Phantom Equity and Cash-Settled Incentives: Alternatives When Issuing Real Shares Isn't Practical

Real equity is the default answer for most Australian startups when the question is how do we align our people with the upside? It is also, sometimes, the wrong answer. There are situations where issuing shares or options is impractical, uneconomic, or actively undesirable — and founders who reach for an ESOP reflexively in those situations can end up with a plan that is expensive to run, disliked by the people it was meant to reward, and difficult to unwind.

Phantom equity and other cash-settled incentives are the standard workaround. They deliver the economic experience of equity — a payout linked to the value of the company — without actually issuing any shares. They are not a panacea, and the tax treatment is materially worse than a well-designed option scheme. But in the right context they are the cleanest and fastest way to share upside. This article explains how they work, when they make sense, and where the traps are.

When Real Equity Is Impractical

Before reaching for a phantom plan, it is worth being honest about why real equity does not work. The common fact patterns are:

• The business is not a company. Trusts, partnerships, and sole traders cannot issue shares or employee options in any conventional sense. Cash-settled plans are one of the few ways to share value in a non-corporate structure.
• The cap table is already fragile. If you have a complex cap table with awkward shareholders, dragged-out SAFE conversions, or a messy history you are planning to clean up before your next raise, adding more shareholders can be the last thing you want.
• Overseas employees. Issuing Australian shares or options to employees in the US, UK, Europe or Asia often triggers local securities, tax and payroll issues that are expensive to solve for a handful of roles. A cash bonus calculated by reference to company value can sidestep most of that complexity.
• Short-horizon staff. Contractors, fractional executives, consultants, and advisors who are unlikely to stay long enough to hit a liquidity event often prefer (and are often easier to pay) via contingent cash.
• Family and founder concerns about control. Some founders are unwilling to issue voting shares or create a wider pool of minority shareholders with statutory rights under the Corporations Act 2001 (Cth) — including rights to inspect books, bring oppression claims, and vote on certain resolutions.
• A near-term exit. If you already know a sale is 12 months away, there may not be time to properly run an ESS, get valuations done, clear ASIC disclosure exemptions, and obtain shareholder approval. A transaction-linked cash bonus can be documented and rolled out in days.

If none of these apply, you should probably be issuing real equity under a proper ESOP. If one or more of them does, read on.

What a Phantom Plan Actually Is

A phantom share plan (sometimes called a “shadow” plan) is, at law, a contractual bonus arrangement. The company promises to pay the participant a cash amount calculated by reference to the value of a notional number of shares. No shares are issued. The participant is not a shareholder, has no voting rights, no access to the share register, and no statutory rights as a member.

There are several variations:

• Phantom shares — the participant is credited with a number of “units”, each of which tracks the value of a real share. On a trigger event, the participant receives the market value of those units in cash.
• Share appreciation rights (SARs) — the same idea, but the payout is only the increase in value from the grant date, not the full value. This is the phantom equivalent of an option: the participant captures upside but not the baseline.
• Transaction bonuses / deal bonuses — a simpler variant, often used close to an exit, where a defined pool of the sale consideration is paid out to nominated employees on completion.
• Phantom dividends — annual cash payments calculated as if the participant held a given number of shares. This is less common in startups, which rarely pay dividends, but occasionally appears in profitable founder-run businesses.

Whatever label you use, the legal mechanics are the same: a written plan document, individual award letters, and a set of rules governing vesting, forfeiture, trigger events, calculation of value, and timing of payment.

Designing the Plan

A workable phantom plan needs to answer at least the following questions up front:

What triggers payment? Common triggers are a sale of the company, an IPO, a capital raise above a defined size, a set date (e.g. five years from grant), or termination of employment. The narrower and more specific the trigger, the lower the risk of dispute.

How is the value calculated? For sale and IPO triggers, value is usually the price per share in the transaction. For time-based or termination triggers, you need a valuation mechanism — typically a board valuation, a formula (e.g. a multiple of revenue), or an independent expert determination. This is where phantom plans go wrong most often; get it wrong and you will end up arguing about methodology years later.

What happens on termination? Good leavers typically retain their vested units until the next trigger event; bad leavers forfeit them. The definitions of “good leaver” and “bad leaver” should track your employment agreements and any restraint provisions.

Are there caps? Many plans cap the total payout, either per participant or in aggregate, to protect the company’s balance sheet if the business performs spectacularly well.

How is the scheme funded? Phantom payouts come out of the company’s cash. If the trigger is an exit, this is typically handled by carving the phantom pool out of the purchase price. If the trigger is a time-based vest or a dividend-style payment, the company needs to have cash on hand when the bill falls due — which can be a real problem for capital-constrained startups.

Tax, Payroll Tax and Superannuation — the Hard Part

This is where phantom plans are materially worse than a properly structured ESOP under Division 83A of the Income Tax Assessment Act 1997 (Cth).

Because no shares or options are issued, a phantom plan does not satisfy the definition of an employee share scheme in s 83A-10. The ESS tax concessions — including the start-up concession that defers taxing points and converts gains to capital — are simply not available. Instead, the payout is treated as a cash bonus: ordinary income in the hands of the participant in the year it is received, taxed at marginal rates, with PAYG withholding obligations on the employer.

The flow-on consequences matter:

• No CGT discount. A well-designed ESOP can let an employee pay CGT on their gain, with the 50% discount available on shares held for more than 12 months. A phantom payout, taxed as ordinary income, cannot access that discount. For a senior employee, the after-tax difference on a large exit payment can be meaningful.
• Payroll tax. Revenue NSW has publicly confirmed that phantom share scheme payments are not “shares or options” under s 18 of the Payroll Tax Act 2007 (NSW). They fall back to being ordinary taxable wages, captured under the general payroll tax rules at the time of payment. Other states take a similar approach.
• Superannuation guarantee. Cash bonuses paid through payroll are ordinary time earnings in most cases, and superannuation guarantee contributions are generally payable on them. ESS payments made in shares or options are not.
• FBT. Cash payments to employees are not fringe benefits and do not attract FBT. That is usually a plus, but it underscores that phantom payments sit in the salary-and-wages system, not the equity system.

For the company, the payment is generally deductible when paid (subject to the usual rules), which offers some small consolation.

Where Phantom Plans Work Well — and Where They Don’t

Phantom plans shine in a handful of specific scenarios:

• Pre-exit retention and transaction bonuses. When a sale is within sight, phantom plans are the fastest way to stand up a meaningful retention tool without touching the cap table. Buyers are often comfortable with them because the obligation is contractual and can be taken into account in the purchase price.
• Overseas or contractor participants. Where the cost of issuing compliant equity in a foreign jurisdiction is disproportionate to the size of the award, a cash-settled plan is usually simpler and cheaper.
• Non-company structures. Trusts, partnerships, and joint ventures cannot issue equity; phantom plans are one of the few incentive tools available.
• Targeted executive long-term incentives. At senior levels, a phantom plan can be a clean supplement to a short-term bonus and a separate ESOP, particularly where existing dilution is already tight.

They are a poor fit for:

• Broad-based employee incentives in a company that could otherwise use the ESS start-up concession. The tax difference is simply too large to justify.
• Long-dated, time-vested grants in cash-constrained businesses. The company may not have the cash when the bill comes due, and the participant may not receive any payout at all if the business fails.
• Situations where the participant is expected to think and behave like an owner. Phantom equity does not make you an owner; most participants know it, and it often does not produce the same psychological buy-in as real shares.

Documentation and Governance

A phantom plan should be documented in a proper written plan — ideally approved by the board and, where relevant, the shareholders. Each participant should receive an award letter that records the number of units, the vesting schedule, the trigger events, the leaver provisions, and the calculation mechanism. The company’s employment agreements should cross-reference the plan and confirm that the phantom award is in addition to, not in lieu of, other remuneration components.

Accounting treatment also needs to be thought about. Under Australian accounting standards, cash-settled share-based payment arrangements are measured at fair value at each reporting date, with changes in value recognised in profit or loss. This can introduce volatility into the P&L that founders are not expecting. Speak to your accountant before rolling out anything significant.

Getting It Right

Phantom equity is a useful tool when used deliberately and documented properly. It is a poor substitute for a real ESOP when a real ESOP is available. Most Australian startups should start with the ESS start-up concession if they qualify, and reach for a phantom plan only when there is a specific reason not to — not as a way to avoid the effort of doing equity properly.

If you are considering a phantom share plan, a transaction bonus, or any other cash-settled incentive arrangement, or you want a second opinion on whether an ESS would serve you better, get in touch.