In this article we’re talking about profit sharing - what it is, how it works and why it can help your small business succeed.
We’ll also look at some common profit sharing structures that small businesses use to drive growth.
What is Profit Sharing?
Profit sharing is simple. It’s when you take a portion of your company’s profits and share them with your employees.
The idea is that when the business does well, everyone shares in the success. For small businesses, this can be a great way to motivate your team and make sure everyone’s working toward the same goal.
And that’s just the thing; profit sharing isn’t just for big corporations. It can be a powerful tool for businesses of any size, including privately owned businesses like yours.
Why Profit Sharing Works for Small Businesses
Employee Motivation
When employees know they can share in the profits, they’re often more motivated to help the business succeed.
It’s a powerful way to boost employee engagement and make sure everyone’s pulling in the same direction. When people feel like they have a stake in the business, they care more about its success.
Attract and Retain Top Talent
Profit sharing can also help you attract and keep great employees. Offering a profit-sharing plan shows that you value your team and want them to benefit from the company’s growth. This makes your business more attractive to potential hires and helps retain your top performers.
Good for The Bottom Line
Lastly, if your team knows their actions can directly impact the company’s profits, they’re more likely to focus on working efficiently and driving growth. So, profit sharing isn’t just good for your employees, it’s great for your bottom line too.
Common Mistakes to Avoid with Profit Sharing
Focusing on Short-term Profit
One mistake that small businesses often make is focusing only on short-term profits. If employees are only rewarded for immediate results, they might make decisions that are not good for the long-term health of the business. This can lead to cutting corners or sacrificing customer satisfaction just to hit profit targets.
A simple way to mitigate this issue is by tying profit-sharing rewards to both short-term and long-term goals. For example, in addition to profit targets, include metrics like customer satisfaction or how well the team meets deadlines and stays productive. This encourages employees to focus on sustainable growth and quality service, ensuring the business thrives in the long run.
Not Setting Clear Goals
Another mistake is not setting clear goals. If your team doesn’t understand how they can contribute to the company’s success, the plan won’t work as intended.
To avoid this, ensure your team knows exactly what’s expected of them. Set specific, measurable goals that tie directly to the company’s success, like improving sales closure rates or customer satisfaction scores.
Break these goals down into smaller, achievable steps or metrics so everyone understands their role and how their work contributes to the bigger picture.
Adjust as Needed
Lastly, it’s important to remember that your profit-sharing plan isn’t a set-it-and-forget-it system. As your business grows and evolves, your plan should too.
Regularly review and update your profit-sharing plan as the business evolves. Schedule periodic check-ins like quarterly or annual reviews to assess whether the plan is still aligned with your business’ goals and team structure.
For example, if your business expands and you add new roles or departments, you may need to adjust how profits are distributed to ensure fairness. Keeping the plan flexible ensures it stays relevant and motivating for your team.
Steps to Implement Profit Sharing in Your Business
Step 1 - Understand Your Numbers
Before you can share profits, you need to know exactly what they are. Make sure your bookkeeping and financial statements are accurate and up to date. If you don’t have a clear picture of your profits, it’ll be hard to build a solid profit-sharing plan.
If you need help getting your financials in order, Avalon Accounting is here to support you. We’ll make sure you have the clarity you need to confidently set up your profit-sharing plan and reach your business goals. Check out the description below for more information on how we can help.
Step 2 - Set Clear Goals
Profit sharing doesn’t have to be based only on profits. You can set other goals like number of new sales closed, improving customer satisfaction or increasing efficiency. Make it clear what your team needs to do to earn their share so everyone knows how they can contribute.
Step 3 - Celebrate Success
When employees hit the goals, don’t just hand out the profit, celebrate it.
You can acknowledge their contributions and show how their efforts helped the business grow. Some people’s appreciation language is words of affirmation, some people prefer gifts!
Adding other ways to give thanks to your team will keep the momentum going and make employees feel truly valued.
Step 4 - Review and Adjust Regularly
Your profit-sharing plan should grow with your business. What works for a small team might need to be adjusted as your business scales. Keep checking in and be open to making changes so that the plan stays relevant and effective.
Examples of Profit Sharing Structures for Small Businesses
Equal Profit Sharing
The first structure we’ll look at is equal profit sharing. This is one of the simplest ways to set up profit sharing. You take a percentage of your profits and divide it equally among all employees.
For example, imagine a small business with an annual profit of $300,000. If the owner decides to share 10% of that profit with the employees, that’s $30,000 to split. If there are 10 employees, each would get $3,000.
This structure works well for smaller teams where everyone’s contribution is pretty equal. It’s easy to manage, and it helps create a sense of fairness. Everyone gets the same share, so it promotes teamwork and unity across the business.
But there are a few things to watch out for. In a business where some employees contribute more than others, this approach might not feel as fair. High performers could end up feeling under appreciated if they get the same payout as someone who contributes less. It’s a simple system, but it may not be motivating for everyone.
Tiered Profit Sharing
Next up is tiered profit sharing, which gives you a bit more flexibility. Instead of splitting profits equally, you divide them based on different tiers or levels. This could be based on seniority, performance, or the role each employee plays in the business.
Let’s go back to our example of $300,000 in profit. You could still share 10%, or $30,000, but allocate it differently. Senior employees might receive 5% of the profit, or $15,000. Mid-level employees could get 3%, or $9,000, and junior employees might receive 2%, or $6,000.
This structure is great for businesses where roles vary significantly, and you want to reward leadership or key performers. It helps motivate employees to strive for higher-level roles and shows that you value those who take on more responsibility.
However, tiered profit sharing can sometimes create a sense of division if employees feel the split isn’t fair. It’s also a bit more complicated to manage than equal sharing, but it does allow you to reward top performers in a way that reflects their contribution to the business.
Goal-Based Profit Sharing
Lastly, we have goal-based profit sharing. This is where you tie profit sharing not only to the company’s profits but also to specific goals or key performance indicators—KPIs—that are important to the business.
For example, you might still share 10% of that $300,000 profit, but employees only receive their share if certain goals are met. These could be individual goals like reaching a sales target, or team goals like improving customer retention. Once those goals are achieved, the profit is distributed based on how much each employee contributed to reaching them.
This structure is perfect for businesses where achieving certain goals is critical to growth, like sales-driven companies or service-based businesses. It aligns profit sharing with the actions that really drive success for the business.
The main challenge with this approach is making sure everyone understands the goals and how to meet them. If the goals are unclear or too hard to achieve, it could leave employees feeling frustrated. But when it’s done right, goal-based profit sharing can be incredibly motivating. It shows employees exactly how their actions lead to success, both for the company and for themselves.
Each of these structures has its strengths, and the right one for your business depends on what you want to achieve.
When to Pay Out Profit Sharing
Regardless of the structure, you have a choice on how frequently to pay out profit to your employees.
End of the Fiscal Year
Paying out profit sharing at the end of the fiscal year is a common approach. It gives you a full picture of the company’s annual performance, ensuring that profits are distributed accurately.
One thing to keep in mind is that waiting until the end of the year may make it harder to keep employees motivated in the short term.
Quarterly Payouts
And for that reason, some businesses opt for quarterly payouts to provide more regular rewards. This keeps employees engaged throughout the year and helps them see the direct connection between their efforts and the company’s success.
Quarterly payouts are a bit more challenging to keep on top of, however. It requires more frequent profit calculations and can be more complex to manage.
After Major Milestones
You can also attach profit sharing to specific company goals or milestones, such as the end of a busy season, hitting a sales target or completing a project. This can help align employee efforts with the business’s key objectives.
Keep in mind, however, if the timeline between milestones is too long, it can lead to the same issues as annual payouts, with employees losing motivation in the interim.
Ensure Cash Flow Stability
Before paying out profit sharing, it’s crucial to check that your business has enough cash flow to cover all ongoing expenses. Profit sharing should never compromise your financial stability.
For this reason, I recommend documenting your profit-sharing policy clearly and including a note that payouts are based on the business’ ability to pay. This helps manage expectations and ensures that employees understand profit sharing isn’t guaranteed if the company’s financial position changes.
And if you’re not sure on the frequency, you can start with annual payouts because it’s the simplest and easiest to manage. It’s easier to start with simple and then make it more complicated only if needed.
Key Takeaways
Why Profit Sharing?
First, profit sharing is a great way to motivate your employees and align their goals with the success of your business. When your team feels like they have a stake in the company’s profits, they’re more engaged and focused on driving growth.
Profit Sharing Structures
There are different ways to set up profit sharing. You can go with equal sharing, which is simple and promotes teamwork. You can use a tiered structure to reward seniority or performance. Or, you can tie profit sharing to specific goals that help the business grow. Each approach has its pros and cons, so choose the one that fits your business best.
Frequency of Profit Sharing
As for when to pay out profit sharing, you can distribute it at the end of the fiscal year, quarterly, or after achieving specific milestones. Keep in mind that annual payouts can leave employees waiting, while more frequent payouts like quarterly or milestone-based ones require more management and regular profit calculations.
Profit Sharing Pitfalls to Avoid
It’s important to make sure your profit-sharing plan is clear, fair, and flexible. And as your business evolves, your profit-sharing plan should evolve with it.
Be sure to document the policy and include that payouts are based on the business’s ability to pay, so employees understand it's not always guaranteed.
Seek Advice from an Accountant
Before you get started, we recommend working with an accountant to set up a structure that works for your business.
At Avalon Accounting, we’re here to help business owners like you understand your finances and reach your goals. So if you’re looking for a partner to guide you through profit sharing or any other financial decisions, head over to our contact page and reach out to get started.
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