Profit Sharing vs. Equity: Which To Offer And Why

In the business world, the choice between profit sharing vs. equity sharing as compensation models can have a huge impact on a company's culture, employee engagement, and, ultimately, long-term success.

Before you jump into this decision-making process, it's crucial to have a comprehensive understanding of both these employee benefits concepts. Profit sharing means sharing a piece of the profits with your team, while equity means giving them ownership stakes.

Both of these methods are powerful tools for inspiring and keeping talented employees. So, if you're ready to learn more about which method is right for your business, then you're going to want to keep reading!

Core Differences Between Equity and Profit Sharing

What is Equity?

Equity is a complex concept that can have a significant impact on both employees and companies. However, in simple terms, it can be a way of giving your employees a slice of the company's ownership pie through stock option plans plans employee stock ownership plans (ESOPs).

It can be a way to motivate and align employees with the company's goal since employees who have equity in a business become more than just workers - they become partners in the business.

Purpose

An equity share comes in several different forms, such as stock options or membership shares. These shares link an employee's returns (outside of salary) to how well the company does. If the company thrives, then employees with equity ownership will also benefit from the company's success when the company is either sold, is able to offer buyouts to shareholders, or can start to pay dividends (it’s worth noting that any distributions are potentially taxed as capital gains).

This helps to create a shared mission within a business where everyone works together to ensure that the business is successful.

Recipients

Usually, equity is given to qualified employees and other people who have a notable impact on the company's direction. This may potentially include founders, top managers, and decision-makers. However, equity sharing isn't only limited to employees.

Most business owners who use an equity compensation scheme also offer an ownership stake to investors who put money into the business or even other companies that they may collaborate with. With this amount of flexibility, companies can foster a culture of shared success.

Frequency

Equity sharing is a way for employees to have an actual long-term ownership stake in the company they work for.

Unlike a profit-sharing model where employees may get regular payouts, equity sharing involves owning a part of the business for a longer period of time. It's also a bit more complex than profit-sharing plans with payouts only coming after liquidity events (often an acquisition or thourgh the company going public).

Companies often use vesting schedules, which means that employees can't just take their equity share and run. Instead, they need to stay with the company for a certain period of time — often tech startups have four-year periods for employees.

If you want to dive a little deeper into the concept of equity in startups, this guide offers a more detailed look at how equity structures work and how to use them.

What is profit sharing?

A profit-sharing plan is a way for companies to share a portion of their profits with their employees. One of the main goals of profit-sharing plans is to incentivize employees and ensure that they have a vested interest in the success of the company.

By implementing a profit-sharing model, companies can communicate to their employees that their hard work directly impacts how well the company is doing. It's a way of saying 'thank you' to workers for their dedication and effort, and can help to boost their productivity - it's a win-win scenario. Plus, any money shared as part of a profit-sharing plan is also tax-deductible.

Purpose

Profit-sharing plans often follow a predetermined agreement or formula, where a portion of the company's profits is set aside to share among employees. It's important to remember that this method is typically used within bigger companies, while equity sharing is more common in small businesses.

This formula gives workers more clarity and provides transparency, making sure that everyone knows how the profits are shared since they're not necessarily a proportionate share among everyone, but can depend on several different factors.

A profit-sharing plan isn't just about rewarding hard work. Rather, it's also about making employees feel like partners in the company's growth and success.

Recipients

When it comes to profit sharing, the profits are usually shared among employees and company owners. This group is generally made up of people who are actively involved in the company's operations and how well it performs.

With this method, profits are very rarely shared with people outside of the company. It's an internal practice that reinforces the idea of working together to boost profitability, motivating employees to put their foot forward.

Frequency

In most cases, companies distribute profit-sharing bonuses either every quarter or every year. However, the specific schedule may depend on the company's financial performance. Profit sharing bonsues can be paid in cash or deffered into 401(k)'s or retirement accounts — learn the difference between profit sharing and 401(k) accounts here.

Whether it's an annual bonus that aligns with the fiscal year or a quarterly boost, a profit-sharing model is a tangible reward for employees who positively contribute to the company's success.

If you're ready to share your success with your employees, then be sure to download ShareWillow’s free Profit Sharing Agreement Template.

Profit Sharing vs Equity: Example Scenarios

Equity compensation tends to attract key personnel who are really willing to invest their efforts into a business for long-term rewards. It's a popular choice for startups who want to put company growth above profits (at least in the beginning). By giving employees an equity share in the business, it helps to encourage them to add to the company's growth.

Alternatively, profit sharing is a lot more appealing for bigger businesses, since it's a direct reflection of its current success and stability. Still, this is only a viable model for companies that are actually making a profit that they are able to share.

Equity Example: Buffer

Buffer is a cash flow positive social media management software company that offered equity to its early employees.

Buffer's journey into equity sharing started during its startup phase when the founders set aside 20% of the company's equity for its team members. The objective of an 'Open Equity' sharing model is to demystify equity ownership and to become an open case study for other entrepreneurs.

The company's open equity-sharing formula is at the center of this model and calculates each team member's stake based on their role, risk layer, and seniority.

The equity compensation program also guaranteed immediate benefits for its employees when it didn't have enough profits to share. For example, if an employee received 0.5% in equity compensation, their potential financial gain in the case of a company sale or the valuation of their shares after an equity raise becomes a little clearer:

• Buffer sells or raises capital at a $30M valuation. Their shares are worth $150,000.
• Buffer sells or raises capital at a $60M valuation. Their shares are worth $300,000.
• Buffer sells or raises capital at a $600M valuation. Their shares are worth $3,000,000.

Now that Buffer is an established business and isn't looking to sell, it has evolved its approach to employee rewards and incentives. Now, the company also embraces profit sharing to help offer a well-rounded strategy to its workers.

Read more: Check out some additional profit sharing plan examples here.

Profit Sharing Example: ConvertKit

Profit sharing at ConvertKit is an integral part of its employee compensation strategy. The company shares part of its profits twice a year, which gives employees a chance to enjoy the benefits of their bonuses much sooner.

According to founder Nathan Barry, ConvertKit's profit-sharing formula has two main components:

• Time with the company (25%): This rewards employees for their loyalty and commitment to ConvertKit. The more time an employee spends with the company, the bigger their share of the profits will be.
• Performance in the last 6 months (75%): The majority of this calculation rests on an employee's recent performance. It's a way to show appreciation and recognition to employees for their efforts.

Since the formula takes both an employee's current performance and long-term commitment to the company into account, it helps to motivate workers to consistently work toward the company's growth.

As a real-world example of how well this method works, ConvertKit has already shared a whopping $3.9 million in profit sharing. And if you're interested to know more about what benefits and perks the company offers its employees, you can check out the ConvertKit handbook.

So Which is Best for Your Company and Employees?

Picking between profit sharing vs company stock options (equity sharing) can be really challenging since the question of which one will work for your business doesn't have a one-size-fits-all answer.

Profit sharing can help with employee retention and team motivation and morale, but it is better for companies that are already well established and profitible.

Equity sharing can be a fantastic choice for small businesses that don't have large profits to share, making it a smarter move if you want to incentivize employees to grow the business as well.

Either way, it's important to take your time to assess your business and implement a plan that will help you to grow.