Is Profit-Sharing Right for Your Small Business?
Profit-sharing? You want me to share my hard-earned profits with people who haven’t invested any capital in my company? Yes, perhaps. Profit-sharing can increase employee productivity and morale while decreasing turnover, among other benefits. Here's a look at whether this strategy could work for your small business.
Ins and Outs of Profit-Sharing
According to the National Federation of Independent Business, there are generally two types of profit-sharing plans: You give employees monthly, quarterly, or annual bonuses based on company performance, or you contribute to an employee retirement plan. Each has its pluses and minuses.
One reason to offer profit-sharing at your small business is “to get everyone in the company aligned to the same goals,” says Michael Jacobs, a professor at the University of North Carolina’s Kenan-Flagler Business School. “When employees benefit as the company benefits, then everyone is pulling in the same direction.”
According to the U.S. Department of Labor, other benefits of profit-sharing plans can include tax-deferred earnings (if monies are kept in a government-sanctioned retirement plan); improved employee morale, teamwork, and productivity; and a greater ability to attract and retain talent. A 2003 study shows that companies offering profit-sharing plans had only 4 percent employee turnover per year, compared with 16 percent at companies that did not offer the incentive.
However, profit-sharing is not right for every business. “It depends on the nature of the business, on the type of employees, and on the education of the employees,” Jacobs explains. “Not everyone is motivated by money. Some people are risk-averse and might prefer a higher salary, others are motivated more by recognition [of their efforts].”
The first sign that your business may be ready for profit-sharing, he says, is if your employees are motivated by financial rewards.
Incentives and Business Goals
“People do what you incent them to do,” Jacobs says, which means you have to be sure your profit-sharing incentives are properly aligned with your business goals.
He cites an example of an automotive-repair business that offered financial incentives mechanics based on the shop’s revenues. The result reflected poorly on the business, because mechanics began recommending unnecessary services to customers, who were turned off by the aggressive repair and maintenance regime.
“That damaged their brand and their reputation,” he notes.
Meanwhile, when profits fail to meet expectations, employees may feel discouraged. “We used to have ad hoc bonuses and profit sharing,” says Jim van Iwaarden, a consulting actuary with Van Iwaarden Associates. “That didn’t work well. It came to be viewed as an entitlement and created resentment when bonuses and profit sharing were smaller than usual.
Instead, Van Iwaarden Associates now puts a “fixed and large percentage of each year’s profits into a bonus and profit-sharing pool, and it’s gotten everyone pulling in the same direction,” he says.
A Few Best Practices
Before you implement a profit-sharing plan, you’ll want to consider everything from which employees will be eligible (and to what degree) to who will manage any funds placed in a retirement account. You may want to consult a professional fund manager.
Meanwhile, keep these best practices in mind:
- Select a profit-sharing program that rewards the behaviors you aim to encourage.
- Be transparent about your company’s financial information with employees.
- Set clear, realistic expectations about what the company must achieve to merit the release of profit-sharing funds.
- Clearly explain what employees must do to benefit from the program and for how much.
- Prepare for a lot of government paperwork and oversight if you choose a regulated plan.