In the corporate world, companies are constantly seeking strategies to attract, motivate, and retain key talent. Among the most commonly used tools to achieve this are stock options and phantom shares, two types of incentive plans with distinct characteristics and effects for both employees and employers.
This article analyze the differences between the two, their advantages and disadvantages, their impact on talent retention, and how they affect the taxation of employees and companies.
Stock options vs. phantom shares: key differences
Stock options are purchase options that allow employees to acquire shares or equity interests in the company, depending on whether the company is structured as a corporation or a limited liability company (LLC), at a pre-established price, generally lower than the market price. On the other hand, phantom shares are economic rights that simulate holding shares or equity interests but do not grant ownership or voting rights.
How they influence talent retention strategy
Both instruments seek to align employees’ interests with those of the company, incentivizing their retention and commitment. Stock options may be more attractive to those looking to actively participate in decision-making and benefit directly from the company’s growth, but they involve capital dilution and can generate complexities in corporate management.
Phantom shares, as they do not grant voting rights or real ownership, avoid capital dilution and simplify the shareholder structure. They are useful for motivating key employees without altering the shareholding makeup, offering economic benefits linked to the company’s performance.
Relevance in startups and established companies
In startups, stock options are common at the beginning to attract talent, offering the chance to participate in the company’s future growth and success, but issuing new shares or equity interests can be complex and costly, especially in early stages.
Phantom shares provide a flexible alternative, allowing economic incentives without changing the shareholder structure, which gives an advantage in initial stages where ownership is usually concentrated.
In established companies, stock options may be less attractive due to possible dilution and the complexity of managing additional shareholders. Phantom shares are better suited in these cases, providing economic incentives without altering the ownership structure or existing voting rights.
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Stock options
Stock options are purchase rights that a company grants its employees, allowing them to acquire company equity at a predetermined price, known as the “strike price.” This price is usually lower than market value at the time the option is exercised. The goal is to align the interests of the employees with those of the company, incentivizing their commitment and effort to increase the company’s value.
When the option is exercised, the employee acquires real equity and becomes a shareholder/partner, gaining economic and voting rights within the company.
Requirements and conditions for granting them
The granting of stock options is generally subject to certain conditions and requirements:
- Vesting period: this is the minimum period that must pass before the employee can exercise their options. This period may be linear or staggered, and its duration varies according to company policy.
- Exercise term: once the vesting period is fulfilled, the employee has a specified time to exercise their options before they expire.
- Service conditions: it is common for stock options to be conditional upon the employee remaining at the company for a specific period or achieving certain objectives.
- Liquidity events: in some companies — especially startups — exercising options may be linked to liquidity events, such as a company sale or an initial public offering (IPO).
Phantom shares
Phantom shares, or ghost shares, are a type of business incentive that gives employees economic rights equivalent to a real share or equity interest, without granting them actual ownership. This mechanism allows employees to benefit from the increase in company value without becoming shareholders.
The operation of phantom shares is based on the allocation of theoretical units that reflect the value of the company’s shares or equity interests. At a future date agreed beforehand, such as the sale of the company or achieving certain goals, the employee receives a payout equivalent to the value of these units. This payment is usually calculated as the difference between the initial value of the shares or equity interests at the time the phantom shares are granted and their value at the time of payment, given the company is presumed to have developed its business and increased its value.
Tax comparison: stock options vs. phantom shares
Personal income tax treatment for employees
Stock options are considered in-kind employment income. The employee is taxed under personal income tax (IRPF, for its Spanish acronym)) on the difference between the market value of shares or equity interests at the time of acquisition and the price paid for them. This income is included in the general tax base and is subject to withholding tax.
Phantom shares are also considered employment income, but in this case as a cash payment. The employee is taxed under personal income tax on the amount received when the phantom shares are settled, with this income included in the general tax base and subject to withholding tax.
Tax impact for the company
In the case of stock options, the company must withhold the appropriate tax on the in-kind employment income imputed to the employee. In addition, the cost associated with acquiring equity may be deductible for corporate tax, provided legal requirements are met.
For phantom shares, the company must also withhold taxes on the cash employment income paid to the employee. The amount paid to the employee for settling phantom shares is a deductible expense for corporate tax, provided legal requirements are met.
When the tax obligation arises
For stock options, the tax liability for the employee arises when they exercise the purchase option and acquire the shares or equity interests, since this is the time when the in-kind employment income materializes.
For phantom shares, the tax liability for the employee arises at the time agreed for payment, that is, when the incentive is settled and the employee receives the corresponding amount.
How to choose the best option according to the business context
The choice between stock options and phantom shares depends on several factors. Stock options may be more appropriate for companies seeking to involve their employees in ownership and management, particularly if they are willing to accept a possible capital dilution. On the other hand, phantom shares are ideal for companies wanting to incentivize staff without altering the ownership structure or granting voting rights.
It is essential to consider the company’s financial situation, its long-term objectives, and its corporate culture. In addition, it is advisable to seek legal and tax advice to design and implement the most suitable incentive plan, ensuring its effectiveness and regulatory compliance.
Conclusion
When analyzing stock options and phantom shares as business incentive tools, significant differences are observed in their structure, tax implications, and effects on talent retention.
For startups and growing companies, phantom shares may be more suitable due to their flexibility and lesser impact on the company’s equity. For startups, phantom shares may offer more flexibility and preserve ownership. In contrast, stock options can be suitable in more mature companies with stable structures and a clear path to liquidity events.
Each company should asses its specific needs, consulting with tax and legal advisers on how to design an incentive plan that optimizes talent retention and complies with current legal and tax obligations.
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