Practicing Phantom Stock Options in Turkey

Oguz Erkan, LL.M.

What is a phantom stock option? What are their advantages and disadvantages? Are phantom stock options applicable in Turkey? Why to use phantom stock options?

1. What Is a Phantom Stock Option?


A phantom stock option is a bonus method used to motivate employees and increase their loyalty to the company, just like regular employee stock option plans. Phantom stock options are based on a contract between the employer and the participant in the phantom stock plan. This agreement gives the participant the right to receive cash payments at specific times or under specific conditions based on the market value of the company's equivalent shares.


The main difference between phantom stock options and regular stock option plans is that participants in phantom stock options do not directly own shares that represent ownership in the company. Instead, they have the right to receive the increased value of these shares in cash.


For example, if an individual gains the right to participate in a phantom stock option plan on a certain date with each share valued at $20, and on another date they earn these phantom shares, and the value of the shares on that date is $40, the individual will receive $10,000 in cash.


If this were a regular employee stock option plan, the individual would first pay the market price for the shares on the participation date and then have the option to keep the shares or sell them at market conditions to receive the price difference in cash.


2. Types of Phantom Stock Option Plans


Phantom stock option plans are divided into two main types: participation in value appreciation and full participation.


As mentioned earlier, in value growth participation plans, the participant gains the right to receive a cash payment equal to the growth in value between the participation date and the earning date.


In full participation plans, participants gain the right to receive the full market value of the promised shares in cash at the earning date. Using the previous example, in a full participation plan, a participant would receive $20,000 in cash for 500 shares worth $40 each at the earning date.


In all types of phantom stock option plans, participants do not acquire ownership rights for the shares. They only have the right to receive cash based on the market value of the shares.


3. How Do Phantom Stock Option Plans Work?


Phantom stock option plans are less complex than employee stock option plans because they do not involve the actual transfer of real shares. Instead, they create a financial bonus program based on a virtual representation of the company's shares. The general process of phantom stock option plans includes the following steps:


a. The company establishes a pool of phantom stock options tied to the value of real shares.

b. Then, the company creates an earning program that specifies how much an employee must work or achieve a triggering event to earn the value growth between the participation date and earning date.

c. When the triggering event occurs, the company pays the employees a bonus amount equal to the value of the phantom shares based on the performance of the company's stock price.


If the company's stock price increases during the vesting period, the value of the phantom shares also increases, resulting in a larger cash bonus for the employees. If the stock price decreases, the value of the phantom shares decreases, resulting in a smaller bonus.


4. Advantages of Phantom Stock Options


Phantom stock options are used quite frequently, especially by larger companies, due to their unique advantages. Some of these advantages include:


Boosting Employee Performance and Motivation: Phantom stock options tie employees more closely to the company's performance. When employees contribute to the increase in the company's stock value, they have the potential to increase their financial interests, motivating them to work with more enthusiasm and dedication.


Improving the Company's Hiring and Retention Abilities: Phantom stock options can be an effective tool for attracting talented employees and retaining existing ones in the long term. Employees may prefer companies that offer such incentives.


Enhancing Capital Structure: Phantom stock options can help improve a company's capital structure. By offering shadow stock options instead of actual shares, a company can preserve its existing capital and prevent new shareholders from joining.


Tax Advantages: In some countries, phantom stock options can offer tax advantages compared to other forms of compensation. The taxation of such rewards for employees is generally at lower rates.


Fostering Collaboration: Phantom stock options can encourage employees to feel like company partners, promoting more cooperation and helping the company achieve its common goals.


However, it's essential to remember that designing and using phantom stock options can be complex financial market instruments, and their advantages, as well as potential disadvantages, should be carefully evaluated in each company's unique situation.


5. Disadvantages of Phantom Stock Option Plans


The potential disadvantages of phantom stock option plans are as follows. It's important to note that not every company or participant will be affected by each advantage or disadvantage, as they depend on individual circumstances.


Reducing the Company's Cash Reserves: Regardless of the company's financial situation, it must have the means to make cash benefits for employees when they are due. Unlike real shares, phantom stock options only benefit employees through cash payments, and if these payments cannot be made, employees have the right to take legal action against the company.


Payment for Third-Party Stock Valuation: When establishing phantom stock option plans, each option's valuation must be performed. These instruments are ultimately capital market tools, so a fair valuation must be conducted. To prove that the valuation is fair, third-party valuation firms should perform valuations, and all costs are usually covered by the company.


Capital Gains Tax Does Not Apply to Phantom Stocks: Since phantom stocks are not real shares, employees miss out on some benefits of actual stocks. Real shares undergo capital gains taxation, meaning tax on profits from selling shares is due. However, phantom stocks are not real and only benefit employees financially, so they are taxed as regular income, with employees being responsible for the tax.


The disadvantage here is that capital gains are usually subject to lower tax rates than regular income. Therefore, while the company saves on capital gains tax, employees have to pay tax on the additional benefit, which could make them reconsider the arrangement's value.


6. Taxation of Phantom Stock Option Plans


In general, phantom stock options are not subject to capital gains taxation. The primary reason is that the participants in the option plan never actually own shares of stock. In essence, participants receive an amount based on the value of the shares or the increase in value in cash when a specific event occurs. As a result, this amount is treated as compensation and subject to ordinary income tax, which is usually at higher rates than capital gains tax.


7. Phantom Stock Option Plans in Turkey


In Turkey, phantom stock option plans are generally used in place of traditional employee stock option plans for two main reasons:


Firstly, convertible capital market instruments are not regulated in Turkey. Parties can make agreements in a way that, when a specific event occurs, the participant will receive shares in return for their existing capital market instruments. However, in this case, the participant does not directly convert their instruments into shares but rather, the other party fulfills its obligation by delivering the shares. This agreement creates rights and obligations solely for the parties, without having any value in terms of corporate law.


Another reason for the preference for phantom stock options in Turkey is that most companies are privately held family businesses. Therefore, family members who control the company do not want to reduce their control over the company by selling shares.


Please keep in mind that the advantages and disadvantages must be evaluated considering the unique circumstances of each company.

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