Sharing Profits, Not Equity
When I worked for large companies, the concept of profit sharing was limited to the upper echelons of the organization generally in the form of annual bonuses that were mysteriously calculated, paid 3-5 months after the end of the year and reserved for the “fat cats” in the organization! The individual contributors, clerical and shop/line employees were never eligible; they were the “mice”!
As the CEO of the company you purchase, you can rectify this imbalance and craft a compensation system that is right for all levels of company, and let everyone be recognized for their effort on payday. Figuring out the best way to “give back” some of your profits to employees will result in a loyal and engaged workforce.
Wait until you have profits
The first rule for profit sharing is: no profit = no payouts. Sounds simple, but “effort” is not enough, net income is what counts. Use earnings after interest and before taxes. EBITDA is for the PE firms to work with, not for paying cash bonuses to employees. Of course, if there are losses, you cannot expect employees to accept loss sharing; they will understand that they get nothing. In my own company we targeted 10% net earnings for distribution, but we never communicated an exact formula; it was just too complicated and fraught with misunderstandings in trying to explain GAAP accounting principles. We even used the same formula when the business was sold to distribute a portion of the selling price.
The second rule is to pay out distributions quarterly, as close to the end of the quarter as possible, as soon as the books are closed for the last month. Employees react much more favorably when they don’t have to wait for an annual payout; after all, they have immediate bills to pay and dreams to spend it on. Yes, there are always some end-of-year accounting adjustments but not worth waiting for, given the benefit from having 4 opportunities to celebrate during a year.
Pay attention to how you make the payments
On payday, provide employees with a separate “profit sharing” check; not everyone wants to have their payment combined with their weekly paycheck…don’t ask why! Consider paying 2/3 in cash and directing the balance to employee’s 401k savings plan. Over the years, these accumulate along with employee and employer contributions to safeguard their retirement. Working for the entire quarter is a requirement for eligibility, so new employees get their first distribution after their first full quarter with your company.
Now for the most unusual element of the system—all employees get the same amount, regardless of seniority or pay level. That’s right, the sales manager gets the same as the second shift clerk. The rationale is that everyone contributed to the success of the company for the quarter, and salary levels account for skill and competency but not for “effort”. Seniority can be rewarded separately with longer vacation time allocations and perhaps a step-level contribution to health care benefits. Individual performance is the basis for merit based pay increases. This puts your money where your mouth is – every team member matters.
Employees understand this profit sharing approach, see its fairness and can see that new orders, cost reductions, pay raises, and even layoffs all have an impact on their quarterly profit sharing check. I found it to be a great way to reinforce an “ownership” culture.
Hold equity dear to your heart
Sharing equity at the business you buy is problematic. You are not running a high-tech “start-up”, nor a company that will soon go “public”. Employees are not putting their cash into the company like your investors have done. Vesting systems have a way of keeping the wrong employees longer than they should. Valuing the company is expensive and fraught with distrust.
Equity may be the “currency” that drives you, but don’t assume that it is at the top of your employee’s list. Equity is not liquid, won’t pay their bills and most front-line employees would much rather see cash in their pocket than some form of “percentage” of ownership.
At your executive staff level, a performance bonus system can be developed that rewards results based on specific personal and company performance objectives and paid out annually, tied with budgets and goals. This cash based system will aid in recruiting and motivating your direct reports.
Over a period of years, this profit sharing system will result in a loyal workforce and employees who are aligned with the business objectives of making a profit, every quarter, and sharing the profits equitably. It allows you to put any bad quarters quickly behind you and stay focused on the future. Don’t tweak it much. When there is an exit, consider what contribution the employees made to reaching that objective and reward them appropriately.
The autonomy and independence that you have as a business owner gives you the freedom to design your own performance reward systems. However, doing so comes with significant responsibility. Tread carefully! I learned that there are two things dear to employees’ hearts that must be thought through very carefully from their perspective and not mine—their pay, and their lunch break!
Feel free to share some of your own best practices or experiences in dealing with these issues in the blog comments. I encourage comments and dialog, allowing all to learn from both my views and the views of others – a virtuous learning cycle. Jump right in! I regularly update individual blog posts, add to the Reference section and Search tips, so visit the www.jimsteinsharpe.com website regularly.
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