What is Profit Sharing? Your Quick Guide for 2024

There are many ways businesses can create incentives for their employees while also showing appreciation for all of their hard work. For certain businesses, profit sharing can be a great way to do so. It’s a great perk for employees, not to mention a way that can make them more motivated to help the business succeed. 

However, not all businesses understand how it works or how easy it is to set up for employees. That’s why we wanted to put together a guide to explain what is profit sharing and how businesses in all industries and of all sizes can start doing it.

The Profit Sharing Definition

The first question that all businesses should understand is what is profit sharing? 

It’s exactly what it sounds like; it’s employees receiving a portion of a company’s profits for a given time period. It’s a common method used by companies to contribute to the retirement plan and employee benefits. 

This means that employees themselves can’t contribute to the account. There are also restrictions when it comes to employees withdrawing funds from this account without incurring penalties.

Most companies will give out profit sharing once per year, although it’s possible to distribute profits quarterly or in shorter periods of time. It’s important for businesses that consider this to know that it’s a pre-tax contribution. Companies also have the option of giving profit sharing as cash or in the form of company stock. They can also give out a set dollar amount or give out profit contributions based on a percentage of the company’s profits during a particular time period. So what is profit sharing, you ask? It’s a way to share profits among employees, in a range of different ways. 

Is Profit Sharing a Good Idea?

Like anything else, there are both pros and cons to a company creating a profit sharing plan for employees. Each company can decide for itself whether it makes the most sense business-wise and for its employees. The good news is that businesses of any size are able to create a plan, even if the company is already using other types of retirement plans for employees, they are welcome to establish a profit sharing plan too.

The Benefits of Profit Sharing 

The obvious benefit of profit sharing is that it makes employees feel like they are helping themselves by feeling more motivated and working hard for the company. They have a personal investment in the company because if the business brings in more profits, they would conceivably get a bigger share. From the company’s perspective, this can boost productivity. Offering profit sharing can also help to attract employees to the company, potentially making it easier to attract high-quality workers to the business.

In some cases, it can play a huge role in building the culture of a company. Employees will feel like they are all working together toward a common goal because they will all benefit from the company’s success. Instead of clocking in and clocking out, there is an incentive for everyone to succeed. Even if different employees have different jobs, profit sharing helps to put everyone on level ground, helping to create the type of team-first atmosphere (one of the best qualities of good employees!) that is usually good for business.

The Downsides of Profit Sharing

Of course, there can be downsides to profit sharing if companies go about it the wrong way. Company leaders need to understand how profit sharing works and have a clear formula for calculating profits and how they are divided amongst the staff. It’s also critical to overcome any workplace communication problems and for company leaders to explain the profit sharing plan to employees in a way that’s easy for them to understand. They need to understand how what they do can help increase profits and how they can measure the money they’ll receive in the plan. 

If employees don’t have a clear understanding of how the plan helps them, the benefits quickly go out the window. They won’t be motivated to work harder, and they won’t feel like they’re part of a team that’s pulling in the same direction. Even worse, a lack of trust could develop among employees, leading some workers to leave the company while others will simply do the bare minimum with no inclination to help the company succeed.

How do Employees Get Paid on Profit Sharing?

In terms of how employees are paid, the true profit sharing formula can get a little complicated because there is more than one way for companies to do this. 

As mentioned, a business can create a profit sharing plan that gives cash bonuses or stock options. Young companies in emerging markets typically offer stock options as a bonus because they have less cash sitting around and want to entice workers to share in the ownership of the business. Of course, while employees have the option to buy stock in the company at a given price as a bonus, they are under no obligation to purchase the stock.

Profit Sharing Formula 1: Annual 

More established companies tend to work out their profit sharing formula the old-fashioned way: by giving employees a yearly bonus based on the company’s profits. But even in this method, there are plenty of variables. First, the company has to determine how much of the year’s profits will be paid out to employees. There are also several options when deciding how to distribute that pool of money.

Profit Sharing Formula 2: Pro-Rata

Most companies opt for the pro-rata profit sharing formula approach, which means that every employee will receive the same amount. In other situations, bonuses will be based on each employee getting a certain percentage of their base salary as a bonus. That percentage can vary from one company to the next. However, most companies recognize that the percentage needs to reach a certain benchmark in order to motivate employees and get them to buy into the profit sharing plan. In this case, it’s also worth it for management to have a solid contingency plan, should an extreme situation present itself. 

Profit Sharing Formula 3: Role-Based

Meanwhile, some companies choose to distribute profit sharing bonuses based on a person’s role and how much they contribute to the company, meaning some employees will get more shares than others, with each share being worth a certain amount based on how much money is in the bonus pool. In this example, a mid-level manager with two shares will get twice as much as a frontline worker who has just one share. Some companies will take this approach but do it based on age, giving older employees more shares because they are closer to retirement age and more in need of a bonus.

Are Profit Sharing and a 401K the Same Thing?

Profit sharing isn’t the same as having a 401K – they are similar in the sense that both are employer-sponsored retirement plans available to employees. But they are two different types of retirement plans. That and, getting these two mixed up can seriously impact your revenue. On that note, see also the difference between 1099 vs W2 employees).  

With profit sharing, employees receive money from a pool of funds that are based on the company’s profits. With a 401K, employees may defer some of their pay into a retirement account. It’s also common for the employer to match the amount of money that a worker is contributing to their retirement account.

Of course, it’s worth noting that most companies can offer employees either profit sharing or a 401K or sometimes both (‘both’ being a solid employee retention strategy!). Individual companies can decide whether they want to offer profit sharing, a 401K, both, or neither to employees. From the perspective of employees, it’s best to offer both options and let them decide if they want to utilize one or both for their retirement fund. But every business must decide if it makes sense to do one or the other or possibly both.

Connecteam: the Easiest Way Manage Profit Sharing, via Effortless Employee Management

For companies that use a profit sharing formula, software like Connecteam can be the best way to track profits for both employees and company leaders. 

As mentioned, it’s always best for employees to be able to monitor profits so that they can know how much they will be earning as part of the company’s profit sharing. Employees can easily access all of the documentation around profit sharing, updated in real-time, in an online knowledgebase, as well as easily chat about it in private 1:1 chats, group chats or direct communication with HR or their managers. 

As far as maintaining employee engagement goes, profit sharing is one of the most effective ways to encourage motivation, and this motivation doesn’t have to cost anything if it’s communicated effectively. Apps like Connecteam allows every employee to remain engaged, with social-style, trackable updates from management to employees, which is just one way to massively improve staff communication cross-organization. 

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With an app like Connecteam, every employee is kept up to date (and are able to communicate openly) about everything and anything management decides to relay in terms of profits and the bonus they can expect. That helps to maintain transparency and motivate employees to work hard because they will be able to see how their work is helping the company to increase its profits.

But, keeping every employee communicative and on the same page about profit sharing is just the tip of the iceberg that an all-in-one business and employee management tool can offer you: you might be surprised to learn you can easily offload a whole range of other business admin and employee management headaches. Connecteam requires absolutely no training to use, and can be rolled out and ready to use in under 2 minutes!  

With a forever-free plan and a 14-day free trial of Connecteam, get your business management off to the right start!