How Do You Set Up a Phantom Equity Plan?

Setting up a phantom equity plan is more straightforward than most business owners expect. Here's the full process.

Step 1: Decide on your business's total unit pool

The first thing you need is a number: how many phantom units exist in total? This is arbitrary — 1,000, 10,000, 100,000. What matters isn't the absolute number but the percentage each grant represents. A useful approach is to decide what percentage of a future sale or profit you're willing to allocate in total (e.g., 10%), then set your unit pool based on that.

Step 2: Define your payout formula

How will the value of each unit be calculated at payout time? Common approaches include:

Percentage of sale proceeds: Each unit represents X% of whatever the business sells for.
Profit-based formula: Each unit is worth a share of annual profits above a defined threshold.
Owner-set valuation: The owner sets a hypothetical value annually and units are worth a fraction of that.

The formula needs to be clear and written down. Vague language creates disputes.

Step 3: Choose your vesting schedule

Vesting determines when units become "earned." The most common structure for small businesses is:

1-year cliff: No units vest in the first year. If the employee leaves in month 11, they get nothing.
Graded vesting over 3–4 more years: After the cliff, units vest monthly or annually until fully vested.

A 1-year cliff + 3-year graded schedule (4 years total) is a standard starting point. Adjust based on how long you typically expect to work with someone.

Step 4: Define your trigger events

When does the payout happen? Common triggers include:

Sale of the business
Annual profit milestone
A specific calendar date
Employee reaching a certain tenure
Owner-declared liquidity event

You can combine triggers. Many plans pay on a sale or on death/disability of the owner, for example.

Step 5: Draft the grant agreement

Each employee who receives units needs a written agreement. This document should include: their name, number of units, grant date, vesting schedule, payout formula, trigger events, and what happens if they leave before vesting (forfeiture clause).

This document is legally binding. You want it to be clear, not long.

Step 6: Issue the grants and track vesting

Once the agreement is signed, you need a way to track which employees have which units, how many have vested, and what the projected payout is at different valuations. A spreadsheet works for 2–3 employees. Once you're beyond that, a purpose-built tool is worth it.

Step 7: Communicate with employees regularly

The plan only motivates if employees understand it. Share an annual update showing their current vested units and what those would be worth at your hypothetical business valuation. This keeps the incentive visible and real.

Do you need a lawyer?

For a straightforward plan with a small number of employees, a professionally designed template agreement — properly reviewed — is often sufficient. For more complex situations (multiple classes of units, large employee pools, or unusual payout structures), a business lawyer who has handled deferred compensation is worth the investment.

A note on Canadian businesses specifically

Phantom equity in Canada is treated as employment income at payout, deductible by the employer. There are no securities law requirements triggered by phantom equity — it's a contract, not an investment instrument. That said, the agreement should comply with provincial employment standards and, in some cases, be reviewed by someone familiar with the Income Tax Act. See our article on Phantom Equity and Taxes in Canada for more detail.