Employee Engagement 101: Phantom Share Schemes

Recruitment business owners often ask us about their options for putting in long-term incentive schemes to retain and motivate key members of their team. The options are many and varied but in this blog series I will look at the usual suspects covering both cash based schemes and equity-based schemes.

In my last blog I considered the traditional cash bonus model, this time I will look at phantom share schemes. In essence, a phantom share scheme is simply a deferred cash bonus scheme. However, rather than simply issuing a standard bonus to employees year on year (which doesn’t really tick the retention strategy box), the company issues an option to the employee in the same way as it would for an equity based scheme.

The value of the cash bonus becomes the notional gain over a given period of time on a set number of shares over which an “option” is granted. This assumes that there is an uplift in value of course! This point is important, as thought will need to be given as to how the notional shares are to be valued both at the date the option is granted and at the date it is exercised (i.e. cashed in).

These schemes can be geared toward individual performance by way of additional notional options being awarded where targets are exceeded, although caution should be exercised here as you don’t want to lose the impact of working as a team toward the goal of increased overall equity value.

Phantom share schemes are not subject to any specific legislation, as they are cash based rather than share based. HMRC are satisfied by the prospect of the entire award being subject to tax through the company’s payroll (more on that below). This means that phantom schemes can be flexed by the company to the degree desired.

The options will be subject to an ‘option agreement’ just as with equity based schemes and that agreement should probably cover matters such as good and bad leaver provisions, and changes of control (e.g. on a sale of the company) provisions.

In summary, the benefits of a phantom share scheme are:

• The existing shareholders’ equity positions will not be diluted which may be particularly relevant where there are multiple shareholders with dissenting views.
• There is no prospect that employees will acquire a small shareholding in a private company which they may find difficult to sell and may be of limited immediate value to them.
• From the major shareholders’ perspective, minority equity interests can be problematic and become an annoyance – this obviously won’t apply with a phantom scheme.
• 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. However, relief is only available at the point that the employee ‘exercises’ his options (as opposed to over the option period which is how accounting rules deal with the issue).
• The schemes can be heavily customised to the commercial needs of the company so that only selected people need to be included and performance criteria applied.

And, the drawbacks….

• The schemes are not tax advantaged in the same way as certain other schemes (other than the ability to claim a deduction for the purposes of corporation tax as stated above), and the bonus will be subject to PAYE and national insurance (both employees and employers) – this is far less favourable than the capital tax treatment, and can certainly be of enough significance to make equity based schemes more attractive.
• A phantom share scheme will involve (potentially substantial) cash outlay for the company, and the company will therefore need the free cash to be able to deliver. This will require some discipline from you as owners . Recognising the accrued expense in the balance sheet (as is required by accounting standards will help) but the company will most likely want to cap the value of the phantom options so that the impact is not too dramatic. It won’t necessarily be easy to arrive at a cap that suits everybody’s objectives.
• Mainstream accounting standards will require that the value of the phantom share options, which is recorded as an expense and a liability in the company accounts, be reassessed at each balance sheet date. This annual exercise may require expert assistance and, consequently, could prove costly.

Our blog series will continue over the coming weeks, with more information on engaging your employees both financially and non-financially. If you would like to discuss any queries, or the subjects raised in the series, please contact me on 01462 687333 or email m.pegram@uhy-uk.com.