M&A Vocabulary – Experts Explain: Phantom Shares

published on 21 July 2023 | reading time approx. 4 minutes

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

Phantom shares or phantom share options are sometimes called shadow shares, synthetic shares, or equity appreciation units. They are commonly used as an award to senior employees for the achievement of time-based or performance-based conditions in private companies. The delivery of said award commonly occurs under a phantom share option plan which is a separate agreement between the employer and the employee. It can be freely structured so that the employee’s right to exercise its award would be subject to rules satisfactory to the board. Phantom shares award their owner a cash bonus calculated on reference to a share option plan.

The calculation of the cash bonus is determined by the potential gain the owner could have made, if he/she had exercised an option of acquiring a certain number of shares instead. The gain of the option to acquire shares to which the cash bonus relates is determined by the market price of the shares, at the time the phantom share option was granted. The features of phantom shares may resemble those of real share option arrangements, such as performance conditions to be met, continued employment requirements and vesting periods.

The treatment of phantom shares for tax purposes is equivalent to that of a regular cash bonus. The cash payment from a phantom share award is subject to income tax via the Pay As You Earn (PAYE) system and the National Insurance Contribution (NIC). However, when employees exercise options over real private company shares that are not readily convertible assets, the income tax is collected through the self-assessment system, and the NIC does not apply. The value awarded by phantom shares is not taken into account when determining the pension for the employee and can therefore be excluded. Therefore, consideration shall be given whether the tax implications make the award of real shares more efficient or not.

Generally, the payment made by the company for a phantom share is deductible for corporation tax purposes, following general principles. Nevertheless, it is not possible to claim a deduction for an accrual related to a liability under an award of phantom shares. The deduction is typically deferred until the actual payment.

Benefits

Phantom shares are suitable to protect the ownership interests of shareholders. A private company may find that the provisions were carefully drafted to protect the interest of its investors, and to protect those interests, phantom shares may be awarded to avoid the distribution of real shares which may jeopardize those interests.

Furthermore, the use of phantom shares may avoid complexity that could arise from issuing real shares by not increasing shareholders. This would facilitate the administrative matters of shareholders such as general meetings, corporate transactions or issues related to share owners leaving the company.

Moreover, the calculation of a phantom share allows for the value of the phantom share to be different from the actual market price of the company’s shares. For example, while the market value of real shares may include further investments of the company that would be included in the valuation, the calculation for the phantom share could ensure that only the growth of the company that the employee operates in is reflected in the valuation.

Application

The time bound conditions regarding the use of phantom share options establish that once the award of phantom shares has been granted, the employee has the option to choose the moment in which he/she exercises the cash bonus of the phantom shares. It is recommended that the terms of the phantom share option plan specify an earliest and latest date to exercise the phantom shares option, as well as certain circumstances under which the option holder may not exercise his/her option.

To ensure that the capital of the company is not threatened by the exercise of phantom share options, it is advisable to include a maximum number of shares or a confirmation by the board regarding the number of phantom shares exercised which ensures that the company is capable of paying the phantom shares’ value without incurring any risks regarding its capital’s capacity to support the sum payable. Furthermore, to keep the administrative costs for the exercise of phantom shares reasonable, a minimum number of shares should be included in the option plan that is referenced for the calculation of the phantom share value in the option plan.

Another useful rule to consider is that upon termination of employment, the option to exercise phantom shares lapses after 30 days. The board would have the power to allow exercise of the options during this period. Furthermore, consideration should be given to including terms that allow the employee's estate a 12 month window to exercise options after his/her death, except for certain exceptions that may be included in the option plan. Consistency and non-discrimination are important in deciding whether to exercise after termination or death.

It is also advisable to include a provision in any share scheme to exclude, to the extent possible, losses associated with options from claims arising from termination of employment or office. It is recommended to include a similar provision in the corresponding employment contract or service agreement for comprehensive protection. This ensures that the potential losses related to options are appropriately addressed and mitigated in the event of termination.

A clause, clarifying the timing and conditions for exercising phantom options following a change of control event, should be considered in the option plan. For example, a 30-day exercise period after a change of control event, during which the holders of phantom shares can exercise their options. After this period, any remaining unexercised phantom shares would expire. The board would be authorized to determine the proportion of phantom shares that can be exercised, as long as it is not below the minimum proportion. It is recommended to include such a clause to outline the exercise period and grant the board the discretion to determine the exercisable portion of the phantom shares after a change of control.

Conclusion

Phantom share options provide a means of enabling employees to participate financially in the performance of the company, while simultaneously offering flexibility in the calculation of the award and offering immunity to shareholders’ ownership interest in the company.