Equity Incentives For LLCs: Phantom Unit Plans
This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
As a company grows, many business owners want to reward their key employees with equity in the business or rewards tied to the business’s performance. We’ve discussed several equity incentive plans for LLCs in prior posts. This post focuses on Phantom Unit Plans.
A phantom unit plan or phantom plan sets out cash payments for grantees at certain defined company events. Company events can include revenue goals, performance metrics (such as reducing turnover or meeting sales targets) or certain milestones (such as achieving a certain revenue or customer count). Most of the time, phantom unit plans are tied to the value of the underlying units of the company. Typically the units will be valued and when the company determines the value has reached a certain threshold, employees will receive a cash payment.
Increasingly, LLC’s are tying Phantom unit plans to a future exit. In this scenario, unit holders who are still employed by the company when it gets sold or bought by another company (an exit) will get a cash payment. Payment are typically equal to the number of units held at the time multiplied by some percentage of the exit event. Percentages generally fall in the 10 to 20 percent range of the exit value the company. This allows employees to share in the upside of the company if it has a lucrative exit. Theoretically, the value of their phantom units grows over time as the company grows. Additionally, it’s easy for the company to move employees into and out of the plan as people are let go or leave the company.
While phantom unit plans have some clear advantages, there are also some considerations.
First, phantom unit plans create a right to a cash payment. This means that the cash paid to employees is a company liability that would be paid out ahead of equity holders. In other words, a founder or business owner cannot get paid out before the phantom unit distribution has been paid.
Second, phantom unit plans are not attractive to outside investors. If the company plans to bring on outside investment, many investors will ask/require companies to get rid of a phantom unit plan which can bring up several issues for the company.
Third, phantom unit plans can be hard to explain to employees. If a company makes the mechanism for payout on the plan complex, employees may not understand the plan or the value of their units. This can negate the incentive that a company was looking to provide so employees may not see how day to day work leads to an increased value in their units. On the other side of the coin, companies could see employees become hyper focused on the company’s numbers and could begin asking for things that company’s don’t typically want to give employees.
Finally, there is a securities consideration with phantom unit plans that involves the structure of the company’s exit. Many company’s receive a combination of cash and stock in the acquiring company when they exit. If a phantom unit plan isn’t drafted carefully, it can leave out the stock consideration at exit. Additionally, even if the phantom unit plan is drafted to allow employees to receive stock, there can be additional security law problems. For example, if employees are non-accredited investors the rules can be complex around allowing them to accept stock. Another issue that can arise is if an acquirer or investor wants the company to restructure (which is common in LLC exits). In this situation, the company may have to get the consent of employees to change the until plan which can stall or even destroy an exit. Even having employees consent to changing the phantom unit plan can present securities concerns and result in timely and costly legal disclosure requirements and legal analysis.
Phantom unit plans can be a good incentive option for some companies, but they deserve scrutiny and proper legal drafting. We’re happy to walk through all of the considerations and how they apply to your company. Schedule a consultation below or check out our other content.
This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal advice and is intended to generate discussion of various issues. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel. Cara Stone, LLP and the author expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post. The views expressed herein are personal opinion.
As a company grows, many business owners want to reward their key employees with equity in the business or rewards tied to the business’s performance. We’ve discussed several equity incentive plans for LLCs in prior posts. This post focuses on Phantom Unit Plans.
A phantom unit plan or phantom plan sets out cash payments for grantees at certain defined company events. Company events can include revenue goals, performance metrics (such as reducing turnover or meeting sales targets) or certain milestones (such as achieving a certain revenue or customer count). Most of the time, phantom unit plans are tied to the value of the underlying units of the company. Typically the units will be valued and when the company determines the value has reached a certain threshold, employees will receive a cash payment.
Increasingly, LLC’s are tying Phantom unit plans to a future exit. In this scenario, unit holders who are still employed by the company when it gets sold or bought by another company (an exit) will get a cash payment. Payment are typically equal to the number of units held at the time multiplied by some percentage of the exit event. Percentages generally fall in the 10 to 20 percent range of the exit value the company. This allows employees to share in the upside of the company if it has a lucrative exit. Theoretically, the value of their phantom units grows over time as the company grows. Additionally, it’s easy for the company to move employees into and out of the plan as people are let go or leave the company.
While phantom unit plans have some clear advantages, there are also some considerations.
First, phantom unit plans create a right to a cash payment. This means that the cash paid to employees is a company liability that would be paid out ahead of equity holders. In other words, a founder or business owner cannot get paid out before the phantom unit distribution has been paid.
Second, phantom unit plans are not attractive to outside investors. If the company plans to bring on outside investment, many investors will ask/require companies to get rid of a phantom unit plan which can bring up several issues for the company.
Third, phantom unit plans can be hard to explain to employees. If a company makes the mechanism for payout on the plan complex, employees may not understand the plan or the value of their units. This can negate the incentive that a company was looking to provide so employees may not see how day to day work leads to an increased value in their units. On the other side of the coin, companies could see employees become hyper focused on the company’s numbers and could begin asking for things that company’s don’t typically want to give employees.
Finally, there is a securities consideration with phantom unit plans that involves the structure of the company’s exit. Many company’s receive a combination of cash and stock in the acquiring company when they exit. If a phantom unit plan isn’t drafted carefully, it can leave out the stock consideration at exit. Additionally, even if the phantom unit plan is drafted to allow employees to receive stock, there can be additional security law problems. For example, if employees are non-accredited investors the rules can be complex around allowing them to accept stock. Another issue that can arise is if an acquirer or investor wants the company to restructure (which is common in LLC exits). In this situation, the company may have to get the consent of employees to change the until plan which can stall or even destroy an exit. Even having employees consent to changing the phantom unit plan can present securities concerns and result in timely and costly legal disclosure requirements and legal analysis.
Phantom unit plans can be a good incentive option for some companies, but they deserve scrutiny and proper legal drafting. We’re happy to walk through all of the considerations and how they apply to your company. Schedule a consultation below or check out our other content.
