Why are phantom shares a good idea to incentivize my startup’s employees?

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If you have a growing startup and you need to start hiring workers, in this article we are going to talk about an issue that will interest you.

These are phantom shares, a variable remuneration system that will allow you to reduce personnel costs before your startup is consolidated.

If you want to know more about this form of payment so used in the world of startups, we will explain it to you right now.

What are phantom shares?

Phantom shares are a variable remuneration system that gives the right to a company employee to receive an amount of extra money at a certain time.

Through this bonus, the company grants the worker economic rights equivalent to a share in the capital stock … without granting him the corresponding political rights.

Unlike what happens with stock options, where the employee can acquire a real share of the capital stock, with phantom shares the employees do not acquire the status of partners at any time.

And although phantom shares do not correspond to real but fictitious shares, their reference value is proportional to the real share capital of the company.

This form of reward is widely used in startups to incentivize their employees since the greater the growth of the company, the greater the variable remuneration received by the worker.

Now that you know what they are, let’s see how they work.

How do phantom shares work?

Phantom shares lack specific legal regulation in many European countries (including Spain), so there is great freedom when it comes to regulating the terms of concession and execution as both parties deem appropriate.

Although it depends on each particular case, a calendar and a series of conditions are usually agreed in advance which, if met, entails the collection of a certain amount by the company’s workers.

If you are thinking of using this system for your startup, you must be clear that the operation of phantom shares must respond in a general way to three questions:

  1. How does the worker get his phantom shares?
  2. When can the worker receive his equivalent amount in cash?
  3. What is the cash value of each phantom share?

1. How does the worker get his phantom shares?

Consolidation is known as the way in which the worker obtains the right to receive phantom shares.

Normally, the delivery of phantom shares to the worker is associated based on the achievement of a series of milestones: for example, hiring the employee, the company reaching a certain turnover or closing a new round of financing.

Phantom shares are usually granted to the worker as a personal and non-transferable right, so that if he leaves the startup before a certain time, he will lose his rights over them.

On other occasions, clauses are added to the contract that allow the beneficiary to sell the phantom shares at a certain price to the startup itself or to other workers as long as they have spent a certain time in the company.

2. When can the worker receive his equivalent amount in cash?

The worker gradually consolidates his phantom shares during a period known as the vesting period, during which if he leaves the company he would only have the right to receive in the future the corresponding to the phantom shares consolidated up to that moment. 

Vesting usually begins with a cliff period, whereby if the worker leaves the startup before said period, they do not acquire any rights.

Phantom share contracts specify the conditions under which the worker or former worker will receive cash compensation for the consolidated phantom shares. 

Generally, this occurs when an external investor acquires all or most of the shares of the company, with part of the purchase funds going to liquidate these rights.

3. What is the cash value of each phantom share?

The value of a phantom share is calculated in relation to the value of each share of the company at the time the sale is executed.

Typically, this cash amount is calculated based on the increase in value of each share from the granting of the phantom share to the time of sale.

In order for you to know when this remuneration system suits you or not, we will talk to you about its advantages and disadvantages below.

Advantages and disadvantages of phantom shares

There are many advantages that this system presents compared to salary increases or other instruments such as stock options. Among them, the following stand out:

1. Encourage employees to help the company grow

Given that the bonus that the worker receives will depend on the revaluation of the startup over time, phantom shares allow us to align the economic interests of the management team with those of employees and collaborators.

2. Allows you to retain the best employees

Given that there is a vesting period during which the worker consolidates the award of their economic rights, this system ensures the permanence of the startup’s employees, thus helping to retain talent in the company.

Thus, if the employee leaves before completing this period, she will receive less extra remuneration.

3. It allows the startup to reduce initial costs

Since part of the worker’s salary is variable and depends on the evolution of the startup, this system allows the company to reduce its initial fixed expenses and not fall into excessively high costs, thus minimizing risk.

4. It does not affect the equity of the startup

As the workers do not become partners in the company, it is a very attractive system both for them and for new investors since it does not involve dilution for either party.

On the other hand, phantom shares have two main drawbacks for their beneficiaries:

1. They imply a tax impact for the worker since they are considered income from work, so she must declare her personal income tax as a salary income depending on the real price of the startup’s shares

2. They are usually agreed without the possibility of assignment to third parties in case of being sold.

As you can see, phantom shares are something quite complex to understand and above all, to carry out.

From The Startup CFO we are especialists in providing financial management services to small startups and SMEs in the technology sector, so if you want to have our help to create a phantom shares plan in your company, we invite you to contact us.

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