Phantom equity refers to a form of incentive compensation given to employees that mirrors the value of actual equity ownership in a company, providing them with a share of the company's future value or profits without granting them actual equity ownership. Examples of types of phantom equity include phantom stock and stock appreciation rights (SARs).
The distinguishing feature of phantom equity is that it doesn't involve issuing actual shares or equity interests in the company, but rather represents a contractual promise to pay a bonus or other compensation tied to the equity in the company. For example, if the company's value increases, so does the potential for compensation to phantom equity holders.
One of the main drawbacks with phantom equity for recipients is that, unlike actual equity which may be eligible for capital gains tax treatment upon sale, phantom equity payouts are typically treated as ordinary income for tax purposes. Another drawback for recipients is they lack voting rights and other rights attendant to holding actual equity.
Nevertheless, phantom equity can be a useful compensation tool for startups, as it allows them to reward team members without diluting the ownership of existing stockholders.