Pros & Cons of Profit Sharing
- Completion time About 15 minutes
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
- 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.
- 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