What are the differences between ESOP, RSU, and Phantom Stocks?
- Employee Stock Ownership (ESOW) comes in a variety of forms, including Employee Stock Option Plan (ESOP), Restricted Stock Units (RSU) and to a certain extent, Phantom Shares.
- ESOP grants employees the option to buy shares of the company.
- RSU grants shares to employees directly with restrictions.
- Phantom shares award financial benefits equivalent to the value of shares, this is closer to a contractual benefit than equity.
- Gains from ESOP are taxed when the employee exercises their stock options and the selling restrictions are lifted. Gains from RSU are taxed once the restriction is lifted. Phantom Shares are taxed when employees receive the cash benefit.
- Recipients of Phantom Shares may face a higher tax burden compared to ESOP and RSU holders in Singapore.
Employee Stock Ownership (ESOW)
An employee stock ownership (ESOW) plan allows workers to own a portion of the company they work for. This is typically offered as part of the compensation package to attract talent and incentivise good performance.
There are many benefits to employee ownership, check out 5 Reasons Why Your Company Should Adopt ESOP or 4 ways ESOP helps founders build and retain a high-performing team to find out more!
Overall, ESOW serves as a general term for employee ownership plans which may include ESOP and RSU.
Employee Stock Option Plan (ESOP)
An employee stock option plan (ESOP), sometimes known as employee stock option scheme (ESOS), is a form of ESOW. ESOP holders are issued stock options. This means that they have the option to buy shares of the company at a future date for a predetermined price - known as the exercise price.
Typically, there is a vesting period or requirement for stock options. Once stock options are vested, the ESOP holder may choose to buy company shares at the exercise price during an exercise period. The exercise price is the amount that ESOP holders will pay to exchange vested stock options for company shares.
ESOP can lead to big financial gains for employees if the value of the company stock rises. During a liquidity event, such as a fundraising round or an exit, employees may be given the opportunity to cash out their shares by selling them. This is the selling price, which is usually the price of the company shares during that liquidity event.
For a quick look at ESOP, check out our simple guide here: A 5-minute guide to ESOP and why they matter.
Restricted Stock Units (RSU)
Restricted Stock Units (RSU) are company shares granted directly to employees with restrictions. RSU plans will typically have vesting periods as well, granting shares to employees over a period of time or when certain milestones are met. RSU plans do not have an exercise price since the employees are granted shares directly.
Phantom Shares are a contractual agreement between the company and recipients that bestows employees the right to cash equivalent to the value of a set amount of stocks.
This promises a financial reward to employees that is tied to the value of company shares without granting them actual ownership over company shares. As such, phantom shares function closer to a contractual benefit than equity.
Similar to RSU and ESOP, Phantom Shares are frequently tied to vesting schedules or KPI requirements.
What’s the difference?
You may be wondering what’s the point behind all these plans? In essence, they all aim to grant employees a form of financial benefit. Here’s why you might choose one over another.
Gains from RSU, ESOP, and Phantom Shares are all considered as part of the employee’s income and taxed as such, subject to prevailing income tax rates. The difference is when the employee is taxed.
For RSU plans, the company shares are transferred directly to the employee upon granting. Employees are subject to taxation when the selling restriction on shares is lifted. The full value of RSU shares is taxable.
On the other hand, ESOP is taxed when the employee chooses to exercise their stock options, paying the exercise price and assuming ownership of the shares. Employees are taxed based on the Open Market Value of the shares on the date they exercise their stock options, or, if there are selling restrictions, on the date that the restrictions are lifted.
In the case of Phantom Shares, the cash awarded to the employee is subject to taxation once it is paid. However, because Phantom Shares are a cash award instead of actual company shares, employees may face a higher tax burden on their financial gains when compared to RSU and ESOP.
Take for example: If my income tax rate is 10% and I receive $100 worth of phantom shares, ESOP (or RSU) each, I will pay $10 in taxes for the RSU and the ESOP I received.
In the case of ESOP/RSU, I have the option of holding my shares and selling them at a later date once the value has appreciated. If I sell my shares gained from ESOP or RSU at $1,000, I will not have to pay additional taxes in Singapore due to the lack of a capital gains tax.
However, with Phantom Shares, since I pay taxes when I receive the financial benefit, I will need to pay 10% of the appreciated value ($100 instead of $10).
Thus, the tax burden can potentially be higher for phantom shares:
Tax on Phantom Shares: 10% x $1,000 = $100
Tax on ESOP/RSU: 10% x $100 = $10
With RSU, granting shares directly to employees may come with administrative issues. Shareholder voting agreements may become more complicated and crucially, the process of taking back unvested shares becomes very difficult.
If an employee leaves the company early, withdrawing unvested shares requires the recipient to sign an agreement and approve the transfer of unvested shares back to the company. If founders are faced with a bad leaver, this could lead to a state of limbo for the shares.
Such a scenario is avoidable with ESOP as shares are only granted once the employee exercises them. ESOP nowadays are also usually presented with standardised terms and conditions, reducing the administrative and legal hassle.
As a contractual right, Phantom Shares function more like an agreement than equity, promising financial benefit to the phantom shareholders as if they held actual shares.
As a word of caution, if you would like to use Phantom Shares as a way to reward employees, we recommend consulting an experienced lawyer. The document on Phantom Shares will need to be carefully drafted to protect the interests of the company and shareholders.
Given the tradeoffs between Phantom Shares, RSU, and ESOP, we would recommend ESOP as it avoids many of the pitfalls of the other two, including a lower tax burden and administrative ease.
If you would like to find out what form of employee stock option plan is right for your business, do contact us! Reach out to us at firstname.lastname@example.org.
Disclaimer: All contents in the article are based on our own opinions and interpretations, and the reader agrees to discharge us of any liabilities for any error or omissions. Article is not meant to be legal or tax advice, but for informational purpose only.