Introduction
Start-ups often face a practical dilemma. They need professional services, marketing support, brand-building activities or strategic assistance, but may not have sufficient cash resources to pay substantial fees.
One structure sometimes considered in such situations is phantom shares or other equity-value-linked contractual arrangements.
At first glance, this can appear to be an attractive proposition for both parties. The service provider gets an opportunity to participate in the future value creation of the business, while the start-up conserves its immediate cash.
However, the commercial attractiveness of such an arrangement depends substantially on how the phantom share entitlement is structured, when it becomes payable and, most importantly, whether there is a realistic mechanism through which the service provider can actually realise the value.
A recent agreement I reviewed brought this issue into sharp focus.
A ₹50 Lakh Consideration — But No Immediate Cash
The agreement was a Brand Partnership Agreement under which an influencer was required to create content for the Company's products and publish the content through her YouTube, Facebook and Instagram channels.
The agreed value of the influencer's one-year engagement was approximately ₹50,00,000.
However, instead of paying this amount in cash, the Company proposed to provide the entire consideration in the form of phantom shares.
At first sight, this may appear to be an equity-linked incentive arrangement.
But the critical question was not the grant of phantom shares.
The critical question was:
When would the influencer actually receive the economic value represented by those phantom shares?
What Are Phantom Shares?
Phantom shares are generally not actual shares in the share capital of a company.
They are typically structured as contractual rights linked to the value of hypothetical or notional shares, with settlement generally taking place in cash based on an agreed formula or valuation mechanism.
Accordingly, a holder of phantom shares does not ordinarily become a shareholder merely because such phantom shares have been granted.
This distinction is important.
An actual issue of equity shares and a contractual right to receive an amount linked to the value of hypothetical shares are fundamentally different arrangements.
SEBI materials have also discussed phantom stock arrangements as cash-settled rights that do not confer shareholder status on the recipient.
Therefore, the drafting of the underlying contract becomes particularly important.
The Problem Was the “Liquidity Event”
In the arrangement under review, the phantom shares had a defined valuation and a vesting schedule linked to the services performed by the influencer.
However, vesting alone did not result in payment.
The phantom shares could be realised only upon the occurrence of a specified Liquidity Event.
The definition of Liquidity Event was particularly restrictive. It contemplated events such as an IPO or strategic sale, together with the Company achieving a specified valuation threshold.
For example, if the Company were required to achieve a valuation of ₹500 crore and thereafter undertake an IPO or strategic sale, only then would the influencer become entitled to realise the value of her vested phantom shares.
The agreement did not provide a meaningful alternative settlement mechanism if such an event did not occur.
This creates a significant commercial concern.
What If the Liquidity Event Never Happens?
Consider the following possibilities:
Scenario 1: The Company continues to operate for several years but never undertakes an IPO.
Scenario 2: The Company remains privately held and never has a strategic sale.
Scenario 3: The Company undertakes a strategic transaction, but the valuation threshold specified in the agreement is not achieved.
Scenario 4: The Company grows substantially, but the particular event contemplated in the agreement never occurs.
In each of these situations, the influencer may have:
completed the agreed services;
created and published the required content;
incurred production and other business costs;
forgone an opportunity to receive conventional cash fees; and
waited for the value of the phantom shares to become realisable.
Yet, depending upon the precise drafting, she could potentially receive no cash realisation at all.
This is where the distinction between “consideration agreed” and “consideration actually realisable” becomes extremely important.
Is Phantom Share Consideration Legally Possible?
The absence of a specific definition of “phantom shares” in the Companies Act, 2013 does not, by itself, mean that every phantom share arrangement is prohibited.
The more appropriate approach is to examine the actual legal substance of the arrangement.
Where no actual shares are being issued and the arrangement merely creates a contractual entitlement to receive a cash amount determined by reference to the value of the Company's shares, the arrangement is materially different from an issue of equity shares or an ESOP.
This also means that it should not automatically be treated as an ESOP merely because the agreement uses terminology such as “shares”, “vesting” or “exercise”.
The statutory framework for employee stock options operates separately. Section 62(1)(b) of the Companies Act, 2013 deals with issue of further shares to employees under an employee stock option scheme, subject to the applicable conditions.
Phantom arrangements, where there is no actual issue of shares and the entitlement is cash-settled, therefore require careful contractual and accounting consideration rather than simply being labelled as an ESOP.
Ind AS 102 also specifically addresses cash-settled share-based payment arrangements and examples involving phantom shares, reinforcing the distinction between the economic arrangement and actual equity ownership.
The Commercial Risk: 100% of the Consideration Becomes an investment
This is, in my view, the more important issue.
If a service provider agrees to accept ₹50 lakh as consideration, but the entire amount is converted into a contingent phantom share entitlement, the service provider is effectively giving up a conventional cash receivable in exchange for a future, uncertain economic benefit.
The risk therefore shifts significantly towards the service provider.
This is particularly relevant where the service provider is not an employee, does not receive actual shares and has no independent shareholder rights.
The service provider may have effectively provided services today in exchange for a future economic benefit whose timing and value are uncertain.
That may be commercially acceptable if both parties consciously agree to such risk.
But the contract should make that risk transparent.
What Could Be a More Balanced Structure?
There is no single structure that will be appropriate for every transaction.
However, where phantom shares constitute the entire consideration for services, the agreement should, in my view, consider whether there should be an additional or alternative settlement mechanism.
Depending upon the commercial understanding between the parties, possible mechanisms could include:
1. Fixed Settlement Date
The agreement could provide for settlement after a defined period, such as two or three years, irrespective of whether an IPO or strategic sale has occurred.
2. Company Settlement / Buy-Out Mechanism
The Company could have an obligation to settle vested phantom shares after a specified period based on an agreed valuation methodology.
3. Termination Settlement
If the service agreement terminates after the service provider has completed specified milestones, the agreement could provide for settlement of vested or proportionately earned phantom shares.
4. Independent Valuation Mechanism
Instead of making payment dependent upon a particular liquidity event, the agreement could provide for valuation by an independent valuer or through a predetermined formula at the relevant settlement date.
5. Combination of Cash and Phantom Shares
Perhaps the simplest commercial solution in some cases may be to provide a minimum cash component sufficient to cover the service provider's costs, with the balance being linked to the future growth of the Company.
This would allow both parties to participate in the upside without transferring the entire economic risk to the service provider.
Vesting Alone Is Not Enough
Another important drafting point is the distinction between vesting and settlement.
A phantom share may vest because the service provider has completed the required services.
But if the agreement does not specify when and how the vested phantom shares will be settled, vesting may provide little practical economic benefit.
Therefore, while reviewing such agreements, it is important to examine at least three separate questions:
1. Grant: What exactly has been granted?
2. Vesting: When does the service provider earn the entitlement?
3. Settlement: When and how can the service provider actually realise the economic value?
The third question is often overlooked.
The Bigger Contract-Drafting Lesson
The use of innovative consideration structures is not necessarily problematic.
Start-ups may legitimately use equity-linked or value-linked incentives to conserve cash and align service providers with the Company's future growth.
The problem arises when the commercial risk associated with the structure is substantially greater than what the service provider may have understood when agreeing to the consideration.
If ₹50 lakh is described or understood as the value of a year's services, but the service provider can receive that value only if a highly uncertain event occurs several years later, the parties should carefully consider whether the arrangement is commercially balanced.
The question is therefore not merely:
“Are phantom shares legally permissible?”
It is:
“Does the contractual mechanism provide a reasonable and realistic path for the service provider to realise the value of the consideration for services already rendered?”
In my view, that is the more important question from a contract-drafting perspective.
Conclusion
Phantom shares can be a useful tool for start-ups and growing companies. They can create an alignment between the service provider and the future growth of the business without immediately diluting the shareholding of existing shareholders.
However, where phantom shares constitute 100% of the consideration for services, the agreement should be drafted with particular care.
The parties should clearly understand:
the number or notional value of phantom shares;
the base valuation;
vesting conditions;
treatment upon termination;
treatment of vested and unvested entitlements;
valuation methodology;
settlement mechanism;
applicable liquidity events;
what happens if a liquidity event never occurs; and
whether there is a long-stop date or alternative exit mechanism.
Because ultimately, an entitlement that can never realistically be realised may have very little practical value, regardless of the notional value assigned to it on the date of the agreement.
And perhaps the simplest way to put it is this:
If the entire professional fee is being converted into a future investment, the service provider should at least have a reasonable opportunity to realise that investment.
Disclaimer: This article is intended for general informational purposes and does not constitute legal advice. The validity and enforceability of any particular phantom share or equity-linked contractual arrangement would depend upon its terms, applicable law, corporate structure, tax/accounting treatment and the facts of the transaction.