by John G. Walsh

Businesses often face the challenge of attracting and retaining star employees. It can be tempting to offer star employees ownership in the business to prevent the hardship of losing star employees 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 star employees “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 used, 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, they 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 them, align their interests with company performance, and retain talent without diluting ownership interests or management control in the company. Phantom units aren’t 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. 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 to Consider When Drafting a Phantom Unit Agreement

Phantom unit agreements are generally structured as a contractual agreement between the employer and employee. They should be carefully drafted to ensure clarity and legal compliance.

A phantom unit agreement should clearly define the terms “phantom units,” “vesting,” and “value.” The agreement should outline the number of phantom units being granted to the employee and the associated value or calculation method of the phantom units.

The agreement should detail when and how the phantom units will vest. For instance, the agreement should outline whether the phantom units will vest over time or upon the achievement of a specific performance milestone.

The agreement should describe how the value of the phantom units will be determined. For instance, will they be based on company valuation, share price, or other financial metrics?

The agreement should outline how the value of the phantom units will be paid—in cash or equivalent—and the timing of 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.

The agreement should clarify the rights of the phantom unit holder, indicating that they have no management rights, voting rights, dividend rights, or other ownership rights typically associated with actual equity of the company.

The agreement should address what happens to the phantom units in the event of a merger, acquisition, or other exit event, and whether there are accelerated vesting or cash-out options.

The agreement should discuss how the phantom units will be treated for tax purposes, including any tax withholding requirements at the time of payout.

The agreement should specify the conditions under which phantom units may be forfeited such as a 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.”

John G. Walsh is a partner at Axley Brynelson, LLP, in Madison, Wisconsin. John practices a wide range of business law including corporate law; mergers, acquisitions and business reorganizations; intellectual property and trademark registration; estate planning and probate; real estate and adverse possession claims; zoning; and land use and development. He can be reached at 608-283-6744 or jgwalsh@axley.com.