The term “shadow stock” is used in several different ways in the financial world. It can refer to a publicly traded stock which gains value when a newly listed stock in a similar industry starts to trend upwards, or to the stock in what is known as a phantom stock plan. In a phantom stock plan, people receive compensation based on rising stock values without actually receiving shares in the company.
In the first sense, a classic example of a shadow stock might be stock in a car company which has been traded on the market and has a history. When a new car company goes public, the stock in the first car company becomes a shadow stock. New companies tend to experience high trading volume when they go public, driving their value up, and shadow stocks often rise in value alongside them. Eventually the market and the values will stabilize.
In the sense of a phantom stock plan, shadow stock is a somewhat complicated concept. Employees in such plans are given a set number of shares of “phantom stock.” This is not real stock and the employee does not have shares in the company. When the value of the company's stock rises, the employee receives compensation based on the number of shares of shadow stock received. In other words, it is as though the company had stock which was generating returns.
Giving employees stock in a company, fake or not, is used as an incentive to provide them with a drive to help the company succeed. It is in the best interests of the employee to do things which will increase the stock value and thus cause compensation to increase. In the case of phantom stock, companies can use this technique if they are not publicly traded so that they can provide performance based compensation without losing shares and publicly traded companies may also offer shadow stock to employees.
Usually, the cash payments which employees are entitled to from a shadow stock program are deferred. This is designed to encourage longevity of employment. Employees may not be offered shares right away and the number of shares of phantom stock provided will increase over time. Payouts may not commence for several years, giving employees a reason to stay with the company so that they can collect their cash bonuses. For tax purposes, the money from a phantom stock program is treated as earned income.
