Saturday, August 1, 2020

Phantom Stock or Share Appreciation Rights (SAR)

"Phantom Stock" or "Share Appreciation Rights (SAR)" is a contractual agreement between a company and the recipient of such rights that gives the recipient the right to a payment, the amount of which is linked to the market value of such company's share valuation at a predefined later date or event. 

The recipients for phantom stock or SAR could be advisors to the Founder, Board of Directors or other important consultants or third party vendors, whose advise may be valuable for the growth of the business.

It is a way to incentivize such persons by linking their compensation or fees to the valuation of the company without actually giving them any share in the ownership of the company.

In terms of the event on which such payment may become due or may be valued, the grants can be tied to negotiated vesting schedules and the payout being tied to a change of control or liquidity event such as an IPO or acquisition.

The benefits of such a compensation or fee structure could be in the form of liquidity management, flexibility of liability and optimized taxation for the grantee. Such a structure also aligns the grantee's motives with those of the owners.

On the payment becoming due or on vesting of such option, tax may become payable and TDS liability may arise u/s 194J or 194C depending on the terms of agreement even if the amount is not actually paid in cash.

For accounting purposes, such stock may be treated in the same way as deferred cash compensation. An entry may be made for the amount accrued till the end of a financial year, which may be adjusted in the subsequent period with the change in valuation.

However, liability under GST based on time of supply, as well as those under TDS provisions on the company and taxability in the hands of the grantee would all depend on the terms of vesting and payment of such phantom stock or SAR.

Important Factors for Designing a Phantom Stock or SAR Compensation Structure

1. Deliverables of Advisor - number of meetings or hours of consulting required in a week or month or in the year.

2. Compensation Credits - a fixed number of credits can be agreed on for each meeting or based on association over time, i.e. credits for each week/month/year of association in advisory capacity.

3. Credit Conversion Ratio - such number of credits may be converted to a value equivalent to X equity shares on a specific event in the future.

4. Specific Event - the specific event when such value of credits will be computed or be due for payment may be an acquisition or next round of funding or an exit - each characteristic of such event may be defined and made part of the agreement.

5. GST and Tax Implication - the tax liability would arise only on the happening of such event when the amount vests or becomes due for payment or is recognized as a liability in the books of accounts. It may be taxed under the head salaries as a perquisite (if given to employees) or income from business & profession (if offered to independent advisors) and even as capital gains depending on the terms of such agreement.

6. Payout - if the payout is in cash, the transaction is fairly simple. If the payout is in the form of stock or shares in the company, then further the terms as applicable under the Companies Act for ESOPs and Sweat Equity Shares may apply, requiring filing with the ROC among other regulatory compliance.

7. Transferability - restrictions may be placed on transferability or tradability of such rights.

8. Clawback - instances may be defined where the company may rescind these rights and nothing may become payable, i.e. in case the person goes to work for a competitor or is absenting for a fixed period 

9. Approvals from Board, Shareholders, ROC - depending on the terms of agreement in light with any restrictions if specifically placed on this in the Articles of Association, such a contract may require approval of the Board or Shareholders, as the case may be, especially so if these advisors are added in any way to the Board of the company.

10. Intellectual Property Rights - it may be clearly specified that work done on the advise of the advisors may not lead them to have any IP rights over the product of the company.

11. Confidentiality & Other Terms - other terms as normally drafted with respect to confidentiality, non-compete, etc. may be as per general legal and commercial prudence.