Abstract
This paper examines the incentive properties of phantom stock. These are non-public shares that give managers participation in the value of the specific subset of activities under their control. These managers cannot be directly motivated by common stock or by options on such stock. The paper provides a theory for the recent adoption of phantom stock in practice and how to design phantom stock to induce desired managerial behavior. It is shown that phantom stock induces agents to take investment decisions consistent with the maximization of common shareholder value independently of the agents' preferences and without requiring the principal to know the probability distribution or the expected value of the free cash flows associated with the investment. This property eliminates the conflict between effort and choice that affect other incentive schemes used in practise. The model allows for early redemption of phantom stock~ with the redemption price produced by a bargaining game with guaranteed individually rational outcome. In addition, the relationship between phantom stock and compensation according to economic value added is examined, and implications for the design of value-added compensation schemes with desirable incentive properties are discussed. (JEL G30, G31)