phantom equity best practice

August 28, 2022

by a searcher from Indiana University, Bloomington/Indianapolis - Kelley School of Business in St Paul, MN, USA

I am interested in acquiring a small, niche company. The key employee is threatening to leave if the seller does not give him xxx amount to compensate for his years of loyalty. I want to buy this company but am looking for someone with similar technical background as the lead employee and offering him equity in the company. I am not ready for cap table but would like to learn more about phantom equity How does phantom equity work? Any best practices? Thank you!

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Reply by a searcher
from University of Illinois at Urbana in Chicago, IL, USA

Are they actually wanting equity? Or just more money? I'd also dig into if the company/equity had been offered to the employee. Equity gets really complicated. I think it can make sense if they are willing to pay in and have skin in the game, but even that can be tricky. It may be easier to adjust their comp plan such that if they hit some easily acheived quotas, they get a nice bump. It incents them to stay invested at least for the short term, while you weigh the longer term options.

Reply by a professional
from William Mitchell College of Law in Minneapolis, MN, USA

Conrad, phantom equity is designed to compensate the employee as if he/she owned stock/LLC interests, without actually owning them. There are a couple reasons to NOT grant the actual stock/LLC interests - avoid granting voting rights to others and diluting control; shareholders/members have certain legal rights such as rights to ownership lists and to vote in a sale of the company; and former employees won't need to be bought out when their employment ends. The phantom equity can be created to provide for annual dividends/distributions but typically is used to incent the employee to help the company grow in value, so the employee realizes a gain when the company is sold. The employee is entitled to a payment upon a sale of the company as if the employee owned stock/llc interests in whatever percentage is granted. A downside (for the employee) is that any gain is taxable as ordinary income, not capital gains, and therefore is subject to a higher tax rate.

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