Profit Sharing Plan that Really Works for Small Business

Don't do it. Read Daniel Pink's book "Drive: The Surprising Truth About What Motivates Us" to find out why.

I realize that this might not be the answer you're looking for, but based on my own experience as recipient in 2 bonus systems / profit sharing models, I really think it is at best no better than regular pay, and at worst might actually do damage. Wikipedia has a quick overview of the issue:

Academic evidence [..] that performance related pay leads to the opposite
of the desired outcomes when it is applied to any work involving cognitive
rather than physical skill.

In my personal experience, the problems with performance pay are:

• The tendency to "externalize costs". Say you measure only the number of sales closed, then there comes a tendency to bring home marginal sales or bad sales which actually cost the company money to fulfill.

• Erosion of motivation. With performance pay, you're in effect saying that a tiny percentage of the activities of a company are valuable. To some extent people will hear that as "those activities not part of the bonus system are of no value", and that tends to be demotivating.

Instead of profit sharing, Daniel Pink suggests to use:

1. Autonomy – the desire to direct our own lives.
2. Mastery — the urge to get better and better at something that matters.
3. Purpose — the yearning to do what we do in the service of something larger than ourselves.

That said, if you feel a profit sharing model should still be implemented, then I think Jarie Bolander's suggestion is wise.

The best bonus program/profit sharing plan I have ever been involved with was the Days of Pay program.

Essentially, the company would set quarterly target for simple things like sales, growth, profit, etc. At the beginning of each quarter, the CEO would set the upper level target or the maximum we could all get. For example, 7 days of pay.

Next, the plan would monitor the metrics and calculate the days of pay each employee would get. The beauty of this is that everyone gets days of pay -- no one gets more or less. This was a great way to do it because everyone understood what a day of pay meant and it was equal for everyone.

In this program, you could also get something even if you did not meet the maximum days of pay. For example, we would track new product revenue and depending on how good that went, would determine the percent days of pay awarded below the maximum.

I think the main takeaway was that the program had to be simple to understand and be the same for all employees. That way, everyone has an equal stake in making it work.

Sorry, I'll be the spoil sport here. I have owned my own companies for over 30 years and have experimented with all kinds of bonus programs to try to motivate people more. My experience with profit share in a small company was dismal at best. Its like burning your money. If your company is consistently profitable, then, basically, you are just sharing the wealth. A nice thing to do but it is not a motivator. For example, lets take a company that has 100 employees and makes 1 million a year in profit. If their profit share formula is to share 20% of profit, then $200,000 goes to the 100 employees or $2,000 each. Now, say Jack in the warehouse feels motivated to help the company because of his positive perception of the wonderful profit share plan, so he figures out some inventory control system that works great and saves the company an extra $20,000 for the year. So now, profits for the year are 1,020,000. Take 20% of that for distribution and you now get 204,000 for distribution. Jack ends up getting an additional $40 for his year long great effort. Whoopee! Sooner or later, every employee does the math and comes to the same conclusion. They have no real power to affect the size of their own bonus. Motivation drops to zero.

Another problem with profit share in any size company is that Management can foul it all up with one decision. Let's build the Edsel! How about we double the charges at NetFlix? Any bright idea that goes astray can wipe out all the good little things that individual employees might do. Additionally, they usually have to wait a full year to get the bonus and in this instant-gratification society that is far too long to keep them motivated day to day.

I found that if I truly wanted to motivate workers, that I needed to design specific programs for each class of worker. The very short version of this is to identify what it is that that worker does which most contributes to the bottom line, do your math and figure out what they are contributing now and then how much more it would be if they did, say 20% better or more. Design a frequently paid bonus (monthly works best) that pays them about 30% of the extra savings or earnings over and above what they were doing anyway and turn them loose. People are very motivated when you can drill down to the specific act they are performing daily and know they can increase their paycheck for doing better NOW.

It is not as complicated as I made it sound. I have done it for years with every employee in the company ... not just sales and management, everyone, even entry level and all hourly personnel.

I've been wrestling with this at my previous company. I ended creating a compensation pool that is a percentage of profits and then people share ownership in that compensation pool according to their impact, which is calculated taking into account time at the company, level/seniority, and performance evaluation. So this is similar to Michael's model, but more complex from the math standpoint. What was important to me was that people feel that they can leave and profit from their hard work if the company is successful, so once people leave they divest out of the compensation pool over time instead of dropping to zero - this creates a feeling of ownership.

I think the most important thing is that people perceive the model as fair, which is very sensitive to the individuals involved. I discovered that if I am transparent and have the right intentions, people forgive mistakes and allow for adjustments in the future. But this means you really need to be careful about managing expectations. At this point, some friends and I are actually starting a company around this compensation model. I'd love to find out more about your specific situation - feel free to drop me a line.