What you need to know about profit-sharing and a phantom share scheme

Considering establishing an employee reward system or share scheme but don’t know what option is suitable for your company? The range of different options can seem overwhelming, but we’re here to help. In this article, we look at the pros and cons of two popular employee reward options, profit sharing and phantom share schemes and why they could be the perfect fit for your organisation.

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What is profit sharing, and how does it work? 

One popular employee reward scheme is profit sharing. This occurs when a company awards employees an ad hoc cash bonus based on a percentage of the company's profits. It is a way to boost employee loyalty and drive performance. Companies can choose to make a profit-sharing bonus arrangement only available to senior leadership and top talent, or they may choose to include all employees. 

Profits are commonly distributed to employees via cash bonuses, which are paid in addition to their regular salaries. Companies may also choose to distribute profit bonuses equally among employees or based on each employee's contribution to the company’s profit success. 

Profit-sharing payments can be made to employees at any cadence a company chooses, which could include annually, quarterly, or monthly.

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What is a phantom share scheme, and how does it work?

Unlike profit-sharing, phantom share schemes (also known as ‘shadow stock’, ‘ghost stock’, or ‘virtual stock’) are a more methodical, structured, and formalised employee reward option. The company’s performance dictates what is distributed to phantom share scheme participants, with the amount each participant receives based on the number of phantom shares they hold. A phantom share participant's dividend increases if the company performs well. This can serve as a powerful performance incentive to employees who are more likely to feel engaged and empowered to have an ownership mentality. 

While participants receive a hypothetical stake in the company, they enjoy all the benefits of company ownership, such as dividend payments and the possibility of their phantom shares converting to actual shares at a future date when specific vesting criteria are met (usually when an IPO, merger or acquisition occurs). 

Phantom shares are commonly offered to junior or mid-level employees and often appeal to companies that want to maintain their equity with new shareholders. However, because of the nature of this scheme, they can also be issued to directors and non-employees such as contractors or service providers.

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What are the advantages and disadvantages of profit sharing?

One advantage of profit-sharing cash bonuses is their ability to nurture employee loyalty and help a company retain top talent. They are an incentive to increase employee productivity, as the better a company financially performs, the higher an employee's bonus payment may be. On the other hand, if a company is less profitable, the percentage of shared profits decreases, allowing companies to continue managing their cash flow. 

Another advantage for employees is that tax obligations are relatively straightforward, and participants are typically subject to income tax when they receive their cash bonus. 

One disadvantage of profit sharing for employees is the uncertainty around when and how much profit will be paid to them. Profit-sharing bonus payments to employees may differ widely from one quarter or year to the next due to how the wider business performs. This can place a financial burden on employees, who cannot forecast a consistent cash flow from the profit-sharing bonus scheme.

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What are the advantages and disadvantages of a phantom share scheme?

One advantage of a phantom share scheme for employees is that tax obligations are generally fairly straightforward. Participants are typically subject to ordinary income tax when they receive their dividends. Depending on the vesting criteria attached to the scheme, participants may be able to convert their phantom shares to actual shares in the future when a specific vesting event occurs, such as an IPO. 

An advantage for companies is that a phantom share scheme doesn’t initially lead to further equity dilution, as the scheme doesn’t involve creating new shares. This can appeal to companies wanting a consistent cap table and ownership structure. 

Another advantage is that they can allow a company to issue equity across countries, which is especially beneficial for multi-national organisations. Since phantom shares are not traditional shares, they avoid some of the issues that issuing traditional shares can create in certain countries.  

However, a disadvantage for employee participants is that since they do not own actual company shares, they may not have voting rights. Employees also need to be aware that the dividend payment they may receive is based on the number of phantom shares they hold, which may differ from dividend payments made for ordinary company shares.

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How to implement a phantom share scheme

The first step is to consult with your board and financial advisors on implementing the phantom share scheme. Then, we recommend you work with a lawyer on the contractual legal agreements that are shared with employee participants. 

This agreement will include details on:

• The phantom share scheme
• What employees are eligible
• A schedule of when dividends will be paid out
• Events that could trigger a payment or phantom shares converting into actual shares, such as a company milestone or liquidity event. 

This agreement needs to be provided to all eligible participants so they know what the scheme entails and their rights. Orchestra’s equity and shareholder management platform helps companies do that by providing administrators and employee participants online access to a personalised dashboard to track their company shares. Orchestra’s platform also allows participants to access the scheme’s documents, any communication about the scheme and a history of their dividend payments.

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Want to discuss how a phantom share scheme can benefit your business? 

Our team is here to help you take the stress out of employee share schemes. Get in contact to book a demo to discover how Orchestra can help set your business up for success. 

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