Skip to main content

Phantom Equity Unity Award Agreement

Phantom Stock or Phantom Units (sometimes called Performance Units).

💡 Phantom Equity & Performance Vesting: Key Design Elements​

1. The "Phantom Unit" Grant​

  • Definition: The Phantom Unit (or "Unity Award") is a contractual right to receive a future cash payment equal to the value of a single share or unit of the company, or the appreciation in that value, upon a specified payout event.
  • Grant Document: The award is formalized in an Award Agreement which references a master Phantom Equity Plan Document. The Agreement specifies the initial number of Units granted to the Participant.

2. Performance Milestone-Based Vesting​

Unlike simple time-based vesting (e.g., 25% per year), your milestone-based vesting links the achievement of the award directly to the success of your agile tech firm and digital marketing studio services.

ComponentDescription & Relevance to Tech/Digital Marketing
Vesting CriteriaA portion of the Units vests only upon the certification by the Compensation Committee (or the Board) that a specific Performance Milestone has been met.
Examples of Milestones* Financial: Achieving a target EBITDA or Annual Recurring Revenue (ARR) for two consecutive fiscal years.
* Operational: Successful launch and stabilization of a new SaaS product line (e.g., V1.0 release + 6 months post-launch).
* Studio Performance: Securing Anchor Client contracts for digital marketing services with a minimum contract value (ACV).
Measurement PeriodThe agreed-upon timeframe (e.g., a fiscal year or a two-year agile sprint cycle) over which the performance is measured. Failure to meet a milestone typically results in forfeiture of that tranche of Units.

3. Valuation and Payout​

  • Valuation Formula: The agreement must clearly define how the Fair Market Value (FMV) of a Unit will be determined at the time of payout. For private companies, this often relies on a formula based on a multiple of EBITDA or Revenue, or a formal 409A appraisal.
  • Payout Trigger Events: These are the events that cause the vested Phantom Units to be paid out in cash. Common triggers include:
    • A Liquidity Event (e.g., acquisition, sale, or IPO).
    • The employee's Termination of Service (Retirement, Death, Disability).
    • A pre-set Deferred Payment Date (e.g., 5-7 years from grant).

4. Critical Legal/Tax Considerations (409A)​

As a form of deferred compensation, the Phantom Equity Plan and the specific Award Agreement must be designed to comply with Internal Revenue Code Section 409A to avoid immediate taxation and penalties on the participant. Key areas include:

  • Fixed Payout Timing: The payment terms (timing and method) must be specified at the time of grant and generally cannot be changed later.
  • Cash Settlement: Phantom Equity is almost always cash-settled and taxed as ordinary income to the recipient upon payout. The company takes a corresponding deduction.

Compliance with IRS Section 409A for a phantom stock compensation arrangement in a Single-Member LLC (SMLLC) using individual performance milestone vesting for an Independent Contractor (IC) requires careful structuring, especially regarding the payout timing. Phantom stock is generally considered nonqualified deferred compensation and is thus subject to 409A unless a specific exception applies.

🔒 Section 409A Compliance​

To comply with Section 409A, the phantom stock plan must strictly adhere to rules governing the timing of deferral elections and, most critically, the timing of payments.

1. Structure the Phantom Stock Plan​

Phantom stock in this context is a contractual right to a future cash payment (or equity) equal to the value (or appreciation) of a specified number of the SMLLC's notional shares.

  • Written Plan: The arrangement must be documented in a formal written plan or agreement (the IC agreement) from the date the IC gains the legally binding right to the compensation.
  • Initial Grant: The agreement must be established before the compensation is considered "earned" or a "legally binding right" is created.
  • Valuation: Since the SMLLC is a private company, the plan must specify an objective method for determining the Fair Market Value (FMV) of the phantom stock units at the time of grant and payment, which is critical for compliance. An independent appraisal is often used.

2. Payout Timing Constraint (Fixed Time or Schedule)​

The most challenging aspect is ensuring the payout timing is a fixed time or fixed schedule that is determined at the time the compensation is deferred (the grant date). This is where milestone vesting must be separated from the fixed payout time.

  • Vesting vs. Payment: Under 409A, vesting (the achievement of the milestone, which eliminates the substantial risk of forfeiture) and payment are separate concepts. Vesting can be tied to a milestone, but the payment date cannot.

3. Potential Exemption: Short-Term Deferral​

The best way to avoid most 409A rules is to qualify for the short-term deferral exception.

  • The Rule: Compensation is exempt if it is paid out no later than the 15th day of the third month following the end of the year (taxable year of the IC or the SMLLC, whichever is later) in which the right to the compensation is no longer subject to a substantial risk of forfeiture (i.e., when it vests).
  • Application to Milestones:
    • If a performance milestone is achieved in 2026, the phantom stock units related to that milestone vest in 2026.
    • To be exempt from 409A, the resulting payout must occur by March 15, 2027.
    • The IC agreement must be clear that payment will occur automatically within this short-term deferral period following the vesting milestone. ****

📅 Fixed Timing Payout with Milestone Vesting​

If you cannot or do not want to use the short-term deferral exception, you must structure the arrangement to comply with the 409A rules for payment upon a fixed date or fixed schedule.

The vesting milestone can determine when the IC becomes entitled to the compensation, but the payment date must be a predetermined, specified, objectively determinable date, regardless of when the milestone is achieved.

How to Implement Fixed Timing​

Instead of making the payout upon the milestone's achievement, the IC agreement should be structured as follows:

  1. Grant Date: The phantom stock units are granted.
  2. Milestone (Vesting Trigger): The grant agreement clearly defines the individual performance milestones.
  3. Fixed Payout Event: The payment is explicitly tied to one of the six permissible 409A distribution events, which must be specified at the time of the grant:
    • Fixed Date or Fixed Schedule: The most straightforward approach. For example:
      • "Payment for any vested phantom stock units shall occur on January 31 of the calendar year immediately following the calendar year in which the unit vests." (This is essentially the short-term deferral rule's deadline, but without relying on the exception, and is safer).
      • Alternatively, "Payment for any vested units shall occur on December 31, 2030." (A single, fixed date, even if the vesting milestone is hit much earlier).
    • Separation from Service: Payment occurs upon the IC's "separation from service" with the SMLLC (subject to specific 409A definitions of separation for ICs).
    • Change in Control (CIC) Event: Payment occurs upon a defined 409A-compliant CIC.
    • Death, Disability, or Unforeseeable Emergency.

Example Payout Structure​

Let's assume the IC's milestone is "Achieve \$1 Million in Revenue."

Milestone Status (Vesting)Fixed Payout Date409A Status
Milestone hit in June 2027Payment is automatically scheduled for January 31, 2028.Compliant (Fixed Date/Schedule)
Milestone hit in December 2027Payment is automatically scheduled for January 31, 2028.Compliant (Fixed Date/Schedule)
Milestone not hit by December 31, 2030The units are forfeited, or the payout is scheduled for a final fixed date, such as December 31, 2032, only if vested by that date.Compliant (Requires clear documentation of the fixed date)

The key takeaway is that the vesting event (the milestone) cannot, by itself, be the payment trigger unless you are relying on the short-term deferral exception (payout by March 15th of the following year). If you want a longer deferral, you must specify one of the six permissible fixed events.

Important Disclaimer: Compliance with Section 409A is highly complex and depends on the specific language of the plan documents. This information is for educational purposes only and is not legal or tax advice. You must consult with a qualified tax advisor or attorney to ensure your IC agreement and phantom stock plan are fully compliant.