share plans.  

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 and all that entails. 
  • Phantom share schemes will protect you and your shareholders from dilution 

    The downside of actual employee share schemes is that 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. 

    In addition, once you set up a class of employee shares, this can cause issues as you move through funding rounds. The scheme has to be accommodated within your existing share structure, and reflected in company documents like Articles of Association and Shareholders Agreements. Plus, if an employee leaves, this can cause problems, depending on whether they depart on good or bad terms, and this needs to be dealt with in the scheme. After all, you wouldn’t want a bad apple staying on as a shareholder in your company. 
  • You can have the upside of an employee share scheme without the downsides like set up and administration costs 

    While employee share schemes are attractive, they can be time-consuming and expensive to set up. They also require ongoing administration, including reporting to HMRC. Phantom share schemes are much cheaper and easier to set up.  

    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 put limits on the bonuses you award. This can be useful where you don’t want phantom shares putting too much of a drain on your cash flow.  

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. This is because employee share ownership can cause issues for funders and founders, like dilution of existing shares, complexity of administration, and problems when employees leave on bad terms. 

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.  

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 partnership share to partnership equity value and offer bonuses to employees equivalent to partnership distributions.  

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? 
  • 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 how often will they be issued? 
  • 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 and what happens if you don’t have sufficient cash flow to pay bonuses linked to share dividends? 
  • What are the trigger events that will entitle the employee to receive a bonus linked to share value? 

What next?

If you’d like to know more about phantom share schemes or employee share schemes in general, whether tax-advantaged or non-tax-advantaged, or special types of employee shares such asflowering shares,growth shares, orhurdle shares our expert corporate lawyers can help explore your options. We also advise companies considering setting up an Employee Ownership Trust. Get in touch on 0800 689 1700, email us at enquiries@hjsolicitors.co.uk, or fill out the short form below with your enquiry. 

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