Every person responds to incentives, and aligning employee incentives with the overarching goals of the business is one of the best ways to mobilize and motivate the team to grow the company. By tying compensation to company growth, employees tend to display higher levels of loyalty, productivity, initiative, and creativity. Traditional high-growth startups use mechanisms such as Employee Stock Option Plans (ESOPs) to accomplish this outcome. ESOPs are fantastic for these companies, because they are a way to incentivize employees without siphoning any revenue or profits the business might need to continue its high-growth trajectory. Additionally, ESOPs can use cliffs and vesting schedules to ensure that employees do not take a significant stake of the company without contributing to its growth.
As a private company, there is one catch to ESOPs: employees cannot make money on their stock if the company never has a liquidity event (i.e. a merger, acquisition, or IPO). Without the possibility of a liquidity event, the incentive structure suddenly breaks down and company founders are giving up equity in their company without a subsequent return on investment through increased productivity and initiative. This problem arises quite frequently in small businesses and other companies where the founders want to retain full control over the company through the long-term. Fortunately, there are other methods of tying employee compensation to company growth that do not involve exchanging equity, and profit-sharing is one such method that many companies use.
Types of Profit-Sharing
Generally, there are two types of profit-sharing plans, with the first being comprised of bonuses given over certain time intervals (usually annually) and the second being a type of employee retirement plan.
Employee Retirement Profit-Sharing Plan
The employee retirement profit-sharing method, also known as a deferred profit-sharing plan (DPSP), can be set up through your company’s bank. The plan involves deciding upon a percentage of net income amount to contribute to your employees’ accounts, but the company has the option not to contribute if, for example, it is unprofitable that year. How that percentage is determined is discussed below, but for DPSPs, as of 2022 the contribution limit may not exceed the lesser of 100% of an employee’s compensation or $61,000 ($67,500 including catch-up contributions). Additionally, the amount of an employee’s salary that can be considered for a profit-sharing plan is limited to $305,000.
Bonus-Based Profit-Sharing Plan
By distributing profits as bonuses, companies set aside a certain portion of profits according to a formula and designate whether the percentage of profits is before-tax or after-tax. These bonuses are usually distributed on an annual basis, but some firms distribute on a quarterly or monthly basis. More frequent payouts have the advantage of increasing employee identification with organizational goals and reinforcing employee involvement, but the disadvantage of being unpredictable in volatile product and market cycles.
How Profits are Allocated
As the name would suggest, profit-sharing is almost always calculated as a percentage of net income. Some firms use revenue as the determinant instead, but this is quite rare because promising a percentage of revenue does not require that the business is already profitable to distribute this additional compensation whereas using net income as the determinant makes profitability a prerequisite. Some companies take this a step further by requiring that a minimum profit threshold has been reached and then distributing the gains above this threshold once it has been exceeded.
The question then arises: how do you decide who gets what percentage of profits? There are two common ways of approaching this aspect of the profit-sharing plan. The first method involves establishing ‘tranches,’ which are generally defined by employees’ levels in the organization. For example, perhaps partners split 30% of shared profits, senior managers split 40%, and so on. The second and most common is called the comp-to-comp method. In the comp-to-comp method, an employer calculates the sum of all its employees’ compensation, subsequently dividing each employees’ salary by that total. This percentage, for each employee, is then multiplied by the amount of total profits being shared.
Company XYZ has two employees, with employee A earning $80,000 per year and employee B earning $100,000 per year. The company shares 10% of annual profits with employees and has earned $100,000 of net income in the fiscal year. Each employees’ annual bonus is calculated as follows:
Employee A = ($100,000 * 0.10) * ($80,000 / $180,000) = $4,444.44
Employee B = ($100,000 * 0.10) * ($100,000 / $180,000) = $5,555.56
Why not have each employee take the same percentage?
Often, companies that entitle every employee to the same percentage of the profit-sharing pool find that this structure incentivizes freeloading in which less productive workers reap the benefits of the business growth produced by more productive workers. This can create a sense of unfairness and demotivation among the company’s most productive employees, stifling growth in the long-term. For this reason, a proxy for employee contribution to the business’s growth such as level in the organization or salary, is almost always used to determine each employee’s payout.
Fortunately, profit-sharing can be structured to include practices common in ESOPs that avoid over-rewarding employees who leave the company after only a year or two. Profit-sharing plans can ‘vest’ over time by starting an employee out at a lower percentage of the total profit pool, with that percentage increasing each year up to a predetermined cap. Companies can also incorporate ‘cliffs’ into their profit-sharing plans by establishing the policy that employees are not entitled to profit-sharing payouts until they have worked for the company for a certain period of time. These ‘cliffs’ can be prorated, meaning that employees who work for the firm longer than the predetermined period of time receive rewards for that period after it is exceeded.
To best implement a profit-sharing plan, it is crucial to speak to a legal or HR professional to understand the rules involved with doing so, such as the requirement not to discriminate in favor of highly compensated employees. Additionally, profit-sharing plans should be continually updated and revised periodically to adapt to changing employee expectations, new market conditions, and evolving strengths and weaknesses of the business.
Pros and Cons of Profit-Sharing
Motivates employees beyond their salary amounts without giving up equity in the company
Easily integratable with other employee incentives (for example, the retirement option can be enacted concurrently with other retirement options such as 401K)
Provides an opportunity to train employees on financial measures and operational behaviors and strategies that affect those measures
Compensation is given from profits, so there is low financial risk to the company
Enhances productivity, loyalty, initiative, and creativity in employees
Provides employees with improved financial prospects, especially in companies where a liquidity event is unlikely
Can be demotivating if the company is unprofitable
Profit can be too broad an objective to focus employees on specific behaviors that lead to organizational success
If employees focus solely on maximizing profit, they may suffer from short-termism and make decisions that undermine the long-term health of the company. Profit is not the only financial or non-financial measure that can be determinant of a business’s success so it is paramount that all employees consider multiple KPIs and stakeholders when making business decisions
Reduces disposable income that could be reinvested into the business
For small businesses and other companies in which management is not aiming for a liquidity event, profit-sharing is a viable alternative to employee stock option plans and other equity-based compensation models. By correctly administering profit-sharing plans, companies can motivate employees to go the extra mile while also improving their financial outcomes.
Another interesting article useful to both potential investors and potential employees. Thank you.