Phantom Stock: a flexible employee incentive tool still rarely used in France
Column by partner Lionel Lesur and associate Laura Isabelle Danet, from our Corporate-M&A department, published in Option Droit & Affaires n° 529 March 10th, 2021. (Unofficial translation)
An original alternative to “standard” types of long-term employee incentives, phantom stock is still seldom used in France. However, highly flexible in nature, it is an effective way to motivate and reward employee performance without diluting equity and their use should therefore be enhanced.
Born out of a primarily financial approach to HR management, long-term incentive (“LTI”) instruments existing under French law (stock options, free shares, warrants, etc.) are designed to both boost company value and incentivize performance from key personnel in order to reduce any risk of them leaving the company.
In return, LTI plan participants usually receive immediate or deferred equity ownership, which serves to cement or increase commitment and thus, align the interests of all parties involved.
Upon becoming minority shareholders, participants engage in a supposedly virtuous circle of increased productivity and pro-shareholder attitude, driving value creation and profitability.
As new shareholders, participants will automatically dilute the equity of existing shareholders. The resulting cost-benefit analysis (equity dilution vs. shareholder value accretion and enduring employee retention) may lead some shareholders, however mature the company may be, to oppose the adoption of “standard” LTI plans in order to protect their own shareholding.
A deceptive name for an original alternative
However, unlike “standard” LTI tools, phantom stock does not confer equity ownership.
While it mirrors the benefits of equity ownership in providing employees with (additional) compensation that reflects any increase in the issuer’s value (or in its financial performance, depending on chosen aggregate(s) or multiples), its main distinctive feature is that it may not result in the issuance of any actual shares. Therefore, holders of phantom stock, which is non-transferable in nature, do not have any voting or dividend entitlement .
Phantom stock plans originated and are still widely used in North America and the UK. That is because they offer a smart alternative to equity awards, such as stock options and free shares, where capital is not available or where the applicable tax or social relief is limited (as is the case in France).
Phantom stock plans are also used in Europe (especially in Northern and Eastern Europe) by SMEs as well as international corporations looking to offer a single LTI plan to all proposed participants, across the various countries where they operate.
An unusual tool aligning the interests of all parties involved
Like “standard” LTIs, phantom stock plans are used by companies and corporations to retain or attract key or high-potential talent while eliminating the resulting risk of equity dilution or sharing of confidential information, which is often a major concern for family-owned groups.
This specificity is among the main reasons why a company may prefer phantom stock plans. These plans are also an effective HR communication tool and do not, in theory, require any financial investment on the part of the participants, unless the company prefers to set up a co-investment plan.
Despite these undeniable upsides, phantom stock plans seem to face two hurdles that may explain why they are not largely used in France.
First, their tax and social security treatment may seem dismissive at first glance. In 2013, the Paris Court of Appeal  ruled that, just like bonuses, payments made under phantom stock plans should be considered, “by definition, as additional compensation” and should, therefore, be subject to payroll taxes assessed on the employer, for which, however, these payments constitute deductible expenses, and on the participants (who, in practice, may include corporate officers, with a few caveats).
Second, just like “standard” LTI plans, phantom stock plans raise the question of what metrics to use to determine the value of the company, to which the value of the phantom stock and the amount of any resulting payments will be linked. While listed companies usually use their stock’s trading price, the answer is less straightforward for privately-owned companies, whose phantom stock may require using a complex valuation method. In that case, the issuer’s legal counsel will be instrumental in coordinating the necessary efforts of compensation and valuation advisors and the action of the relevant company’s decision makers and governing bodies, in order to facilitate the design and implementation of the plan.
Although, at first glance, phantom stock plans may seem to give participants a lower net yield than “standard” forms of LTIs, a closer assessment of all their perks and benefits (including retirement benefit rights) may prove otherwise.
Moreover, because phantom stock does not confer equity ownership, participants do not face any liquidity risk. Finally, phantom stock plans differ from other LTIs in that neither the participants nor the company are exposed to any additional tax or social security liability resulting from the French authorities recharacterizing payments made under the plan.
In practice, companies make the always difficult choice between the various LTI instruments by comparing their ease-of-use and flexibility (which is especially true for international corporations), the identity and tax residency status of participants, the applicable tax and social security treatment and related exposure, as well as the value they create.
A highly flexible tool
Despite these sometimes merely theoretical obstacles, phantom stock has great practical value. A company or, even more so, an international corporation with participants who are tax residents in different countries may find it best to offer a phantom stock plan, despite its apparent lower yield potential, because it better protects the integrity of its share capital and, above all, offers more flexibility.
In France, phantom stock is not subject to any specific statutory or regulatory provisions. The concept is simply mentioned in a law that does not recognize phantom stock, but allows companies to use plans relying on a similar principle .
It is entirely up to the company to design and tailor its compensation plan based on carefully considered factors like the number of underlying shares, the appropriate valuation metric (the amount of the payout may be tied to the company’s EBIT or EBITDA and/or profitability), maturity date, valuation milestones triggering payouts, accelerated vesting upon separation from service or other triggering events (e.g., change in control or IPO), or maximum payout caps to protect the company in the event of an exponential rise in value.
What makes phantom stock particularly attractive is its versatility and adaptability (especially in time, under certain conditions). A phantom stock plan merely requires a bespoke agreement that is personal to the participant and is therefore governed by the “freedom of contract” principle.
Without any structural impediments to its expansion in France, phantom stock is bound to gain ground beyond listed companies, which, these past few years, have been increasingly using phantom stock, described as a “multi-year variable” in the French code of corporate governance for listed companies (the AFEP-MEDEF code).
The crisis hitting today’s increasingly global economy should compel companies and corporations, ever reluctant to part from a fraction of their share capital, to boost their value by using this flexible tool to increase key employee engagement and enable them to finally unleash their untapped potential.
 “Les actions fantômes” (“Phantom stock”), Revue de Droit Bancaire et Financier magazine, issue No. 3, May 2017, study No. 10, Ph. Thomas.
 Paris Court of Appeal, December 12, 2013, No. 11/12986.
 Law no. 2006-1770 of December 30, 2006.