Profit-Sharing Options: Pros and Cons
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“Profit-Sharing Options: Pros and Cons”
Consider profit sharing as a way to keep employees happy, interested and motivated. Their personal "ownership" of your company will return rewards to everyone. Here we give you profit-sharing choices (other than stock options), and the pros and cons of each.OVERVIEW [top]
Share the wealth. It’s a simple phrase, but it means so much. Employers who let employees share in the success of the company know that employees pay back that investment with greater loyalty, more productivity and expanded creative energy.
"It’s the difference between renting a car and owning a car," says Debra Sherman, marketing manager with the Foundation for Enterprise Development. People take better care of something they own.
But don’t leap directly to "stock options" when you think about a profit-sharing plan. Incentive plans take many forms. What’s the best choice? It depends on your company’s strategic objectives.
In this Quick-Read, we will:
- Examine the reasons and key considerations for having a profit-sharing plan.
- Discuss the pros and cons of different profit-sharing strategies.
Reasons for having a profit-sharing plan:
- Profit sharing makes the link between work and reward. If you are going to ask the most from your employees, they will expect something in return. Increasingly, pay is not enough. A plan that rewards employees with a share of the fruits of their labor draws a direct connection between work and reward.
- Profit sharing helps create a culture of ownership. When employees are rewarded based on their contributions to the company’s success, employees feel like owners. As owners, employees have more incentive to increase the company’s profitability. However, this strategy will work only if the company and its management create ways for employees to understand the company’s challenges and contribute to the solutions. Open two-way communication, flat management structure and employee involvement foster such a culture.
Issues to consider when creating a profit-sharing plan:
- Empower employees to succeed. Employees must be able to make decisions that will have a true impact on their bonus. "It [profit sharing] is not worth much, unless there’s participation in decision making," says Bob Nelson, president of Nelson Motivation Inc. in San Diego, Calif., and author of 1001 Ways to Reward Employees.
- Know your objectives. Before developing a plan, define your objectives. Is it employee recruitment? Retention? Do you want liquidity for your equity? Do you want to boost production? Or perhaps you want a little of everything. The answers will help you choose the right plan for your company.
- Know your industry. Old-economy businesses may have actual profits to share. New-economy enterprises may be years from that, so stock options carry more appeal. If your workforce is young and well-educated, immediate stock awards provide more motivation. Older workers may be more interested in plans geared toward retirement.
- Know the stage of development of your business. At the startup stage, a company may want to protect cash and offer stock options. At a rapid-growth or mature stage, when a company has become profitable, stock-option awards, cash and stock bonuses, or profit sharing become possible.
Various profit-sharing strategies, advantages and disadvantages:
- Performance-based incentives:
Direct cash and bonuses — Employees are paid extra for a certain level of performance, either individually or on a company-wide level. The employer deducts the payment as a business expense, and the employee pays income tax on it. Scanlon plans or gain-sharing plans entail bonuses for teams of employees based on calculated savings/profits that their suggestions produce.
Deferred compensation plans — The employer contributes the bonus to a pension trust and deducts the contribution. The employee pays income tax on the contribution when the money is received from the trust. Research indicates that cash bonus plans are better productivity motivators than deferred compensation plans, presumably because of the immediacy of positive behavior reinforcement (Profit Sharing by Douglas L. Kruse, W. E. Upjohn Institute for Employment Research, 1993).
Stock options — Widely used by early-stage companies in rapidly growing markets. The company gives employees the right to buy shares at a set price during a specified time period. The employee faces no obligation to exercise the option and no financial risk — or actual benefit — until the option has been exercised. Stock-option availability must be offered as a bonus in order to be considered a profit-sharing plan. If availability is equal to all or based on salary, then it is just a perquisite, not a profit-incentive plan.
- Advantages to performance-based incentives: Flexible and relatively inexpensive to implement. May be geared to specific teams or individuals. Vesting schedules can aid retention.
- Disadvantages: Requires more creative management. Employees may see options as less certain than cash. When many companies are offering options, they do little to engender loyalty. They also create a tax liability to employees.
- Broad-based benefits plans:
Section 423 stock-purchase plans — Employees can use payroll withholding to buy a set number of shares, at a discount of up to 15% from market price on a given date.
Non-leveraged employee stock-ownership plans — The company makes annual contributions of stock or cash invested in stock. Fund assets are apportioned by formula among employees and distributed at termination or retirement.
401(k) plans — Such plans offer tax-deferred investment and a potential match of cash or stock by the company. 401(k) plans are profit-sharing plans only in the special case when the employer contribution is on a sliding scale based on company profits.
- Advantages: Best suited to sharing profits or ownership with all employees.
- Disadvantages: Strictly regulated, they may not be used for specific teams or individuals.
- Leveraged employee stock option plan:
A leveraged ESOP uses borrowed funds to buy company stock, which is allocated to employees as the loan is repaid. The sponsoring corporation contributes funds to cover ESOP debt service.
- Advantage: Rewards all employees by creating a retirement benefit with tax benefits for the company.
- Disadvantage: Not suited to providing a performance incentive except to the degree that it makes employees feel and act like owners of the company.
REAL-LIFE EXAMPLE [top]
"I wanted to build a company that treated its employees right and to create a company that I myself wanted to work in," says Sabrina Horn, founder and owner of the Horn Group, a public relations firm with headquarters in San Francisco.
With annual profit sharing, quarterly bonuses, a 401(k) plan with a 20% match, and a chance for employees to share in the public-market-equity valuations of its high-tech clients, Horn’s company has delivered on her dream. Founded in 1991 and since selected to the Inc. 500, the Horn Group is projected to grow 48% in billings to around $9 million this year.
It offers no stock options because Horn has no plans to take it public.
Every year, the company sets a revenue target. Meeting the target — as it has, eight years running — kicks profit back to workers, based on base salary. Payouts range from $750 to around $14,000. Incentive-based quarterly bonuses can add $4,000 to $16,000 more to annual paychecks. When client companies go public, stock taken in lieu of cash is sold, and more than 50% of proceeds go to employees.
Horn says her company’s profit-sharing plans have been critical to improving its hiring and retention efforts.
DO IT [top]
- Meet with a qualified profit-sharing-plan consultant. To find one, contact the Foundation for Enterprise Development (See Resources).
- Get clear on your objectives for the plan. Is it meant to aid hiring, retention, or productivity? Is it geared for everyone or a key few?
- Approach the process with an open mind. Not every company needs to offer stock options. Be creative in structuring your profit-sharing plan to achieve your desired objectives.
- Whatever your inclination, remember that the most effective plans integrate profit or equity sharing with the development of a culture of ownership. That means sharing information with employees, involving them in planning and decisions, and providing them with the education and tools needed to perform their best.
- Monitor the plan and employee participation. As the company grows and its revenue picture and staffing needs change, the plan itself may also need to change.
Gainsharing and Power: Lessons from Six Scanlon Plans by Denis Collins (Cornell University Press, 1998). Collins first describes the experiences of six companies that implemented Scanlon plans. One chapter, “Power Games, Outcomes, and Lessons Learned,” offers conclusions and tips for gain-sharing plan implementation.
Entrepreneur’s Guide to Equity Compensation, 3rd edition, edited by Ron Bernstein. (Foundation for Enterprise Development, 2002).
1001 Ways to Reward Employees by Bob Nelson (Workman Publishing, 1994).
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