ESOP Vs Phantom Shares For NZ Startups

You have found a key hire you really want, but cash is tight and you want them to feel genuinely invested in the upside. That's a very normal startup moment.

The tricky part is choosing the right incentive. An employee share option plan gives real equity rights if the person exercises their options, while a phantom share plan usually pays a cash bonus linked to company value.

If you're comparing ESOP vs phantom shares in NZ, the best choice usually comes down to cost, dilution, tax, governance and how simple you want the offer to be when you're still moving quickly.

What Is The Difference Between An ESOP And Phantom Shares?

An ESOP gives a person a right to acquire real shares later, while phantom shares are usually a contractual promise to pay cash if certain value or exit events happen.

With an employee share option plan, your company grants options over shares. If the vesting rules are met, the person can exercise those options by paying the exercise price and becoming a shareholder. That means they may later have voting rights, information rights, dividend rights and other rights under your constitution, shareholders agreement and the Companies Act 1993.

With a phantom share plan, no shares are issued. Instead, the participant receives a cash-settled amount that tracks the value of a notional number of shares or a percentage of company growth. They get economic upside, but they don't usually sit on your cap table.

That one difference changes a lot:

• ESOP: best when you want true ownership and are comfortable with possible dilution.
• Phantom shares: best when you want to share value without issuing shares or adding people to the shareholder group.
• ESOP: more familiar to venture-backed startups and investors.
• Phantom shares: often simpler for closely held companies, service businesses and startups that aren't ready to manage extra shareholders.

Neither is automatically better. The right structure depends on what you're trying to reward, who you're offering it to and what your next funding or exit plans look like.

Which Option Costs More To Set Up And Run?

It depends, but an ESOP often costs more to set up properly because it touches your share capital, company constitution, shareholder approvals and employee share scheme rules.

The cost isn't just the document itself. It's the thinking behind it. A good plan needs to match your hiring strategy, cap table, tax position and future raise plans. A free template may look cheaper at the start, but it can miss the details that investors, employees and Inland Revenue care about.

What Drives The Cost Of An ESOP?

• How many people you want to include now and later.
• Whether your constitution and shareholders agreement already allow options.
• The size of the option pool, share vesting schedule and exercise price.
• Whether you need board and shareholder approvals.
• Whether the offer can fit within Financial Markets Conduct Act 2013 exclusions for employee share schemes.
• How much tax input you need on share scheme taxing dates and reporting.

What Drives The Cost Of A Phantom Share Plan?

• How the notional value is calculated.
• Whether payment is tied to an exit, valuation, profit target or time period.
• How you'll fund cash payouts.
• How PAYE, KiwiSaver, ACC levies and Holidays Act 2003 calculations may apply.
• What happens if the person leaves before a payout.

A traditional firm may bill by the hour. An online fixed-fee legal service should tell you the scope and fee up front. Either way, you want the setup to include the plan rules, offer documents, approval documents and practical instructions for using the plan.

Will An ESOP Or Phantom Share Plan Dilute Your Cap Table?

Yes, an ESOP can dilute your cap table when options are exercised, while a phantom share plan usually doesn't dilute ownership because it's cash-settled.

Dilution isn't always a bad thing. If a senior engineer, sales lead or product person helps you grow the company, giving away a small slice may be worth it. The issue is making sure you know exactly how much you're giving away and when.

Say Aroha runs a Wellington software startup with 1,000,000 ordinary shares on issue. She creates a 10% ESOP pool, so there are options over 100,000 shares available for the team. She offers Ravi 10,000 options with a $1 exercise price and four-year vesting.

If Ravi vests and exercises all 10,000 options, he pays $10,000 and receives shares. If the company later exits at $8 per share, those shares are worth $80,000 before tax and transaction costs. Ravi has real shares, and everyone else has been diluted because there are more shares on issue.

If Aroha used a phantom share scheme instead, Ravi might receive a cash bonus equal to the growth in value of 10,000 notional shares. Using the same $1 starting value and $8 exit value, the notional gain is $70,000. Ravi gets cash, but no actual shares are issued.

For you, the practical difference is this:

• ESOP: less cash pressure at payout, but more ownership dilution and shareholder management.
• Phantom shares: no ownership dilution, but you need cash available when the payment is triggered.

How Do Tax And Payroll Issues Compare?

It depends on the design, but phantom shares are often easier to treat through payroll, while ESOP tax can be more technical because New Zealand has specific employee share scheme rules.

For an ESOP, benefits under an employee share scheme are generally employment income under the Income Tax Act 2007 at the share scheme taxing date. That date isn't always the grant date. It's usually when the employee holds the shares free from substantial conditions and real risk that they will lose them. For options, that can depend on the plan terms, vesting conditions, exercise timing and any buy-back or forfeiture rights.

Your company may also have Inland Revenue reporting obligations for employee share scheme benefits. PAYE withholding isn't always straightforward, so you should get tax advice before you make offers, especially if the value could rise quickly.

For phantom shares, the payout is usually a cash bonus, not a profit share or revenue share unless drafted that way. That means it's commonly processed through payroll with PAYE and may also affect KiwiSaver, ACC and leave calculations. Under the Holidays Act 2003, regular or formula-based incentive payments can form part of gross earnings for holiday pay calculations. A genuinely discretionary payment may be treated differently, but the wording and how you apply it matter.

There's also an employment law angle. If the participant is an employee, their written employment agreement under the Employment Relations Act 2000 should sit neatly with the incentive documents. If you're offering incentives to contractors or advisers, check the worker status carefully. From 2026, the Employment Relations Amendment Act 2026 introduces a contractor gateway test for some arrangements, so your contract and day-to-day working relationship need to line up.

What Documents Do You Need Before Making Offers?

You need more than a one-page promise, because both ESOPs and phantom share plans can create expensive confusion if the terms aren't clear.

For an ESOP, you'll usually need:

• Board approvals and, if required, shareholder approvals.
• Employee share option plan rules.
• An individual offer letter for each participant.
• An option certificate or grant notice.
• Exercise notices, share issue documents and share transfer documents where needed.
• Updates to your share register when shares are issued.
• Companies Office filings, including a notice of share issue to the Registrar within 10 working days after issuing shares.
• Updates to your constitution or shareholders agreement if they don't already work with the plan.

For a phantom share plan, you'll usually need:

• A phantom share agreement, plan rules or a bonus plan agreement.
• An individual participation notice.
• A valuation method or formula.
• Leaver rules.
• Payroll treatment instructions.
• Board approval for the plan and each grant.

Fill-In Outline For Your Plan Rules

This outline isn't a finished legal document. It's a starting point for the issues your legal adviser should tailor before you use it.

1. Purpose: explain what behaviour, retention goal or value creation the plan is designed to reward.
2. Eligibility: state who can receive grants, such as employees, contractors or advisers.
3. Grant Terms: set the number of options or phantom units, grant date, exercise price or starting value.
4. Vesting: describe time-based, milestone-based or performance-based vesting conditions.
5. Leaver Rules: explain what happens if the person resigns, is dismissed, becomes redundant or stops providing services.
6. Exit Events: say what happens on a sale, listing, merger or other liquidity event.
7. Valuation: set out how shares or phantom units will be valued and who decides.
8. Tax And Payroll: explain who bears tax and how reporting, PAYE or deductions will be handled.
9. Confidentiality: keep cap table, valuation and plan information confidential.
10. Company Discretion: reserve sensible board discretion without making promises that could mislead the participant.

How Do You Choose The Right Incentive For A Key Hire?

The right choice depends on whether you want to give real ownership, preserve your cap table or keep the arrangement simple and cash-based.

Start with the commercial outcome, not the document name. Ask yourself what you're trying to achieve with this person and what your company can realistically support over the next few years.

Choose An ESOP If

• You're building a venture-backed or high-growth startup where equity is expected.
• You want senior hires to think and act like owners.
• You're comfortable with dilution if the person contributes to growth.
• You have, or plan to have, a clean shareholders agreement and cap table.
• You may raise investment and want an investor-friendly incentive structure.

Choose Phantom Shares If

• You don't want more shareholders.
• You want to reward value creation without issuing shares.
• You run a closely held company where voting rights and governance need to stay tight.
• You can manage a future cash payout.
• You want a simpler structure for a senior employee, contractor or adviser.

You should also think about the message you're sending. ESOPs can feel more meaningful because they create a pathway to ownership. Phantom shares can feel cleaner because the person gets upside without needing to buy shares or deal with shareholder paperwork.

Be careful with verbal promises during hiring. If you say someone will get 2% equity, make sure you know whether you mean shares, options, a percentage of an option pool, fully diluted ownership or a cash equivalent. A loose promise can become a difficult expectation to manage later.

Common Mistakes To Avoid

Most problems come from moving too quickly, using unclear language or promising more than the company can safely deliver.

Before you send an offer to a key hire, work through this checklist:

• Check Your Authority: confirm who can approve the grant under your constitution, shareholders agreement and board process.
• Model The Numbers: calculate the dilution under an ESOP or the possible cash payout under a phantom plan at low, medium and high valuations.
• Use Clear Leaver Rules: decide what happens if the person leaves before vesting, after vesting or just before an exit.
• Match The Employment Contract: make sure the employment agreement, contractor agreement or adviser agreement doesn't say something inconsistent.
• Keep Securities Law In Mind: real equity offers may need to fit within Financial Markets Conduct Act 2013 exclusions or another lawful pathway.
• Plan For Tax Early: get tax input before the grant, not after the first person asks what they owe Inland Revenue.
• Avoid Vague Valuations: don't say the company is worth a certain amount unless you have a fair basis for saying it.

The Fair Trading Act 1986 can also matter if you make misleading statements during recruitment or fundraising. Keep your offer documents accurate, balanced and clear about what is guaranteed and what depends on future events.

This doesn't have to slow your hiring down. It just means getting the foundations right before you put an incentive in writing.

Key Takeaways

• An ESOP gives a pathway to real shares, while phantom shares usually give a cash bonus linked to company value.
• ESOPs can be more attractive for venture-style startups, but they bring dilution, cap table management and more governance work.
• Phantom share plans avoid share dilution, but they can create a future cash payment that needs to be funded.
• Tax treatment is different for each option, so you should get tax advice before making offers.
• Your documents should cover vesting, leaver rules, valuation, tax, confidentiality and what happens on an exit.
• Clear wording matters. Avoid loose promises like '2% equity' unless you have clearly defined whether that means shares, options, fully diluted ownership or a cash equivalent.

If you'd like help with setting up an ESOP, preparing a phantom share plan, reviewing your incentive offer documents or checking your leaver and vesting rules, you can reach us at 0800 002 184 or team@sprintlaw.co.nz for a free, no-obligations chat.