Historically, stock option plans have been the preferred method for companies to provide long-term incentive compensation to their executives. However, these plans have drawbacks: the stock's market price can be impaired by the whims of securities analysts; executives face tax consequences when exercising the options; and executives must accumulate cash in order to exercise the options. The need for cash can unnecessarily inhibit plan participation. Although the amount of cash required for exercising options may be immaterial to the capital structure of the corporation, it is usually a significant sum to an executive.

Phantom Stock Plan
Phantom stock plans are a viable alternative for corporations where there is sufficient time available for appreciation in the underlying business. An employer grants hypothetical units of the business to an executive. These units may rise or fall in value based on a specified formula or the value of the employer's business. At the end of a specified period, the executive realizes income based on any appreciation in the hypothetical units.

Many phantom stock plans provide a benefit equal to both the value of the hypothetical units granted plus the appreciation. It is also common for these arrangements to have the hypothetical shares, or units, accrue dividends based on dividends granted to the underlying shares. Depending on the terms of the plan, these credited dividend equivalents may earn interest, be converted into additional phantom stock units or simply remain on account without any growth.

A phantom stock plan allows the executive to participate in the long-term growth of corporate value. Unlike a stock option plan, the executive's value is based upon criteria which are not subject to market vagaries. In addition, an executive has no need for a substantial cash investment. The executive pays no tax on the accumulated values until they are paid at the time prescribed by the plan. The corporation can use the plan design (vesting schedules, etc.) to determine the timing and level of payments to the executive based upon corporate objectives.