Startups are keen to use motivational tools like the Employee Stock Option Plan (ESOP). These programs do not burden the company with the economic cost of paying additional cash compensation. This way, startups can preserve their cash flow, which is especially sensitive during the initial stages of business development. Simultaneously, such programs effectively motivate employees, who have an interest in increasing the value of the company, as they become its co-owners. For this reason, the cap table of almost every startup today includes an entry for an option pool. However, not every founder wants or can commit to permanently transferring part of the company to employees. In such cases, the Phantom Stock Option Plan (PSOP) presents an interesting alternative.
What is a Phantom Stock Option Plan?
A PSOP is a program aimed at motivating managers by linking their compensation to the value of the company, without the need to issue actual shares or equity. Unlike traditional ESOPs, participants in PSOPs do not receive real equity but a monetary equivalent calculated based on the value of shares or dividends as if they were real shares. Therefore, contrary to the program’s name, it does not involve actual shares but rather cash compensation.
Motivational programs based on so-called “shadow equity” are not a recent invention. In 1960, Harvey M. Adelstein published Deferred Compensation—The Phantom Stock Plan Materializes, which described this innovative mechanism for motivating management teams, then rapidly gaining popularity. In the U.S., this concept is still in practice, and nonqualified deferred compensation plans, which include PSOPs, are regulated from a tax perspective under Section 409A of the Internal Revenue Code. Today, this trend is also gaining traction in the CEE region.
Why is the Phantom Stock Option Plan Becoming Popular?
- Avoiding Equity Dilution
A key advantage of PSOPs over classic stock option programs is that company owners avoid dilution. As a result, they retain both the economic benefits of ownership and full control over the company. Even the transfer of a small equity stake could reduce control, due to the necessity of respecting protective rights granted to minority shareholders under the law.
- Simplified Shareholding Structure
For private companies, maintaining a straightforward shareholding structure facilitates decision-making on matters reserved for shareholders. This is particularly important for startups, especially if an investor is involved but no supervisory board has been established. In such cases, the shareholder meeting effectively takes on the role of the supervisory body. Expanding the shareholder base complicates decision-making within this body.
- Avoiding deadlocks
Some actions regarding a company may require joint acting of all of the shareholders. As an example we may show, popular in Europe, the so-called “Delaware Flip”. This operation involves all shareholders exchanging their shares in a European company for shares in a newly created U.S. company. A lack of cooperation from even a single shareholder can significantly hinder, if not entirely block, such a process.
Key Elements of the PSOP
The essence of a PSOP is granting employees a benefit whose value mirrors the financial rights associated with owning real shares (“shadow equity”). Such bonuses can take two primary forms:
Full Value Plans
In this case, the program’s terms specify that the bonus paid under the program will reflect the value of shadow shares as of a date determined by the program’s rules.
Appreciation-Only Plans
This variation provides that the bonus is calculated as the difference between the value of the shadow shares at vesting and their value on a baseline date specified in the program.
A crucial aspect of implementing such plans is defining in the motivational program’s rules how the shares’ value will be determined. For public companies, this value would be based on the market price. However, PSOPs primarily concern companies not yet listed on regulated markets. In such cases, the value might be determined by a formula specified in the program, for example, based on the company’s EBITDA over a given period, as reported in financial statements. Alternatively, the valuation might be conducted by an external entity specifically for the program. The appropriate valuation method depends primarily on the company’s industry, assets, and stage of development.
The PSOP may also provide for the payout of dividends associated with shadow shares. The specifics depend on the creativity of those designing the program. In certain cases, such payouts may occur during the vesting period, ensuring employees don’t have to wait until the program concludes to receive financial benefits.
ESOP vs. PSOP: Similarities and Key Features
Although the benefits under ESOP and PSOP differ, these conceptions include many common elements whose effectiveness in ensuring motivation and employee retention has been proven.
Key Performance Indicators (KPIs): Granting shadow shares or determining the number of shares can be tied to achieving KPIs set by the management. These KPIs can be defined at the organizational level or individually for each participant. Their achievement should be regularly monitored and documented to avoid future disputes.
Vesting Period/Cliff Period: The vesting period assesses an employee’s performance in relation to their eligibility for the program’s benefits. It can be broken into shorter “cliff periods,” during which the employee earns rights to subsequent installments of the program’s benefits. Cliff periods may depend on the passage of time, meeting objectives (OKRs), or a combination of both methods.
Good/Bad Leaver Clauses: PSOP regulations should address the settlement process in case of participant departures, whether amicable or due to violations. Properly defining these terms can positively influence the retention of key employees, as the potential loss of benefits encourages them to stay with the company.
Challenges associated with PSOPs
- Tax Implications
The implementation of a PSOP should be preceded by a thorough analysis of tax, accounting, and securities regulations in the relevant jurisdiction. PSOPs may not always be the most tax-efficient solution compared to ESOPs, which enjoy tax preferences in many countries. Additionally, the company may be responsible for withholding income tax on bonus payouts, which should be considered in the program’s design.
- Impact on Financial Results
PSOPs create financial liabilities for the company, which must recognize provisions for future payouts. This impacts financial results, potentially reducing the company’s valuation and limiting dividend distribution. Such considerations may deter some companies from implementing PSOPs.
- Securities Regulations
Offering participation in a PSOP might be considered a securities issuance in certain jurisdictions, subjecting it to legal requirements. Violations of securities offering laws can lead to severe financial penalties.
Hybrid ESOPs: A Flexible Alternative
Hybrid ESOPs, allowing conversion to PSOPs, are increasingly popular. Such programs defer the issuance of real shares until the vesting period ends. Upon a triggering event, the company can decide whether to issue shares or pay an equivalent cash amount, effectively converting the ESOP into a PSOP under the full value plan model.
To ensure effectiveness, the program rules must specify the conditions, timing, and procedures for converting ESOP to PSOP, as well as the method for determining the equivalent value and payment deadlines.
Conclusion
The PSOP is an attractive alternative to traditional ESOPs, particularly in the CEE region where market conditions are unpredictable. A hybrid ESOP with the option to convert to a PSOP offers flexibility, enabling companies to choose the best solution when obligations become due. This makes PSOPs a valuable tool in today’s volatile business environment.
By Pawel Machowski, Associate, KWKR Konieczny Wierzbicki and Partners