Profit sharing and equity share ownership are two very different types of employee compensation, but both can be used to encourage employee performance and retention.
That’s about where the resemblance ends.
Equity compensation provides company shares in lieu of or in addition to a salary, giving recipient employees an actual ownership stake in the company.
Profit sharing, on the other hand, distributes a portion of company profits to qualified employees using a company-determined formula.
Here’s where some folks start to get confused: Profit sharing can be paid in equity — but in most cases, it’s paid in cash, not shares. (Anyway, it’s still profit sharing, and not equity compensation.)
If you’re reviewing options for incentivizing and rewarding productivity and profitability, read on to learn more about the most important differences between these in-demand employee benefits.
Profit Sharing Vs Equity Share Ownership
Employee compensation usually comes in a combination of salaries or wages, bonuses, commissions, and benefits — and it can also come with equity compensation. For some employees, equity can be an attractive option that encourages high-level talent to join a team and stick around for a while.
What is Equity Share Ownership?
Equity offers are typically used to boost the value of a compensation offer by including partial company ownership as non-cash payment. This increasingly popular compensation strategy can help new or startup businesses attract highly qualified, experienced professionals, especially for key executive, leadership, and/or mission-critical positions. Startups often look to equity as a way of building a strong leadership bench with limited cash resources. Likewise, mature businesses can use it to encourage their top talent to stick around.
So equity share ownership can help attract and retain high-level, proven talent. How? For their equity to deliver value, they need to do two things:
- Hold the company stock for a period of time
- Achieve business results that increase share prices
Equity compensation is often negotiable and subject to vesting — but every equity compensation agreement is unique between that employer and employee. Employees can also get the benefit of lower capital-gains tax rates, rather than regular income tax rates, if they wait to sell their shares.
Equity compensation is not the same as a stock option plan, yet another type of compensation that allows employees to purchase shares in specified quantities for a limited period, at a reduced price.
What is Profit Sharing?
Unlike equity compensation, profit sharing isn’t tied in any way to an ownership stake in the business. But because a company can choose to tie profit sharing to business performance, profit-sharing plans incentivize and reward behaviors that help the company succeed and grow.
When a company is profitable, it can choose what to do with the profits:
- Reinvest in the company
- Share with investors in the form of a dividend payment
- Share with employees
- Any combination of these options
Profit sharing happens when the company chooses to share with employees. As mentioned above, a company can choose to make profit sharing payments in equity as long as employees’ proportional payouts follow the profit-sharing allocation formula. Companies can also make profit-sharing payouts as cash bonuses or tax-deductible qualified plan contributions (up to IRS contribution limits).
Would Your Employees Rather Receive Profit Sharing Payments or Equity Share Ownership?
Trick question! The answer is probably both, but maybe not equally for everyone, because they really are apples and oranges.
Can you offer both? Sure. Should you? Most business owners have an idea about who among their employees has the entrepreneurial potential to effectively share equity ownership and accountability for the company’s continued success or failure.
But if your interest is in establishing a wider, shared culture based on ownership thinking, equity compensation isn’t your only option.
An employee stock ownership plan, or ESOP, provides a way for owners of privately held companies to broadly extend beneficial ownership stakes to employees. ESOPs enable owners to sell shares of their company stock for full fair market value, and allocate those shares proportionally among employees.
What is an ESOP?
An ESOP is a flexible business transition tool, a vehicle for employee ownership, and a qualified retirement plan. Business owners can access liquidity — as much or as little as they want or need, up to 100% — with tax advantages both to the seller and the company. Employees earn a tax-deferred retirement plan balance without having to make an employee contribution — a benefit with proven recruiting and retention value.
An ESOP can be a powerful way to control your business legacy, reward loyal employees, and enjoy your own business equity, instead of waiting for a third-party sale and the uncertainties it can bring. Learn more about the benefits of making an ESOP part of your business exit strategy with our free ebook.