While capital interests or options are frequently used to incentivize C-suite executives or upper-level management, incentivizing rank-and-file employees with a stake in the sale of the business can be more effective.
Candace Groth and Kevin Vela
What is phantom equity?
Phantom equity enables the employee-recipient to receive a cash payout or share of annual profits when the company achieves a major milestone, such as being acquired.
Companies can choose a wide range of goals to trigger phantom equity distributions—for example, an acquisition, or hitting certain revenue or profit metrics. Phantom equity awards may, but are not required to be, an “appreciation only” award like an option.
There is a variation of phantom equity, called unit appreciation rights, which is limited to any appreciation over the company’s initial value at the time of the grant (see more on this phantom equity variation below.)
The other key characteristic of phantom equity, including UARs, is that recipients remain employees rather than becoming members of partners of the LLC.
Recipient retains employee status
This means employees continue to receive company benefits and W-2 tax forms, and their employer can continue to withhold taxes from their regular cash compensation, as they do not hold an equity stake and do not become members or partners.
Minimal employee burden
The recipient doesn’t have to pay to acquire this equity type, they maintain employee status, and they have no tax obligation or tax forms until they receive their cash payout.
Ease of administration
Phantom equity generally requires few, if any, changes to the LLC’s operating agreement. If awards are designed as full value awards, there’s no need to track threshold values at the time of the grant or calculate the spread between the threshold value and the company value at the time of exit.
Employee pays ordinary income tax on payout
Contrast this to other equity types, such as PIUs, which when handled correctly are potentially taxed at lower, long-term capital gains rates. Phantom requires the employee to pay ordinary income on their payout.
Lack of liquidity
Employees generally cannot sell or transfer phantom units. However, if a company has robust regular cash flow, phantom equity can be structured to provide for a share of annual distributions of profits.
Participants in phantom equity plans are generally required to remain employed with an LLC to benefit from any payouts. If employment is not required, significant complexity in drafting and administration is introduced. It’s important to document rules in the award agreement related to termination or forfeiture of phantom equity.
For the company:
Like Unit Appreciation Rights, the amount paid out will generally be deductible as a compensation expense by the company.
Phantom stock unit payouts are taxable to the employee at ordinary income tax rates (generally higher than capital gains tax rates).