Phantom equity pays a cash amount that mirrors what a real equity grant of the same size would be worth, without granting shares or diluting the cap table. It is taxed as ordinary income when it pays out, unlike real equity structured under the ESS rules.
A bonus that behaves like equity, without being equity
A phantom equity plan assigns the recipient a notional number of units. Each unit tracks the value of a real share, and on a trigger event, usually a sale of the company or an agreed liquidity date, the company pays out the cash value of those units. No shares change hands at any point.
Because nothing is transferred, phantom equity sits outside the ATO employee share scheme rules that govern real shares and options.[1] It is instead taxed as ordinary income at the time it is paid, with PAYG withholding applied like a bonus, which is simpler to administer but removes the capital gains treatment that makes a start-up-concession ESOP grant attractive.
Where it genuinely beats a real option grant
For a founder who does not want to touch the cap table, or who is close to a raise and does not want a new option pool complicating the round, phantom equity is a clean way to still give a senior hire genuine upside tied to company performance. It also avoids ESS compliance overhead entirely, since it is structured as deferred compensation rather than equity.
What a candidate gives up by taking it
The trade-off runs the other way for the recipient. No cap table entry means no capital gains treatment, no start-up concession, and no claim if the company sells the underlying business rather than a liquidity event the plan actually covers. A candidate comparing a phantom equity offer against a real ESOP grant of similar headline value should ask what happens on every exit scenario, not just the one the company is planning for.
I set out how to price any equity or equity-like grant as a range of dollar outcomes before comparing it against cash.
Common questions
What is phantom equity?
A plan that pays a cash bonus tracking the value of a real share, without transferring any actual shares. No dilution, no cap table entry, and no ESS tax treatment; it is taxed as ordinary income when it pays out.
How is phantom equity different from stock appreciation rights?
They are close cousins. Stock appreciation rights (SARs) typically pay out the growth in value from grant to payout; phantom equity plans more often mirror the full value of the notional share. Both avoid transferring real ownership.
Is phantom equity taxed the same way as an ESOP?
No. Because no shares or options change hands, phantom equity sits outside the employee share scheme rules and is instead taxed as ordinary income, with PAYG withholding, at the time it pays out.
Should a candidate accept phantom equity instead of real options?
It depends what the company is offering it in place of, and what exit scenarios the plan actually covers. It can be a fair trade for a founder unwilling to dilute, but a candidate should confirm what happens under every plausible exit, not just the one the plan was written for.
References
- The ATO's ESS rules apply to grants of actual shares, options or rights; a phantom equity plan that pays cash only sits outside that framework, per the general ESS basics guidance.
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