Retain Key Employees With Phantom Units

October 19, 2018

Employee retention is a challenge many small businesses face. Turnover costs business owners in training time, productivity, continuity, and, at times, office morale. To mitigate turnover and increase retention, employers often look to offer competitive benefits packages tied to performance-based cash bonuses, health insurance plans, retirement plans, and vacation days. Employers that want to set themselves apart from competitors, however, may want to consider offering key employees equity-based incentives such as “phantom units.”

A phantom stock plan allows business owners to give key employees many of the benefits of ownership without actually relinquishing any company stock. This article will focus on phantom units as they’re related to limited liability companies (LLCs).

LLCs and Their Members

The owner of an LLC is identified as a “member” under Wisconsin’s statutes. The member’s ownership interest is comprised of units (often referred to as a “membership interest”). Generally, a member has certain basic ownership rights associated with the LLC that are set forth in an operating agreement. When the LLC is formed, the agreement identifies:

  • Members and their initial capital contributions and respective membership interests in the LLC; and
  • Certain rights of the members, such as profit-and-loss allocations, distributions, management structure, voting rights, restrictions on the transfer and assignment of units, admission of new members, and the right to wind down and dissolve the LLC or enter into a purchase and sale agreement to sell its assets or units.

The basic rights are significant and provide members with the authority to determine the LLC’s direction and operation.

As a business grows and certain employees become more valuable, members may want to reward them with equity in the LLC and consider offering units of membership interest to them. The approach may work for certain businesses, but members should exercise extreme caution when deciding whether to transfer a membership interest to a key employee (and subsequently grant certain rights under the LLC’s operating agreement to the individual along with those units). After all, the original members may be diluting their membership interest and diminishing their rights under the operating agreement.

Inviting a key employee to become a member can create unwanted and unintended risks as the original members now have a new dynamic to work with and consider under the operating agreement. One way to mitigate the risks may be to offer phantom units rather than an actual equity interest in the LLC.

How Do Phantom Units Work?

Phantom units are conveyed by contract rather than as a true equity interest. They can imitate the units a key employee can earn through “sweat equity” but carry no ownership rights and don’t receive profit allocations/losses or LLC income distributions.

Phantom units can align a key employee’s desire to grow the company with members’ goals by providing a financial incentive for the individual to continue working toward increasing the LLC’s worth and, as a result, the phantom units’ value. The approach can satisfy the key employee’s desire for “ownership” in the LLC while at the same time protecting members from having to relinquish membership rights such as management procedures, voting rights, transfer restriction, purchase and sale, and dissolution.

Generally, phantom units are conveyed to the key employee under the terms of an agreement between the individual and the company. Here are several factors to consider when drafting the agreements:

  • How many phantom units to offer;
  • Value of the phantom units;
  • Vesting period (if any); and
  • What happens to the units if the key employee chooses to leave or is terminated.

The phantom units’ value may be determined by an agreed-upon process based on their fair-market worth, stipulated to by the members, predetermined by a written formula outlined in the operating agreement, or established by appraisal. No taxes are paid on the issuance of units. They are taxed as ordinary income, however, when they’re paid out after a liquidity event such as the sale of the LLC. They also may be tied to employee bonuses rather than liquidity events. For instance, if sales exceed a certain number, each phantom unit would earn a predetermined amount.

Bottom Line

Phantom units provide a flexible way for companies to reward and incentivize key employees with competitive compensation packages that can help separate businesses from their competitors.

This article, slightly modified to note recent updates, was featured in the September 2018 issue of the Wisconsin Employment Law Letter, which is co-edited by Axley Brynelson Attorneys Saul Glazer and Michael Modl and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.