June 14, 2017 Business Planning en_US Aligning your business success with employee compensation is tough. An effective profit sharing plan can help you net a win for you and your employees. https://quickbooks.intuit.com/cas/dam/IMAGE/A8CwJD23O/b92273b7c3e2532da1053494f62f52a9.jpg https://quickbooks.intuit.com/r/business-planning/create-profit-sharing-plan-business/ How to Create a Profit Sharing Plan for Your Business
Business Planning

How to Create a Profit Sharing Plan for Your Business

By Eric Carter June 14, 2017

As an employer, you may struggle to align the overall success of your business with the individual interests of employees. A common tool used to achieve this alignment is profit sharing. If you can achieve effective alignment through a profit sharing plan, you may enjoy the benefit of increased employee retention, and more buy-in from employees into the company’s mission.

Profit sharing comes in many forms that vary both across industries and positions. Regardless of the model, profit sharing is typically determined through a formula with components consisting of certain company metrics. Accordingly, an automated system of tracking such metrics and incorporating the metrics into the profit sharing plan is key to avoiding payroll headaches.

Below are some common profit sharing models within specific industries.

Profit Sharing for Agencies and Law Firms

Businesses that bill by the hour have long been known to compensate employees via profit sharing. Consider ad agencies and law firms. Both bill by the hour, and both are famous, or perhaps infamous, for partnership hierarchies. Underlying those notorious hierarchies are profit sharing strategies that compensate employees more lucratively as they bill their way up the partnership ladder.

An old-school formula for calculating profit sharing within the billable-hour/partnership model is based on an employee achieving a billable hour target, and receiving a profit share based on progress towards that goal:

  • 100% of target = 30% of salary profit share
  • 90% of target = 10% of salary profit share
  • 80% of target = 5% of salary profit share
  • <80% of target = no profit sharing

A common prerequisite to payout under any profit sharing model is the business reaching an overall target. For instance, before any payouts are made, the business must achieve a target metric (e.g. operating income, EBITDA, profit, etc.).

In recent years, billable hour-based compensation has come under fire, especially in the legal industry. Many have argued that the model encourages employees to concentrate on billing a certain amount of hours as opposed to delivering quality work.

To combat concerns, many firms and agencies have attempted incorporate other elements into their profit sharing equations— things like tenure, profitability, client satisfaction, business development, personal skill development, etc. Incorporating such elements into a profit sharing formula can be challenging, as some metrics are more measurable than others. Some businesses use a point system to address the challenge:

  • Tenure: one point for each year of tenure
  • Profitability: two points for every dollar* of profit generated
  • Client satisfaction: one point for a positive client rating
  • Business development: one point for meeting a new client generation goal
  • Personal skill development: one point for meeting a personal skill development goal

*”every dollar” could vary depending on the business (every $1,000, every $10,000, every $100,000, etc.)

These points can be arranged or weighted differently with the overarching goal of achieving a profit sharing formula that aligns business success with the highest level of payout to the employee. Below is an example of how these elements might fit into a profit sharing formula:

  • 6 points = 30% of salary profit share
  • 5 points = 10% of salary profit share
  • 4 points = 5% of salary profit share
  • 3 points = 2% of salary profit share
  • < 2 points = no profit sharing

Whether you adopt the old-school formula, the more modern approach, or something in between, certain company metrics are bound to end up into your formula. The more complex the formula, the harder it is to track so be sure to build it into your payroll workflow.

Profit Sharing for Retail Businesses

Unlike industries tied to billable hours, the retail industry has its own set of success metrics that find their way into profit sharing formulas. If you are in retail, your salesforce is likely salesperson heavy and your profit sharing model might look similar to a commission structure.

Profit sharing in a retail environment will most likely be tied to revenue or margin generated through product sales. Before diving into two common retail profit sharing models, it should be noted that profit sharing and commissions are completely different types of compensation. Commissions are typically paid as part of a salary, earned at frequent, consistent intervals throughout the year. Alternatively, profit sharing is paid at infrequent intervals, and is typically not guaranteed since it is often contingent upon the entire company reaching a certain level of success.

Two common models for a sales-focused, retail environment are the net revenue model and a gross margin model.

The Net Revenue Model

In a net revenue model, the profit share is based on a percentage of net revenue from an employee’s sales. In a retail environment where salespeople have no control over product pricing, the net revenue model might be most appropriate. The formula is simple, straightforward, and the salesperson is purely compensated to drive more sales:

(Revenue) * (X%) = profit share

To view this formula in operation, let’s assume you calculate the profit share once a year, based on an entire year’s worth of a salesperson’s sales. If the salesperson makes 2% of the yearly revenue he or she generates, $100,000 in yearly sales generates $2,000 in profit sharing.

Before deploying this strategy, you need to make sure you can afford paying out profit share based on revenue. Revenue does not account for cost of the goods sold, or other business expenses. Consider the example above in light of the costs listed below:

  • Costs of goods: $30,000
  • Salesperson salary: $65,000
  • Other expenses associated with sales: $4,000

When accounting for the additional costs associated with generating the $100,000 in revenue, a $2,000 profit share leaves your business with a loss of $1,000 for this particular salesperson. Accordingly, tracking all of your business costs is key to understanding whether net revenue profit sharing is feasible for your business.

The Gross Margin Model

If your retail business includes an environment where a salesperson negotiates price, it might make sense to use a gross margin model. Gross margin is the revenue generated from the sale of goods, less the direct cost of the goods. The employee’s share in a gross margin model, incentivizes the employee to sell at a higher price:

(Revenue – COGS) * (X%) = profit share

Consider the example used above, where the cost of goods was $30,000. If the salesperson is paid 3% of gross margin, and sells at $100,000, his or her profit share is $2,100. Like the previous example, your company is in the hole if the salesperson sells at $100,000. But, if the salesperson sells the same goods for $102,000, the salesperson’s profit share increases to $2,160, and the company actually enjoys a $840 profit.

This is a perfect example of a profit sharing scenario that aligns the employee’s interests with business success. By incentivizing the salesperson to sell at a higher price, the employee increases profit share while increasing the overall profitability of the business.

Profit Sharing for E-Commerce Businesses

Like retail, e-commerce is sales heavy. However, distinct differences between e-commerce and brick and mortar retail require tweaks to the the net revenue and gross margin models listed above, or an entirely different approach altogether.

The Affiliate Model

In an e-commerce environment, competition is essentially endless. There is no store where you can get in front of your customers at the exclusion of the competition. Further, a consumer can price check your goods and services against every other e-commerce competitor with the click of a mouse. Accordingly, attention and mindshare become of prime importance to an e-commerce business. Out of this environment, the online affiliate model was born.

An e-commerce store can gain attention and mindshare by deploying a limitless force of affiliates to promote products or services. If an affiliate is successful in closing a sale, the e-commerce shop compensates the affiliate for the sale.

The net revenue and gross margin formulas work exactly the same for the affiliate model as they do in the retail model. The key difference is the percentage paid. In some e-commerce set ups, you may be able to afford a much higher percentage rate. For instance, if you are a solopreneuer selling a digital product that costs you nothing to reproduce, a 50% profit share with your affiliates may be perfectly reasonable—your cost of goods is low, no sales person salaries, and other expenses might be low.

On the other hand, if you are selling low margin products, or products that are resource intensive to develop, your percentage may be very low. In either case, the key is to track the metrics applicable to your profit sharing model carefully.

The Equity Model

An alternative model for e-commerce, or any industry, is profit sharing through equity awards or payment rights. You may look to these options in your early years before there are any profits to share. Generally speaking, equity is ownership in the actual company. Founders often give up some portion of their equity (or ownership) to early employees because the funds are not there to compensate well through salary or profit sharing.

The only way an employee can make money through equity is if the company becomes successful to the point of distributing profits to its equity owners. There are many approaches to an equity strategy, but a key point is that giving up equity means giving up control. If giving up control of your company is a problem, you might consider a payment rights strategy.

The Payment Rights Model

Payment rights act like equity from a profit sharing standpoint, but payment rights come with no ownership or control rights. Here’s an example. Let’s say you and a co-founder split the company 50/50. You each own half of the company and you each are entitled to half of the company’s distributed profits.

A talented candidate you want to hire requires a restructured profit distribution in three equal amounts: 33/33/33. You and your co-founder are fine splitting the profits three ways instead of two, but you don’t want to give up your control over the company. Granting the new candidate a payment right of 33% gives the candidate the compensation desired through a right to 33% of any profits shared. However, the payment right comes with no actual ownership or control of the company. The original co-founders keep their 50% control. Payment rights are a creative way to give highly qualified employees significant financial incentives via profit sharing without losing control of the company.

Track Your Metrics

Profit sharing comes in many flavors. The formula that fits your business depends on many factors. The one consistency across all profit sharing formulas is the inclusion of metrics applicable to the success of the business. Metrics must be tracked and easily accessible to successfully evaluate, implement, and execute a profit sharing plan. If you can choose and track the metrics that drive success for your business and enable profit sharing, you may find a win-win for your business and your employees.

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Eric is the founder of Dartsand and Corporate Counsel for a global technology solutions provider. He is a frequent contributor to technology media outlets and also serves as primary legal counsel for multiple startups in the Real Estate Development, Virtual Assistant and Mobile App industries. Read more