The Emergence of Phantom Stock Options (PSO) for Start-ups in India- An Alternative to Employee Stock Option Plans.

1. IndoAsia Partners
Investment Banking: Finance & Regulatory Compliances.
India & Indonesia, Representatives in UAE, Europe & Singapore
Sanjay H. Indulkar
91 9867161367
indoasiapartner@asia.com
Disclaimer: The information contained in this note is for dissemination of information purposes only
and shall not be relied upon as any opinion or advice, in any way.
The Emergence of Phantom Stock Options (PSO) for Start-ups
in India- An Alternative to Employee Stock Option Plans.
A Phantom Stock Option (“PSO”) is a performance-based incentive plan which
entitles an employee the right to receive cash payments after a specific period of time
or upon fulfilment of specific criteria and is directly linked to the valuation and the
appreciated value of the share price of the company. PSO or shadow stocks are
nothing else but performance-based incentive plan by way of compensation which
entitles the employee to be rewarded subject to the fulfilment of certain terms and
conditions which are linked to employment.
Regulatory: The Companies Act, 2013 has prescribed rules for issuance of shares
under ESOP which involves creation of an ESOP plan, setting up of internal
committees, passing of appropriate board resolutions and other necessary compliance
related work with the registrar of companies. From an administrative point of view
an ESOP plan is not feasible. On the other hand there is no compliance related work
with regard to the issuance of PSO.
Start-up perspective: PSO enables companies to share a portion of their profits with
the employees and not part with any stake of the company. Typically in the case of an
ESOP plan a part of the founders shares are allocated for the employees since the
creation of the ESOP is not dilutive as far as the investors are concerned, assuming
that the start-up is funded. Since there is no shareholder dilution no shares are issued,
the founders are able to maintain their shareholding in the company.
Employee perspective: Since there is no concept of a share or a stock involved in a
PSO the employee is not entitled to any voting right in the company but is only
entitled to receiving a cash component equivalent to the share price.
Taxation perspective; cash received by the employee is treated as a perquisite and is
therefore taxable in the hands of the employee. Further there is a TDS implication.
Despite the advantages of a PSO, the concept has not yet taken off in India. Till
such time that specific provisions are introduced under the Companies Act, 2013 to
bring PSO within its purview, companies will have the flexibility of formulating
schemes for the grant and exercise of the PSO.

2. Applicability of SEBI Regulations to Phantom Stock Schemes
SEBI recently issued two informal guidance’s in response to queries raised by
Mindtree Limited and Saregama India Limited. The queries raised by the two
companies were in relation to employee benefit schemes called the “Phantom Stock
Scheme” granted to their employees. Mindtree granted Stock Appreciation Right
(“SAR”) units to 6 employees who are also promoters of the company, while
Saregama granted certain SAR units to its managing director. As per the scheme,
notional SAR units were issued at a pre-determined grant price and the
promoters/MD were entitled to receive cash payment for appreciation in the share
price over the grant price for the awarded units, based on the company achieving the
specified revenue targets. The scheme, however, did not involve any actual purchase
or sale of shares of the company. The issue involved here was whether the Phantom
Stock Scheme fell within the purview of the SEBI (Share Based Employee Benefits)
Regulations, 2014 (“SBEB Regulations”) and whether issuance of SAR units to
promoters of the company, who were also employees is fully compliant with the
SBEB Regulations. Saregama, in addition to queries raised by Mindtree, also raised a
query as to whether such phantom options could be granted to its managing
director.
SEBI in its response stated that the provisions of the SEBI (Share Based Employee
Benefits) Regulations applied to a scheme involving dealing in or subscribing to or
purchasing securities of the company, directly or indirectly. Since the Phantom Stock
Scheme did not involve any actual purchase or sale of equity shares of the company,
SEBI held that the SEBI (Share Based Employee Benefits) Regulations “may not
apply to the instant Phantom Stock Scheme”. Since the Phantom Stock Scheme did
not fall within the purview of the SEBI (Share Based Employee Benefits) Regulations
the other queries posed by them as to whether the same could be granted to
promoters or the managing director became irrelevant and SEBI did not answer
them.
It has to be noted that while Regulation 1(3)(iii) of the SEBI (Share Based Employee
Benefits) Regulations provides that it applies to stock appreciation rights schemes, in
light of the response given by SEBI in these two cases, the SEBI (Share Based
Employee Benefits) Regulations shall not apply to those stock appreciation rights
schemes that do not involve dealing in or subscribing to or purchasing securities of
the company, directly or indirectly.