Advantages and disadvantages of stock options and phantom shares

Advantages and disadvantages of stock options and phantom shares

Stock options and phantom shares are two systems of incentives available to companies to try to stimulate their employees, or external collaborators (normally those who are key to the company), in the development of their functions within the company so that the performance of these workers is optimised, as well as these systems also serve to attract and retain talent.

However, this indirect effect on the company’s interests does not always have a sufficiently strong impact on the feelings of the employees, who may see themselves as alien to the company’s interests.

Incentive schemes can therefore break down the separation of interests between the parties that characterises the respective roles of employer and employee. With the aforementioned plans, it is possible to transfer to the employee, to a greater or lesser extent, part of the particularities that, in principle, correspond to the employer.

For this reason, incentive plans can be very attractive for companies, since a good use of these tools will help employers to have workers (in the improper sense as well) who are more motivated and better aligned with the interests of their companies, as they will participate in the good running of the company and, in this case, will act in part as if the earnings were their own.

Main differences between stock options and phantom shares

Having said all this, it is worth differentiating between stock options and phantom shares before describing their main advantages and disadvantages, which we at Letslaw highlight.

Firstly, stock options are, as their name suggests: options on shares (or participations, which, moreover, is the most common in the startup ecosystem). They are the granting of rights over shares to employees (and/or collaborators) of the company, which will be exercisable if certain requirements and milestones are met, which will have to be assessed in the respective cases.

In this case, the holders of the stock options, once vested and accrued, will have the right to purchase the number of shares assigned to them at the price determined, normally below the market price.

In this way, the holders of the stock options, once they have vested, will have access to the share capital structure as full shareholders of the company, being able to exercise all the rights inherent to the shares they have acquired, both political and economic, and will therefore participate in the company’s affairs to the extent that corresponds to the shareholding quota obtained.

There is also the possibility of granting phantom shares. This is the most commonly used incentive in Spain. In this case, the holder is not granted the possibility of acquiring a number of shares in the company, but is granted the economic rights inherent to the percentage of the share capital that is determined, provided that the milestones and requirements stipulated in the respective plan are also met and also that a “liquidation event” occurs, i.e. a significant sale of shares in the company or a capital increase, for example.

Having defined the spirit of the incentive plans and briefly defined stock options and phantom shares, the main advantages and disadvantages of each of the two systems can be addressed.

Advantages and disadvantages of stock options and phantom shares: Stock options

Advantages

As mentioned above, they incentivise employees to contribute to the better functioning of the company and attract and retain talent.

They allow employees to acquire equity in the company at a normally reduced price.

Disadvantages

Employees and collaborators who are granted these rights will, as mentioned above, become part of the share capital structure, so you need to be very careful who you want to have as a partner.

Taxation for employees may be another drawback, since, although it is exempt from personal income tax (hereinafter, “IRPF”) up to a limit of 12,000 € per year (if no more than two years pass between the date on which the agreement granting the stock options is made and the time of exercising this right, otherwise, they will also enjoy a 30% reduction in the IRPF quota), they would have to pay tax on the surplus.

It must be understood that the holder of the stock options has shares in a company, which is not a liquid asset as it is not a listed company, and therefore the tax payment will have to be charged against any savings.

Advantages and disadvantages of stock options and phantom shares: Phantom shares

Advantages

Like stock options, they serve to motivate, attract and retain talent in companies. However, they do not allow their holders access to the share capital by becoming partners in the company.

This can be an advantage if you do not want to grant political rights to the holders of stock options.

When it comes to paying tax on phantom shares, i.e. once they have been exercised and cashed in, the employee will have liquid money with which to pay the corresponding taxes.

Disadvantages

As with the advantages, the disadvantage, perhaps from the employee’s point of view, is that phantom shares do not allow the employee to become a shareholder. If what is wanted is to form part of the company with the same rights as the rest of the partners.

At Letslaw we specialise in the incorporation of incentive plans, so if you need lawyers for phantom shares and stock options, our team of commercial lawyers will be able to advise you on everything you need.