Phantom Stock Options

Sharda Balaji
Sharda Balaji, Founder
Posted on Tue, 09 May 2017

Employee Stock Option Plan (“ESOP”) is a well-known mode of employee retention, reward and recognition mechanism, especially amongst startups who cannot provide market driven salaries.

For private limited and unlisted public limited companies, ESOP is governed by Section 62(1)(b) of the Companies Act, 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014. For listed companies it is Securities and Exchange Board of India (Share Based Employee Benefits) Regulations, 2014 (SEBI Employee Benefit Regulations).

ESOP comes with its set of guidelines such as, eligibility criteria, exercise price, tax issues at the time of exercise, amongst others. Further, the employees may not be entirely aware of the benefits they may derive, but are exposed to taxation at the point of exercise. Please read our earlier posts on ESOP Primer

( which covers tax implications. With the Companies Act, 2013, ESOP process is laid out in detail in the above mentioned section and Rules.

In ESOP, it may be noted that upon exercise, the option holder becomes a shareholders and is issued share certificates. If the organization wishes to provide the “economic benefit” linked to share price but not shares themselves, then they may explore Stock Appreciation Rights.

Stock Appreciation Rights (“SARs”) means a right given to an employee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be by way of cash payment or shares of the company.

Among SARs, Phantom stock options (“PSOs”) are those options which are settled by way of cash settlement. It is a performance based incentive plan through which an employee is entitled to receive cash payments after a specific period of time or upon reaching a specific target. This is directly linked to the value of the company’s share price. In other words, an employee could have promise of x number of shares at y price as grant. At exercise, the appreciation in the value of the share price, is handled out as cash incentive.

In a cash bonus, management decides on the amount of bonus based on performance and available cash set aside for bonus disbursement. Whereas in PSOs, the cash incentive is linked to the appreciated value of the share price, which then brings about a common vision for growth of the company.

Legal framework: The Companies Act, 2013 has prescribed rules for issuance of shares under ESOP. However, it is silent with regard to the issuance of PSOs. Further, SEBI in one of the queries raised, opined that since PSOs do not relate to any actual purchase/sale of shares, SEBI (Share based Employee Benefits) Regulations do not apply.

Tax and accounting: The amount of appreciation received by way of cash incentive, is subject to tax in the hands of the employee and as perquisite. Further the company is liable to deduct tax at source.

The company is required to make provisions for estimated cash requirement for settlement on the basis of estimated fair market value at the end of each financial year till the estimated life of PSOs or actual exercise/settlement of PSOs.

Advantages of PSOs:  PSOs are advantageous over ESOPs as it enables companies to share a portion of their profits with the employees and not part with any stake of the company. Second, PSOs do not result in shareholder dilution because actual shares are not issued and the employees do not become owners. Third, as the amount of settlement is linked to the share price, the employees and the promoters will have a common objective of increasing the company’s value. Lastly, it is less administrative in comparison to ESOP.

Although PSOs has its advantages, employees may not feel a stakeholder in the growth, because they do not get any voting rights and other advantages of being a shareholder.

Globally, PSOs are popular, while in India, the adoption is still at a nascent stage. Most startups go through the conventional ESOP route for incentivising their employees. If employees and organizations believe in “economic benefit” to employees linked to the share-price, then PSOs could be a great alternative to explore.

Author: Shruthi Shenoy

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