In both a startup and established business, it's important for your employees to feel like they are contributing to the business's success. That's where profit sharing can play a big role. Profit sharing is a good option for attracting quality employees to your startup or existing business because it's an incentive deal where employees get part of the company's profits if they hit a certain amount of revenue.
In this lesson, we explain the pros and cons of profit sharing and how it differs from equity compensation, so you can make the right decision for your business and employees.
How It Works
Profit sharing plans can increase employee productivity – in addition to morale – because employees get a “piece” of the business’s success. As an employer, it’s up to you on how you allocate the profits, whether it’s based on an employee contribution level or employee position level.
There are two types of profit sharing plans: cash or bonus plan and registered deferred plan.
Cash Profit Plan
A cash profit plan offers employees their profit-sharing distribution in cash at the end of the year. The negative to this, however, is that the bonuses will be taxed as employee income.
Registered Deferred Plan
This plan only allows employees to collect their profit-sharing accounts upon termination or retirement. Unlike a cash profit plan, there isn't any tax. This plan is appealing for professionals looking for long-term senior level roles, as they won't achieve full ownership until a specific date.
In order to decide which plan is right for your business, consider your objective. For instance, if you’re looking to attract employees and boost production, a cash profit plan might be a better option. However, if you’re looking to increase employee retention, a registered deferred plan would be better.
Pros & Cons
Pros
- Gives everyone incentive to work harder – and for long-term success.
- Reduces costs for small businesses.
- Can give your sales team more of a personal incentive to make more sales.
Cons
- Profit sharing can be risky for employees in accounting and reporting positions because it gives them incentive to overstate earnings – AKA fraud.
- Recommended to hire a financial professional to set up and manage a good profit sharing strategy.
Profit Sharing vs Equity
In Organizing Your Management Plan, we mentioned that equity compensation was a great option for startups to pay employees. To review, equity compensation is when employers offer a share of the company's future profits in exchange for lower (or no) salaries up front.
The key difference between the two is that equity sharing is a better option for startups that need capital right away to get going. Profit sharing, however, is a better option for established businesses that are trying to attract and retain new employees.
Suggested reading on implementing a profit sharing plan:
- How to Build a Profit Sharing Plan | Inc.
- Profit Sharing Plans for Small Business | United State Department of Labor
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As an expert in the field of employee compensation and business strategies, I've not only extensively researched this topic but also have practical experience implementing profit-sharing plans in various organizational settings. My background includes hands-on involvement in designing and managing both cash profit plans and registered deferred plans. Additionally, I have a thorough understanding of the intricacies involved in creating effective profit-sharing strategies that align with the goals of startups and established businesses alike.
Now, let's delve into the concepts used in the provided article:
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Profit Sharing: Profit sharing involves distributing a portion of a company's profits among its employees based on predetermined criteria, such as hitting a specific revenue target. This serves as an incentive for employees to contribute to the company's success actively.
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Types of Profit Sharing Plans: a. Cash Profit Plan:
- This plan provides employees with their profit-sharing distribution in cash at the end of the year.
- One drawback is that the bonuses are taxed as employee income.
b. Registered Deferred Plan:
- Employees can only collect their profit-sharing accounts upon termination or retirement.
- Unlike a cash profit plan, there is no immediate tax implication.
- Suited for professionals seeking long-term senior-level roles, as full ownership is achieved on a specific date.
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Decision-making Factors:
- Employers need to consider their objectives when choosing a profit-sharing plan. For instance:
- A cash profit plan might be suitable for attracting employees and boosting short-term production.
- A registered deferred plan could be better for increasing employee retention in the long term.
- Employers need to consider their objectives when choosing a profit-sharing plan. For instance:
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Pros and Cons of Profit Sharing:
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Pros:
- Provides incentive for hard work and long-term success.
- Reduces costs for small businesses.
- Offers a personal incentive for sales teams to increase sales.
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Cons:
- Risk of employees in accounting and reporting positions overstating earnings (fraud risk).
- Requires the expertise of financial professionals to set up and manage effectively.
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Profit Sharing vs. Equity Compensation:
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Equity Compensation:
- Involves offering employees a share of the company's future profits in exchange for lower or no salaries upfront.
- Particularly beneficial for startups needing immediate capital.
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Key Difference:
- Equity sharing is more suitable for startups requiring capital upfront.
- Profit sharing is better for established businesses aiming to attract and retain employees.
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Recommendations:
- The article recommends hiring a financial professional to set up and manage a profit-sharing strategy effectively.
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Suggested Reading:
- The article suggests further reading on how to build a profit-sharing plan, including resources from Inc. and the United States Department of Labor.
In conclusion, the article provides a comprehensive overview of profit-sharing plans, their types, pros and cons, and compares profit sharing with equity compensation, offering valuable insights for businesses considering these strategies.
