Phantom equity reward without hidden costs

Does phantom equity really stand a ghost of a chance of being a viable alternative to traditional equity plans for limited liability companies? The answer for many companies can be a resounding yes.
By granting phantom equity, owners of limited liability companies can properly incentivize many of their key employees without running the risk of having these grants come back to haunt them. Especially for those limited liability companies that wish to award an employee equity interest in the company’s existing capital, a phantom-equity plan can certainly be preferable to actual equity awards.
By opting for phantom-equity plans rather than traditional employee equity-option plans, limited liability companies can sidestep potential costs, regulatory requirements and corporate considerations that may prove to be problematic or unwieldy. Additionally, phantom equity can prove to be a viable means of providing retention and motivating key employees.
What is phantom equity?
Simply put, phantom equity is an agreement by a limited liability company to pay a cash bonus to an employee that is equivalent to the value of a certain number (or percentage) of the membership interests of the company’s equity. A phantom-equity program can be structured to pay an employee an amount equal to the value of the equity of the company on an annual basis, or alternatively, the program can allow bonuses to be granted upon any number of specified events (sales targets, net income, company valuation targets, change of control, etc.). Phantom equity may be traded at will and only will retain value when key conditions are met.
Upon receipt by an employee of the phantom-equity cash award, the bonus will be taxed like any other cash bonus, as ordinary income.
A participant in a phantom-equity plan forgoes the ability to obtain capital-gains treatment on appreciation in the value of the underlying equity after the vesting date of the phantom-equity award. In this respect, a phantom-equity plan is less attractive to the employees than a restricted-equity plan that may provide the chance for capital-gains treatment. However, the limited liability company as payer of the award would typically receive a corresponding tax deduction. By allowing for this deduction by the limited liability company, a phantom-equity plan can be an attractive option for limited liability companies looking to minimize their tax profile.
Investment, membership, ownership
Typically, a phantom-equity plan does not require an investment by an employee and will not confer any ownership in the limited liability company that has granted the phantom equity. Phantom-equity awards (unlike profit interests) come with no membership-owner benefits or requirements, no required access to financials by the recipient of the award, and thereby avoid potential fiduciary issues. They only create a contractual relationship. Accordingly, limited liability companies retain management control and still incentivize key management. In order to implement a phantom-equity plan, a limited liability company typically will have to maintain valuations of the company to determine the amounts payable at the time a phantom-equity award becomes due.
Phantom-equity plans can be designed to be simple and straightforward. Phantom-equity plans typically set out how payments are determined along with variables that include: eligibility; valuation methodology; payout events; restrictions; change-of-control provisions; events of death, disability and dismissal; notice provisions; and form of payment. By granting phantom equity, employers can create a sense of ownership in the future success of the company. Recipients feel incentivized to help the company grow. By granting phantom equity, limited liability companies are able to maintain a capitalization table that has not been diluted by equity grants to employees.
Impact on cash flow
While phantom equity will not directly dilute the shareholder value, payouts should be considered when evaluating the overall value of the limited liability company and can have a significant impact on the cash flow of a limited liability company at the time of payout.
There are a number of circumstances that may make it beneficial for a limited liability company to adopt a phantom-equity plan. The cost of implementation of a phantom equity plan is low; owners of a company can maintain a smaller ownership base and maintain control of the company while still sharing in the value of the enterprise; and phantom-equity plans can provide a goal-oriented incentive for employees. The phantom-equity plan can provide for a degree of flexibility while avoiding having to be concerned with the underlying equity ownership of the limited liability company.
However, there can be some drawbacks for limited liability companies. If phantom equity is paid in cash, this can be financially draining on a company’s cash flow at the time of payment. Additionally, by granting phantom equity, outside valuations of the company may be required on an annual or semi-annual basis for tax purposes as well as practical implementation purposes, depending on how the phantom-equity plan is structured. •


Christopher Matteodo is an attorney in the business-law practice of Duffy & Sweeney. He may be reached at cmatteodo@duffysweeney.com.

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