This article explains the notion and practice of issuing phantom stock and stock appreciation rights.
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Phantom stock and stock appreciation rights can be a great way for entrepreneurs to offer incentives to employees and tie their compensation to the performance of the company without taking the tradition risks and allocating as many resources as they would if they issued stock options or restricted stock.
Phantom stock is essentially a promise of a cash bonus which is directly related to the value of the company. Employees issued phantom stock would usually be unable to purchase or sell this "stock" but instead simply receive a bonus as per the contract of the phantom stock which is somehow tied to the valuation of the company.
Stock appreciation rights (SAR) act as an imaginary form of equity of the company which usually carries no voting rights (but voting rights may be assigned) and is directly tied to the trading price (if the company is publicly traded) or valuation of the company.
When issuing SARs an employer could issue any number of shares at any price, but usually the current trading or valuation price is used. The employee can then choose to "sell" his stock back to the company when the stock price increases.
Let's say that a company issues 1000 SARs to an employee valued at 5 dollars a share. Three months down the road, when the share value increases to 15 dollars, the employee can vest or "sell" this virtual stock and receive a $10,000 check (the change in the value of the stock multiplied by the number of shares granted) from the company. SARs can also be vested in the form of real shares of a company.
For tax and accounting purposes, phantom stocks and SARs (when issued in cash) are treated as deferred cash payments and must be recorded as ordinary income. Phantom stocks and SARs are taxed when they are vested, but, unlike stock options or restricted stock, cannot be taxed under capital gains.
Phantom stocks and SARs are a great way for a company to reward employees for the performance of the firm even if they face obstacles toward awarding stock in the traditional manner or have concerns regarding dilution— perfect tools for the entrepreneur of a young company.