Phantom Ownership: How to Use Phantom Units to Incentivize Star Employees

Businesses often face the challenge of attracting and retaining star employees. It can be tempting to offer star employees ownership in the business to alleviate the hardship of losing them after investing time, money, and resources into training and onboarding. The main drawback of offering ownership is potentially relinquishing some control in the business. Employers that want to incentivize and retain star employees, without relinquishing actual equity or control of the entity, should consider offering “Phantom Units” rather than membership interests of a limited liability company or stock in the corporation. This article will provide a brief overview of how Phantom Units and Phantom Unit Agreements are utilized, what to consider when drafting Phantom Unit Agreements, and how to align the interests of the star employee with the company through the use of Phantom Unit Agreements.

What are Phantom Units?

Phantom Units, commonly referred to as phantom stock or shadow stock, are a form of employee compensation or incentive mechanism, similar to the structures often used in employee stock ownership plans (ESOPs) or deferred compensation plans. Unlike ESOP plans, where employees typically receive actual ownership of company stock, Phantom Units are not actual shares, rather, Phantom Units are shares that equal the value of company shares.

Employers use Phantom Units to grant employees the right to receive compensation, such as a cash payout, based on the value of the corporation’s stock or a limited liability company’s membership units, without conveying the employee an ownership or controlling interest in the company. Awarding Phantom Units to an employee is often used to incentivize the employee, align their interests with company performance, and retain talent without diluting ownership interests or management control in the company. Phantom Units are not actual membership units, shares, or stock options, but they are designed to reflect the value of the company’s outstanding membership interests, stock, or a similar performance measure.

The concept behind Phantom Units is to provide employees with benefits comparable to stock ownership without granting the employee actual equity, management, or voting rights in the company. The value of Phantom Units increases as the company’s performance improves, such as an increase in revenue or stock price. When an event occurs, such as an employee leaving the company or the business being sold, the employee receives a payout based on the value of the Phantom Units which is generally negotiated when the Phantom Unit Agreement is entered into rather than at the end of employment.

Phantom Units generally mirror the company’s value by tracking with the value of the company or a related metric. Phantom Units typically provide cash payouts. Employees will receive a cash payment equivalent to the value of their Phantom Units, rather than shares of stock. Taxes on Phantom Units are typically paid when the payout is made, often as ordinary income.

What are the Considerations When Drafting a Phantom Unit Agreement?

Phantom Unit Agreements are generally structured as a contractual agreement between the employer and employee. When drafting an Agreement, the following points should be considered to ensure clarity and legal compliance:

• Clearly define the terms “Phantom Units,” “Vesting,” and “Value.”
• Outline the number of Units being granted to the employee and the associated value or calculation method of the Phantom Units.
• Detail when and how the Units will Vest (i.e., over time or upon the achievement of a specific performance milestone).
• Describe how the Value of the Units will be determined (i.e., company valuation, share price, or other financial metrics).
• Outline how the Units will be paid, in cash or equivalent, and the timing of the payments. The timing of the payout is typically triggered by a liquidity event like the sale of the company, IPO, or when an employee departs.
• Clarify the rights of the Phantom Unit holder, indicating that they have no management, voting, dividend, or other ownership rights typically associated with actual equity of the company.
• Address what happens to the Units in the event of a merger, acquisition, or other exit event, and whether there are accelerated vesting or cash-out options.
• Discuss how the Units will be treated for tax purposes, including any tax withholding requirements at the time of payout.
• Specify the condition under which Phantom Units may be forfeited such as resignation, termination for cause, or failure to meet vesting requirements.

Bottom Line

Awarding Phantom Units to a star employee can be a mutually beneficial way to retain and incentivize the star employee and align company performance without diluting ownership interests or management control of the company. Phantom Unit Agreements should be drafted with care and clearly define the terms “Phantom Units,” “Vesting,” and “Value.”

This article, slightly modified to note recent updates, was featured online in the Great Lakes Employment Law Letter and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.