How To Split Profits In A Small Business Partnership

Splitting your company's income between yourself and your business partners can be tricky. And if it’s not all set up and agreed properly it can strain relationships and impact your success.

In this guide, we’ll look at exactly how to set profit sharing in a partnership. You'll learn how to split business income between partners to ensure you’re building a business that’s set up for long-term success.

Understanding Profit Sharing

In short: Profit sharing in a business partnership is how the profits divided among the business partners or stakeholders. The division of profits is usually based on predetermined rules or agreements.

When profit sharing is in place, each business owner or partner is invested in how well the business does since it will directly affect how much they get out of it through thier base salary plus proft sharing. In turn, this encourages teamwork, provides motivation, and ensures that there is a shared focus on making the business successful.

To better understand how profit sharing works, you first need to know how profits are calculated. In simple terms, the profit is what's left when you subtract all the costs and expenses from the total money the business brings in.

First, you need to figure out the gross profit, which is the difference between all the money the business earns and the cost of making or buying the things it sells.

The net profit goes a step further by subtracting all the other costs like taxes and bills from the gross profit. It gives you more of a complete picture of how well the business is doing financially.

Most partnership business profit sharing agreements will be based on sharing the net profit left at the end of a quarter or financial year. The amount paid to individual partners will depend on your profit sharing agreement (more on that below).

Structuring a Profit Sharing Partnership

1. Understand your type of partnership

Understanding your profit share partnership type is really important for profit sharing since different structures impact how profits are shared. There are three main types: general, limited, and limited liability partnerships.

• In general partnerships, profits and responsibilities are shared equally among business partners based on ownership percentages.
• A limited partnership agreement is one where general partners manage the business and limited partners invest in the business but have limited involvement, which can sometimes lead to different profit sharing agreements.
• A limited liability partnership offers a good amount of flexibility and allows profit sharing based on different factors. These factors may include individual contributions, responsibilities, or a mix of fixed and variable ratios.

2. Set a profit sharing ratio

Once you understand your partnership agreement type, you can work on setting a profit sharing ratio. During this step, there are several factors to consider to find a ratio that works for you, your business partners, and your company.

Partners with varying roles can sometimes establish ratios that reflect their responsibilities. In this case, what you put into the business is what you'll get out of it. For instance, Partner A may get 70% of the profits if they handle most of the day-to-day operations of the business, while Partner B would get the remaining profits (30%).

In some cases, partners may contribute different amounts of capital to the business and can create ratios that are equal to their contributions. An example of this might be when the first partner contributes $400,000, while the other partner contributes $100,000. In this scenario, the first partner would be eligible for 80% of the profits.

Another thing that may influence a profit sharing ratio is when partners negotiate their own unique ratios based on certain considerations. However, it's important to document these terms in the partnership agreement to decide on how profits are shared. When there aren't partnership agreements, all the partners usually divide the profits equally.

3. Create a partnership profit sharing agreement

Coming to an agreement with your partners on how to share the profits of the business is integral to having a successful business partnership. Creating a partnership agreement sets clear rules that every partner is expected to follow to keep the wheels turning smoothly within the business.

In your partnership agreement, you should think about things like:

• Contributions: If someone invests money or assets into the business, you'll need to decide if they will get that money back before you split profits with everyone.
• How you'll split profits: You and your partners need to agree on your profit sharing ratio and decide how to split profits equally and fairly among all of the partners.
• Decision-making: Knowing who is responsible for business decisions and how you'll handle disagreements can help to keep partnerships stable. It can also sway how the profits are divided, since someone with more responsibility may be eligible for a larger share.
• Responsibilities: Make sure to define what each partner will do to manage the business and add it to your profit sharing agreement.
• When profits are paid out: Decide when and how profits will be paid out. In some cases, businesses may choose to reinvest these profits for growth, repay partner loans, or use them for tax reasons.

Set a timeframe for revisiting the agreement

Generally, a profit sharing agreement needs to be revised on a regular basis. To do this, you'll need to agree on a regular review schedule. Typically, reviews are done on a yearly basis.

Yearly reviews of the profit sharing agreement are effective because they allow you to assess and update the agreement to make room for any changes in your business or your partner's duties or circumstances.

Because business landscapes (and even your business partnership) can evolve and change, it's essential to ensure that your profit sharing agreement stays relevant and can adapt to new situations. So, regularly revisiting the agreement can help to maintain clarity and make sure that it continues to reflect the best interest and goals of your business partnership.

If you're ready to draw up your profit sharing agreement, then be sure to download ShareWillow’s Profit Sharing Agreement Template.

Partnership Profit Sharing Example

What exactly does a partnership profit sharing agreement look like? Below, we've created a scenario to illustrate exactly how these agreements work and what they may look like.

In a vibrant city known for its food culture, four friends (Alex, Betty, Charlie, and David) decided to open a restaurant called 'Tasty Bites'. In turn, they pooled their resources and skills together to make their culinary dreams come true.

Ownership stakes:

• Alex (40% ownership): Since Alex is the managing partner. He was the driving force behind Tasty Bites and gave the initial capital to secure a prime location and set up the restaurant.
• Betty (20% ownership): Betty is known as a finance wizard and took charge of managing the restaurant's finances for smooth business operations.
• Charlie (20% ownership): With a background in human resources, Charlie took responsibility for management duties, including managing the employees.
• David (20% ownership): David is passionate about marketing and handled promotions to get feet through the door of the restaurant.

The profit sharing strategy above was outlined by the group based on their ownership stakes and personal contributions.

Profit distribution:

As per their profit sharing arrangement, when Tasty Bites had a profitable year, the group calculated the net profit (total revenue - total expenses) and shared it. The restaurant made $500,000 in revenue in its first year. After deducting their expenses, the net profit was equal to $75,000, and the remaining profits were split as follows:

• Alex: $30,000
• Betty, Charlie, and David: $15,000

Additional considerations:

The group decided that splitting profits annually made the most sense for them. Additionally, at the end of each year, they reinvested a portion of their profits back into the restaurant.

Lastly, they included a clause in their agreement that outlined how new partners could be added if they decided to expand. At that time, they would adjust their agreement to accommodate the new partner's contribution. It could also be worth conisdering whather your profits will be shared as cash (like a bonus) or put aside into a 401(k).

Understand the Stage of Your Business

Understanding the stage of your business is incredibly important when you're thinking about profit sharing. Consider this example: a tech startup with a growth-centered business strategy may not choose to prioritize profitability at the get-go.

In this case, there may be little to no profit in the first few years to share, since it will be reinvested in the business.

However, even if your business is prioritizing rapid growth at the expense of immediate profits, having an agreement in place is a smart business decision. It ensures that when the time does come to share profits, you have a structure ready to share them fairly.

On the other hand, businesses with a different strategy may find profit sharing more relevant straight off the bat. Because of this, knowing where your business stands in its growth journey is key in deciding when an agreement fits into your business plan.