THE RISE OF PHANTOM EQUITY: STRUCTURING STARTUP ESOPS WITH LEGAL PRECISION
Introduction: Reimagining equity in the startup world
The startup ecosystem thrives on innovation, not only in products and services but also in the way talent is engaged and rewarded. Equity compensation has long been a cornerstone of startup growth strategies, aligning employee interests with the long-term vision of the company. While traditional Employee Stock Option Plans (ESOPs) have served this purpose, they come with challenges related to dilution, regulatory compliance, and tax implications.
Phantom Equity is a modern, flexible alternative that allows startups to simulate equity participation without the complexities of actual share issuance. In an increasingly globalized and compliance-conscious environment, phantom equity provides a powerful solution for startups seeking to reward performance, preserve ownership, and defer tax burdens.
Phantom Equity: A contractual mirror of ownership
Phantom Equity, also known as Phantom Stock or Shadow Stock, is a contractual arrangement that mimics the benefits of stock ownership without transferring actual shares. Under this arrangement, selected employees are granted a number of phantom units, each notionally linked to the value of a share of the company. These units do not confer legal ownership, voting rights, or dividends. Instead, they promise a future cash payout based on the increase in the company’s valuation over time.
Typically, the payout is tied to liquidity events such as an initial public offering (IPO), a merger, acquisition, or the achievement of predefined financial or operational milestones. The amount paid is equivalent to the notional value of the phantom units, calculated based on the company’s fair market value at the time of the event. This creates a direct financial incentive for employees to contribute toward the company’s growth, without entangling them in ownership or governance matters.
Why should startups prefer phantom equity
Startups are increasingly turning to phantom equity as a strategic tool to navigate the constraints of early-stage growth. The benefits are both financial and operational.
One of the most compelling advantages is the avoidance of equity dilution. Founders and early investors can preserve their ownership stakes by offering notional equity instead of actual shares. This is particularly important during the Seed and Series-A stages, where every percentage point of equity can significantly impact future control and valuation.
From a compliance perspective, phantom equity plans are typically governed by contract law rather than corporate or securities law. In India, this means companies are not bound by the procedural and regulatory framework of the Companies Act, 2013, especially Section 62(1)(b), which governs ESOPs. There’s no need for shareholder approval, no filing of forms with the Registrar of Companies (ROC), and no requirement to maintain a stock options register.
Additionally, phantom equity aligns perfectly with startup cash flow realities. Since the payout is deferred until a liquidity event, it does not burden the company with upfront cash commitments. This makes it particularly attractive for startups that are pre-revenue or bootstrapped.
Another critical advantage is retention of control. As employees do not become shareholders, there’s no need to allocate voting rights, board seats, or share sensitive governance information. This helps founders maintain decision-making autonomy while still rewarding key contributors.
Tax efficiency is another motivator. In India, payouts under phantom equity plans are taxed as salary income only at the time of disbursement, avoiding the complex dual taxation structure of ESOPs, which are taxed at the time of exercise (as perquisite) and again at the time of share sale (as capital gains). This deferral can make phantom equity more palatable for employees and less burdensome for employers.
Legal framework and compliance in India
In India, phantom equity is not specifically regulated under the Companies Act, 2013, or any other dedicated statute. However, it must comply with general contract law principles, labour law, income tax regulations, and accounting standards.
Contractual basis and agreement structure
The phantom equity plan must be formalized through a well-drafted agreement. This agreement should clearly define the number of phantom units awarded, their vesting schedule (which could be time-based, performance-linked, or hybrid), and the events that will trigger a payout. Common triggers include IPOs, mergers, acquisitions, or achievement of certain revenue or profitability targets.
Valuation methodology must also be detailed in the agreement. This typically involves a fair market valuation (FMV) carried out by a Registered Valuer in accordance with the Companies (Registered Valuers and Valuation) Rules, 2017. The agreement should also spell out termination conditions, including whether unvested units will lapse in case of resignation, termination for cause, or death.
Tax implications
From a taxation standpoint, phantom stock payouts are treated as salary income under Section 17(2) of the Income Tax Act, 1961. The employer is obligated to deduct Tax Deducted at Source (TDS) under Section 192 at the applicable income tax slab rate. Since no actual shares are transferred, there is no capital gains tax component.
This is in contrast to jurisdictions like the U.S., where phantom equity must comply with the complex provisions of Section 409A of the Internal Revenue Code. In India, the absence of such a framework makes phantom equity relatively more flexible, though still subject to scrutiny under general tax and labour laws.
Accounting and financial reporting
Under Indian Accounting Standards (IND AS 19 – Employee Benefits), phantom equity is treated as a long-term employee benefit. The associated liability must be recognized in the company’s books as an expense over the vesting period, and adjusted periodically based on changes in fair value. This impacts earnings before interest, taxes, depreciation, and amortisation (EBITDA), net profit, and ultimately valuation, especially during due diligence in funding or M&A scenarios.
Transparency and governance
While not governed by statutory disclosure requirements, good governance demands that companies communicate phantom equity arrangements transparently to both employees and investors. Misunderstanding or miscommunication can lead to legal disputes or disgruntlement among team members. It’s essential to clarify that phantom stock does not equate to real ownership or equity participation in shareholder decisions.
International perspective: Lessons from global markets
Globally, phantom equity has become a standard tool in jurisdictions with mature startup ecosystems. In the United States, phantom stock plans are widely used in family-owned businesses and non-listed companies. However, these are subject to ERISA (Employee Retirement Income Security Act) regulations unless structured to fall under specific exemptions.
In Germany, startups often use “Virtuelle Anteile” or virtual shares, which function similarly to phantom equity and are governed by civil law contracts. In the UK, companies often use stock appreciation rights (SARs) or enterprise management incentives (EMIs), which offer some tax advantages.
While India lacks a specific legislative framework for phantom equity, this flexibility allows companies to craft tailor-made solutions under the Indian Contract Act, 1872. However, as foreign investors increasingly participate in Indian startups, global best practices, particularly those around governance, vesting, and payout triggers are beginning to influence local structuring.
Strategic implementation: Best practices for startups
The successful implementation of a phantom equity plan requires legal clarity, financial prudence, and strategic alignment. Startups should begin by engaging experienced legal and tax professionals to ensure the plan is compliant and enforceable. Ambiguity in terms such as “liquidity event” or “valuation” can lead to future conflicts and must be carefully drafted.
It is also advisable to align phantom equity plans with overall compensation and retention strategy. These plans work best when integrated into a broader framework that includes base salary, performance bonuses, and long-term incentive structures.
Periodic review is essential. As the company scales, the terms of the phantom equity agreement may need revision to reflect new realities such as additional funding rounds, regulatory changes, or updated business priorities.
Finally, internal communication plays a critical role. Employees must be clearly informed about what phantom equity entails and what it does not. Transparency builds trust and aligns expectations, making phantom equity an effective tool for motivation rather than a source of confusion.
Conclusion: Phantom equity as the future of talent retention
Phantom equity is a forward-looking compensation mechanism that addresses the unique challenges of startups in India and across the globe. By decoupling financial upside from actual ownership, it enables companies to reward performance, retain key talent, and preserve strategic control. While the absence of a statutory framework in India allows flexibility, it also places a premium on clear documentation, regulatory awareness, and ethical implementation.
Authored by
Adv. Somesh Pandey
