Profit Sharing is when employees are given a percentage of the company’s profits, some sources consider it a type of retirement plan or a reward system for employees. Fairly common in America, surveys indicate between 19-23% of companies have offered profit sharing in some form since 1963.
There are several different types of profit-sharing plans, different ways to go about them, and they all vary on how they calculate the amount given to employees. It all depends on the industry and size of the business. Essentially, the variations in profit-sharing schemes can be understood by looking at two things: how employees receive their share and how their share is calculated.
One of the models defined by how employees receive their share is the Cash/Bonus Plan where employees receive a cash or stock bonus at the end of the year. This model is fairly simple to implement, however it has a major drawback: taxation. Any cash or stock an employee receives is taxed as ordinary income, meaning the employee actually receives less than intended. This is where the second type comes in.
To avoid immediate taxation a deferred plan can be set up, with a major example being 401k plans. With this plan, shares are held in individual accounts which employees are only allowed to access and withdraw from under certain conditions, for example, for some companies, employees may only begin withdrawing after reaching a certain age.
Two of the profit-sharing plans that are defined by how the share an employee receives is calculated are: ‘straight’ profit-sharing, and ‘hurdle rate’ profit-sharing.
Straight profit-sharing plans are quite common and under this plan all employees are eligible to receive a portion of profits. The share pool is usually generated as soon as profit starts and then a formula is used to calculate the exact amount each employee receives; a somewhat fairer way of calculating portions as each employee would receive the same amount regardless of status.
Hurdle rate profit-sharing, on the other hand, uses a minimum threshold that must be reached before profit is divided up. This plan often distributes higher amounts to employees with higher status under the assumption that they hold higher-impact roles, and have a greater level of experience. A slightly more secure plan, the higher the minimum threshold is set at the less risk to the company, providing of course that the threshold is actually achievable. Generally, the minimum threshold is set on what the company is expected to make (based on business forecasts and the business planning process).
Another option would be ‘complete’ profit-sharing. A method outlined and explained by small business owner on TikTok, Madeline Pendleton, who implements a system where employees vote on what to do with any leftover profits the business makes. Complete profit-sharing could be quite popular with Gen Z small business owners.
Overall, the benefits of profit-sharing far outweigh the negative. It’s a great way for employees to gain a sense of ownership and ensures that employees are encouraged and motivated, increasing productivity which then increases profits.
For small businesses in particular, the practice is ideal as it greatly helps to increase employee loyalty and allows businesses with fluctuating profit levels to share their wealth. This encourages employees when business is good, but doesn’t obligate them or put them in a tough position when times are hard, especially when implementing the hurdle rate plan.
For large corporate businesses or chains, the practice could be difficult to implement and could cause differences in salaries which has the potential to decrease employee’s performance, but when it comes to small businesses profit-sharing can be a particularly attractive option.