UK: Guide To Phantom Share Schemes

Last Updated: 6 March 2013
Article by Amanda Solomon

There are many different schemes and plans which can be used to incentivise employees. Some, such as the Enterprise Management Incentive ("EMI") scheme or Company Share Option Plan, are more tax efficient. Others, such as a nil-paid share scheme or unapproved options, are perhaps less so, but are not limited by as many legislative requirements –meaning that they can be tailored a great deal to suit the needs of the company.

However, one common theme with all of these forms of incentive is that they involve the issue, at some point or another, of shares by a company to its employee. Whilst the issue of shares to employees will often be commercially agreeable, there will be times when doing so is less appealing for the company and its shareholders. One way to solve this problem is through the use of a phantom share scheme.

In essence, a phantom share scheme is a cash bonus scheme. However, rather than simply issuing a 'standard' bonus to employees each year, the company issues an 'option' to the employee in the same way as it would for an EMI scheme our unapproved option scheme. The difference is that, instead of being an option to acquire shares at a certain price, the option is over cash. The value of the cash bonus will be the notional gain on the shares which would have been issued under a share option scheme, and so the gain is the equivalent to the uplifted share value.

As the phantom option is linked to company performance (as would be the case for a share option scheme) the company is able to ensure that bonuses are linked to an actual increase in the value of the company– a central objective for an effective incentive scheme. Bonus awards can also be graduated, so that stronger company performance leads to better returns for the individual employee.

Phantom share schemes are also not regulated by specific legislation, as they are cashbased rather than share-based. This means that phantom schemes can be drafted to maximise the commercial goals of the company, and can be fairly sophisticated, with the inclusion of such things as 'good and bad leaver' provisions, performance conditions and change of control provisions.

Benefits of a Phantom Share Scheme

The fundamental reason for adopting a phantom share scheme is that the company will not wish to grant or issue shares to employees. This could be for a number of reasons, such as:

  • The company may be operating under dilution limits, whereby a certain maximum percentage of shares can be issued by the company at any given time. For example, companies which comply with the guidelines of the Association of British Insurers will have a dilution limit of 10% over a 10 year period, and the issue of shares or options under an incentive scheme may cause the company to breach that limit. A phantom share scheme will not affect the company's dilution limits and is often therefore favoured by companies which are approaching their dilution limits; and
  • There is no risk that employees will acquire small shareholding in the company. Majority shareholders will often be keen to avoid minority shareholdings, as they may affect their ability to run the company effectively (for example if the minority shareholders are active dissenters), and can also increase administrative burden if the company is being sold.

A phantom share scheme also has a number of other benefits, including the following:

  • The amounts paid by the company as a bonus can be offset against the company's profits, therefore reducing the company's corporation tax bill; and
  • As highlighted above, there are no regulatory requirements and schemes can be customised to the commercial needs of the company.

When might a Phantom Share Scheme not be suitable?

  • Whilst phantom share schemes can be tailored to suit the commercial objectives of the company, they are not tax advantaged in the same way as certain other schemes, and the bonus will be subject to income tax and national insurance – this is less favourable than capital treatment, and if the reduction of taxation is an issue for the company, other schemes may be more favourable than a phantom share scheme;
  • Unlike a share scheme or share option scheme, a phantom share scheme will have some cash outlay for the company. As the option is being satisfied in cash, the company will have to satisfy this cash value as and when the option is exercised, and will therefore need the reserves to do so. Also, the option will be exercised by the employee rather than the company, and as such may be exercised at a time which is less convenient for the company (at the employee's discretion). Therefore, the company will need to consider whether it is 'cash-rich' enough to satisfy the options as and when they become exercisable;
  • The phantom share option scheme is more suitable for targeting at certain employees, rather than being adopted for all employees of a company. This is because the option is linked to increases in company share values – if an employee has no direct impact on the value of the company, then it is counter-intuitive to reward them for such increases. As such, phantom share schemes are usually reserved for management and senior employees;
  • The accounting standards of companies generally require that phantom share options, which are recorded as expenses in the company accounts, be reassessed at each balance sheet date. This differs from traditional share option schemes, which will require valuation on a less regular basis (for example on determining market value of the option at the date of grant). For private companies, this may lead to valuation issues, not least the fact that an expert valuation may be costly, perhaps disproportionately so as compared to the value of the option itself. Listed companies (whether listed on the Main Market or the Alternative Investment Market) should hopefully have less problem valuing their shares, as they will be regularly traded; and
  • As the company will have a cash liability at the date of exercise, and as the company will not know how much the value of the option may appreciate before it is exercised by the employee, the company will most likely want to cap the value of the phantom option.

There will be an inherent issue with determining the correct value of the cap – too high and the company will be exposed to a potentially significant cash flow cost, too low and the employees may be insufficiently incentivised. Sometimes companies will find it easier to implement a share option scheme, which will not need such an 'appreciation cap', as there will be no cash flow cost. However, drafting a cap should not in itself deter companies from using a phantom share option scheme, as advisors will be able to work with the company to determine a suitable cap.

The above are just a few examples of the types of issues which should be considered in relation to phantom share schemes – there are many more, and it may even be that another type of incentive scheme is more suitable for your company. Professional advisers can assist with these issues (both highlighting and resolving), and can help effectively link employee performance with financial returns.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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