Published on

October 9, 2024

Phantom Equity: A Simple Guide for Europe

Kristine Mora

Filled under

Employee

Equity

Options

Kristine Mora

Phantom equity is a valuable tool for companies that want to reward employees based on the company’s financial performance, without giving away actual shares or ownership. It’s commonly used by startups and private businesses in Europe, where stock options may not be practical or desirable. In this guide, we’ll explain what phantom equity is, how it’s regulated across Europe, where it’s most popular, and the different types of phantom equity plans, including Virtual Stock Option Plans (VSOP) and Stock Appreciation Rights (SAR). We’ll also look at the advantages and disadvantages of these plans.

1. What is Phantom Equity?

Phantom equity refers to compensation plans that allow employees to benefit from the success of a company without receiving actual shares. Instead, employees are granted a right to future payments based on the company’s value or stock price. These payments are usually made in cash and mirror the value or appreciation of real shares.

‍

There are many names for this bonus incentive system, but they all mean the same — paying cash to your employee if there is a liquidity event, such as the sale of company shares. This means that either current shareholders give up their fraction of the share price in sales to benefit employees, or the company creates some reserves to pay out this bonus.

🏦
So when you see names like phantom shares, phantom stock options, phantom equity, ghost shares, virtual shares, virtual stock, shadow stock, and share appreciation rights, they all mean that employees are not getting actual shares but only the monetary value of those shares at the exit.

🚨
However, the phantom equity doesn’t give voting rights or real ownership of actual shares. That**'**s why “virtual” or “phantom” is used to call them - as no actual shares have been given out, and it is more of a promise from the company or shareholders to employees to pay out bonuses when a liquidity event happens mirroring the value of actual shares.

2. How is Phantom Equity Regulated in Europe?

There is no specific regulation of phantom equity in Europe. However, each Member State has its own tax laws and labour regulations governing employee compensation, which phantom equity is, in general - a bonus or compensation in addition to salary. Some examples among European countries:

‍

Tax Treatment: Phantom equity is generally treated as deferred compensation and is taxed when payouts are made as regular income, thus subject to income tax and social security contributions.
Labour Laws: Phantom equity agreements must comply with labour laws that protect employee rights. For example, employees in Germany and France are entitled to certain disclosures and protections when entering into these agreements. Companies must be aware of local employment regulations to avoid legal disputes.
Cross-Border Plans: For companies with employees across multiple European countries, managing phantom equity plans can be a relief as the phantom equity will be taxed the same as the salary, but it might become challenging to allocate fairly.

3. Where is Phantom Equity Most Popular in Europe?

Phantom equity is especially common in countries with strong startup ecosystems or where traditional Employee Stock Option Plans have bureaucratic burdens or no tax reliefs. Key regions include:

‍

Germany: Phantom equity is popular in Germany, particularly in tech hubs like Berlin and Munich, where startups use it to attract top talent. Many German companies use VSOP (Virtual Stock Option Plans) to reward employees based on company performance without giving away actual shares.
Netherlands and Scandinavia: These regions also see high use of phantom equity, particularly in the startup and private sectors, where businesses often favour retaining ownership while providing financial incentives to employees. Many companies use Stock Appreciation Rights (SAR), which are contractual rights that entitle the employee to a payment in cash equal to the value appreciation of a specific number of shares in the company over a certain period.

4. Types of Phantom Equity Plans: VSOP and SAR

There are different forms of phantom equity plans, two of the most common being Virtual Stock Option Plans (VSOP) and Stock Appreciation Rights (SAR). Both plans allow employees to benefit from a company’s success, they are quite similar in some functions, but there are some nuances that are mostly because of regulations in specific countries.

Virtual Stock Option Plans (VSOP)

VSOPs are one of the most popular forms of phantom equity in Europe, particularly in Germany. A VSOP mimics traditional stock options but without issuing actual shares. Employees receive "virtual" shares that represent the value of real shares in the company. Employees receive cash payouts based on the value of these virtual shares, typically at the time of an exit event like a sale or acquisition. Some VSOPs may have a strike price for virtual shares to provide the value from the increase in the company’s stock price from the grant date to the payout date.

‍

How VSOP works: Employees are granted virtual shares, which grow in value as the company grows. If the company is sold or reaches a liquidity event, employees with VSOPs are paid out based on the value of their virtual shares.
- For example, if an employee is granted virtual stock when the company’s stock price is €10, and the stock later rises to €40, the employee will receive €40 per virtual stock. Unless the strike price is agreed upon, the strike price is deducted from the received amount; for example, if the strike price is €10, then the employee receives €30.
Advantages: VSOPs are flexible. They can be a powerful incentive for employees to help grow the company, especially in the lead-up to a sale or other exit event. Simpler to manage compared to other forms of equity and does not require changes in corporate documents of the company.
Disadvantages: Employees don’t gain voting rights or true ownership in the company, and are non-transferable. In addition, the company needs to have cash available for payouts, which can strain finances or the shareholder's profit from sales of the shares is reduced by the amount promised to employees under VSOP.

Stock Appreciation Rights (SAR)

SARs are another type of phantom equity plan that allows employees to benefit from the appreciation of a company’s stock, which is mostly used in Finland and the Netherlands. Unlike VSOPs, which mimic full share ownership, SARs only pay employees based on the increase in the company’s stock price from the grant date to the payout date. The employee is paid the difference (the appreciation) between the grant price and the company’s stock price at the time of payout.

‍

How SAR works: Employees are granted SARs with a set price. If the company’s stock price increases, employees receive the difference in cash at the time of payout.
- For example, if an employee is granted SARs when the company’s stock price is €10, and the stock later rises to €20, the employee will receive €10 per SAR.
Advantages: SARs incentivise employees to help increase the company’s value and can be an effective tool for aligning employee interests with company growth. They are simpler to manage compared to other forms of equity and do not require changes in the company's corporate documents.
Disadvantages: Similar to VSOPs, SARs require the company to have cash on hand for payouts, do not offer employees true ownership or voting rights and are non-transferable.

5. What is the difference between phantom equity and equity?

In summary, equity plans come with more risks to the participants of those plans, while phantom equity comes with higher taxes. When a company decides on what plan to create, it should take into account many factors, which we have described more in this article:
Employee Compensation Plan – Understand ESOP, VSOP, and Other Plans

6. How does phantom equity work?

Here’s how it works with examples:

‍

Creating Phantom Stock Pool:
A company sets up a pool of "phantom shares," which are virtual shares tied to the actual value of the company's stock.
- For example, a company created a 10% phantom share pool that represents 10% of the company's current share capital. If a company has 10,000 shares, then phantom shares are in the total amount of 1,000 and covered with the actual company’s 1,000 shares value.
Create Phantom Stock Options Plan:
Define the terms that will regulate the vesting periods, cliff periods, strike price, good leavers and bad leavers terms, and how the payout happens - are there any specific trigger events (also called liquidity events), such as the sale of shares or assets, revenue milestone or profit. Additionally, it is crucial to understand how the payout to employees shall happen. Will the shareholders be liable for that, or will the company create reserves with the aim of redeeming phantom shares when a trigger event happens?
- For example, a company creates a plan as follows:
  - A standard 4-year vesting period with a 1-year cliff period - this means the employee must stay with the company for at least 1 year before receiving any phantom shares. After that first year, 25% will vest, and the remaining 75% will vest evenly over the next 3 years.
  - A strike price of €50 per phantom share - this means when a trigger event happens, employees will receive a payout based on the difference between the company’s actual stock price and this strike price for phantom shares. For example, if the stock value rises to €80, employees would receive a payout based on the €30 increase per share (€80 - €50).
  - Good leavers are set as the employees who leave under favourable terms and retain vested phantom shares for future payouts, while bad leavers, like those fired for misconduct, forfeit their phantom shares.
  - The company defines trigger events that will determine when payouts occur. These could include:
    - The sale of the company (e.g., if the company is bought for €200 million, all phantom shares are paid out).
    - Reaching a revenue milestone (e.g., when the company reaches €50 million in annual revenue).
    - A successful IPO (Initial Public Offering).
  - The company decides to create a reserve fund instead of personally liable the shareholders for payouts. This reserve will be used to redeem phantom shares when a trigger event occurs. For example, if 10,000 phantom shares have vested across all employees and the trigger event occurs with a stock price of €90, the reserve will need €400,000 (10,000 shares x €40) to pay out employees.
Grant Phantom Shares to Employees:
Employees and other participants receive phantom shares according to the plan’s rules.
- For example, if an employee is awarded 100 phantom shares, and the company’s stock is valued at €50 per share at the moment of awarding, then those phantom shares are worth €5,000.
Managing payout to Employees:
When a previously defined trigger event happens, and the company has sufficient reserves, it may redeem phantom shares and pay out employees.
- For example, if the trigger event happens in year 3 of the vesting period and the employee has vested only 75% of the total amount of phantom shares granted, the company may redeem them, while the other 25% is either cancelled (in case the company is sold) or continues vesting until the next event (like hitting the next profit target).

Conclusion

Phantom equity, in the form of VSOPs and SARs, is an increasingly popular compensation tool for European companies, particularly in countries like Germany, the Netherlands and Finland. It allows businesses to reward employees based on the company’s growth, offering flexibility and a common understanding of how they might be taxed across different jurisdictions.

‍

However, the complexity of setting up phantom equity plans, along with cash payout questions and taxation on shareholders and company side, as well as the lack of true ownership for employees, can be drawbacks. Companies must carefully design these plans to comply with local labour laws and align them with their long-term goals.

Thank you! Your submission has been received!

Oops! Something went wrong while submitting the form.

Phantom Equity: A Simple Guide for Europe

Kristine Mora

BSPCE: The French Formula for Employee Incentives

Elo Madiste

Rocking Team Options: How to Share the Pie

Kaisa Luht