Incentive Equity Explained: Profits Interests, Phantom Units, and More

If you work around private companies, you have probably heard someone mention profits interests, phantom units, incentive units, or carried interest. These all describe ways a business shares its future value with the people helping to build it. The terms overlap, the structures vary, and they’re often explained in technical terms. This article walks through the most common types, what they are called, and how they differ.

Why companies offer incentive equity

Companies backed by private equity or venture capital usually have several classes of equity, each with its own rights. Many also give key people a piece of the upside on top of their salary. The idea is simple: if the business grows in value, the people responsible for that growth share in it.

Owners use incentive equity to recruit good people, keep them around, and give them a reason to think like owners. It can also let a company offer meaningful upside without spending cash today or giving away value that already belongs to the existing owners.

Start with the type of entity

The tools available depend on how the company is organized. Corporations (C or S corporations) issue stock, so their incentive tools are built around shares: stock options, restricted stock, and stock appreciation rights. Limited liability companies (LLCs) taxed as partnerships issue membership units, which opens up a different set of tools, most notably the profits interest. Many private-equity-backed companies use an LLC holding company above the operating business, partly for this reason.

S corporations are more limited. Because an S corporation can only have one class of stock, it generally can’t issue profits interests directly, and doing so can put the S election at risk. S corporations typically use phantom stock, SARs, options, or restricted stock units instead.

The common types

Capital interests

A capital interest as a true ownership stake. The holder shares in the value the company has today and any value it builds from here, and has a claim on capital if the company is wound down. Companies can layer on features like preferred returns, or create separate classes for different roles. When used as compensation, the challenge is that a capital interest is worth something the moment it’s issued, so the recipient is generally taxed on that value at grant or at vesting. Avoiding that upfront tax is one of the main reasons profits interests are used.

Profits interests

A profits interest is a share of future value only. The holder doesn’t share in what the company is worth on the grant date, just the growth after that. Existing owners keep everything they’ve already built, so they can share upside without diluting their current stake.

No two plans are exactly alike. The operating agreement and grant documents set out who gets paid, when, and based on what, so those documents are the place to start.

Payouts generally work in one of a few ways, and some plans combine them:

• +Growth over a threshold: the holder shares in any equity value created above the company’s value at grant. This is a very common setup in private-equity-backed LLCs, and it works much like a stock option.
• +Payout at an event: the units don’t pay until a specific event occurs, such as a sale of the company or investors reaching a target return.
• +A cut of profits: the holder receives a share of annual earnings, usually linked to financial goals. When the payout is based on revenue or another fairly predictable income stream, it may not qualify for profits interest tax treatment, which is why these are often structured as bonus or phantom plans.

The value of a profits interest comes down to a handful of factors: how much growth is needed before the units are in the money, how far away a likely exit is, how volatile the business is, and where the units fall in the distribution waterfall. Two grants for the same percentage can carry very different values.

Incentive units

“Incentive units” is what many private-equity-backed LLCs call the profits interests they grant to management. They’re often a separate class, like Class B or Class C units, with a floor set at the company’s equity value on the grant date. Vesting usually depends on time, performance targets like EBITDA growth, or a sale where investors hit a minimum return, often called a hurdle. If the holder leaves, unvested units are typically forfeited, and the company can often buy back the vested ones.

Phantom units and ghost units

Phantom units, sometimes called ghost units, are a contractual promise to pay cash based on the value of a set number of units or shares. The holder gets the economics of ownership without actually owning anything. There is no vote, no capital account, and no seat at the ownership table. Payment usually comes at a sale or another defined event.

Phantom plans are popular with closely held and family-owned businesses because they are easy to set up and keep the ownership group unchanged. The tradeoff is that payouts are generally treated as ordinary compensation income, and the company has to fund them in cash.

Stock appreciation rights (SARs)

A stock appreciation right pays the holder the increase in value of a share above a set price, usually the value on the grant date. SARs can be paid in cash or in stock. They are the corporate cousin of an appreciation-based profits interest or phantom unit, and the terms are similar. Like options, a private-company SAR generally needs to be granted at no less than fair market value, with the payout limited to appreciation from grant to exercise, to stay outside IRC 409A.

Stock options

A stock option gives the holder the right to buy shares at a fixed price, called the exercise or strike price, for a set period. If the company grows, the holder buys at the old price and keeps the difference. For private companies, the exercise price is generally set at or above fair market value on the grant date, which is where a 409A valuation comes in.

Restricted stock and RSUs

Restricted stock is actual stock granted subject to vesting. Restricted stock units (RSUs) are a promise to deliver stock, or its cash value, once vesting conditions are met. Unlike options and SARs, these carry the full value of the share, not just the growth.

Carried interest

Carried interest is the profits interest that private equity, venture capital, and real estate fund managers receive in the funds they manage. The manager shares in fund profits, often around 20%, once investors clear a preferred return. Depending on the fund’s waterfall, that is measured across the whole fund or deal by deal. Under the 2017 tax law, carried interest generally needs a holding period of more than three years, rather than one, to qualify for long-term capital gain rates. In most cases, what counts is how long the fund owned the investment being sold. The concept is the same as a management profits interest, applied at the fund level.

A simple example

Names you’ll hear

The same structure can go by several names depending on the industry, the law firm, or the company. Here is how the most common terms line up:

• +Profits interest: also called incentive units, management units, appreciation interests, or subordinated units
• +Performance units: usually a cash-based, long-term incentive award in a corporation, though some LLCs use the term for profits interests
• +Phantom units: also called ghost units, phantom equity, or shadow stock
• +Stock appreciation rights: also called SARs or appreciation rights
• +Carried interest: also called carry or, in real estate, the promote

The name on the document matters less than the terms inside it. Two plans with the same label can work very differently.

What to know before issuing or receiving incentive equity

Incentive equity comes with financial reporting, tax, and valuation considerations for both the company and the holder.

Financial reporting. For companies that report under GAAP, incentive equity is generally a compensation expense, and how it’s recorded depends on how the award is structured and settled.

Tax. When and how a holder is taxed depends on the structure. Profits interests can receive favorable treatment when set up properly, while phantom units, SARs, and options can raise 409A considerations. Bring in your CPA early.

Valuation. These interests typically need to be valued when granted, and often again down the road. Tax relies on fair market value and GAAP relies on a fair-value-based measure under ASC 718, so one award can be valued differently depending on why it’s being valued. Since these are usually illiquid minority interests, a discount for lack of marketability is often appropriate.

This article is a general overview for educational purposes only and is not tax, legal, accounting, or investment advice. Every plan is different, so talk with your advisors before making decisions. If you don’t have the right team in place, reach out and we can help you build one.

The bottom line

Incentive equity gives companies a flexible way to share future value with the people who help create it. Whether it’s called a profits interest, an incentive unit, a phantom unit, or carry, the key is understanding what the interest actually entitles the holder to and what it’s worth. That matters for owners, holders, investors, and their advisors alike.

ProDelta Advisors helps owners, investors, and their advisors understand, structure, and value equity incentive plans.