Phantom share schemes vs employee share option plans (ESOP)

In the world of employee incentives and equity-based compensation, two popular mechanisms stand out: Employee Share Option Plans (commonly known as ESOP) and Phantom Share Schemes. Both are designed to motivate and reward employees by offering a stake in the company's success. However, they differ fundamentally, from their structure to how employees perceive (and thus value) each. Let’s explore the key differences between these two very different schemes to help you understand which one might suit your organisation better.

Employee share option plans (ESOPs)

Employee Share Option Plans, often known as ‘stock option plans’, are a widely used tool for attracting and retaining talent in companies. They offer employees the right to purchase company shares at a predetermined price, known as the exercise or strike price and are typically used by companies that are expecting a steep growth trajectory (such as startups).

1. Ownership

Share Option Plans allow employees to eventually have actual ownership of company shares. When they exercise their options, they become shareholders and can have voting rights and the potential for dividends. Basically the same rights and responsibilities as other shareholders. Employees can benefit directly from the company's growth and profitability as the value of their shares increases over time.

2. Tax Implications

The tax treatment of share options can be complex. In general, employees may be subject to capital gains taxes, which, depending on the country they are based, might be calculated at the point of grant, exercising or sale of shares. It’s highly recommended that both employees and company alike understand the local tax treatment.

3. Dilution

Companies issuing share options may experience dilution as more shares are created (when options are exercised into shares). This dilution can affect existing shareholders and, in some cases, lead to the need for additional capital to compensate for it.

Phantom Share Schemes

Phantom Share Schemes are another popular approach to incentivising employees. Unlike share options, phantom share schemes do not grant actual ownership of company shares. Instead, employees are given all the rights of share ownership (such as a dividend payment) without ever owning real shares - hence the name ‘Phantom’.

1. Ownership and Rights

Phantom share schemes do not grant actual ownership of shares, so employees do not have voting rights.

Employees are only entitled to receive a dividend based on the number of phantom shares they hold. Noting that the total dividend amount per phantom share may differ from the amount paid for Ordinary shares.

2. Tax Implications

Tax treatment for phantom share schemes is generally more straightforward. Employees are typically subject to ordinary income tax when they receive their cash bonus/dividend.

3. Dilution

Typically, Phantom share schemes do not lead to share dilution, as they do not involve the creation of new shares. This can make them more appealing to companies looking to maintain a consistent ownership structure and tighter cap table.

Key Differences

1. Ownership: Share Option Plans provide actual ownership of company shares, while Phantom Share Schemes offer a cash bonus based on stock price appreciation.

2. Voting Rights and Dividends: Employees in Share Option Plans will usually have voting rights and dividend entitlements once they have exercised their options to shares, whereas Phantom Share Scheme participants do not have voting rights but are entitled to dividends.

3. Taxation: The tax treatment is more complex for Share Option Plans, as it depends on the type of options and the holding period. Phantom Share Schemes are subject to simpler tax treatment.

4. Dilution: Share Option Plans can lead to share dilution, potentially affecting existing shareholders. Generally speaking, the granting of Phantom Shares does not result in dilution. NB there are some forms of Phantom Share Schemes that allow Phantom shares to convert into real shares at a point of liquidity (usually an IPO or company acquisition).

5. Cash vs. Equity: Share Option Plans offer the opportunity for employees to receive equity in the company, while Phantom Share Schemes provide cash bonuses.

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Choosing the right plan

The decision to implement a Share Option Plan or a Phantom Share Scheme depends on various factors, including the company's goals, ownership structure, and the desired level of complexity in administration. Above all else, the most important consideration is whether the company is focused on increasing share value or returning profits to shareholders.

Share Option Plans are well-suited for companies that want to offer employees direct ownership and the opportunity to benefit from share price appreciation. This can be particularly appealing for startups and high-growth companies where equity ownership aligns employee interests with the company's success. However, the administrative burden and tax complexities should not be underestimated.

On the other hand, Phantom Share Schemes can be an attractive option for companies that want to provide employees with a financial incentive tied to the company's performance without creating share dilution. This can be particularly advantageous for established companies with a stable ownership structure. Phantom Share Schemes offer a simpler approach to equity compensation and are often preferred for their ease of administration and taxation.

Both types of schemes have their advantages and drawbacks, and the choice between them should align with the company's goals, its ownership structure, and the level of complexity the organisation is willing to manage. Understanding the differences between these two options is crucial for making an informed decision that benefits both the company and its employees. Whether you opt for direct ownership with Share Option Plans or a cash bonus with Phantom Share Schemes, the ultimate goal remains the same: to create a motivated and loyal workforce that contributes to the company's success.

Above all else, it’s vital that employees understand the type of scheme they are a part of and can easily engage with how it works and how it benefits them. Having a dedicated platform for employee visibility is a smart way to keep this type of incentive front of mind.

Book a demo with one of the team at Orchestra to learn more.