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Two co-founders and I have started a project that is going rather well. We sell a service that is paid on a monthly basis but that also has some up-front costs (revenues for us).

Thus far we have relied on sharing any 'profit' we make (80% * (revenues - base tech hosting/domain costs)) based on the effort we put in. This is paid out on a quarterly basis. We have very little startup capital and are in no position to pay proper salaries, so profit-sharing seemed fair enough.

Now as we begin to grow, when does the profit-sharing model start to break down? If we either grow enough to afford salaries, or find investment should we eliminate profit sharing all together and opt for assigning salaries to the founders and future employees?

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Continuing the model of sharing profits can and should continue. What will need to change is your model for calculating profits.

You don't want "profits" walking out of the company when you have R&D, marketing, design, development and talent costs. As your revenue grows the percentage you are taking out should go from 80% down to something reasonable. Maybe 10-15%?

You have very little start-up capital, so you will need to bootstrap with the revenue generated by the company. develop a realistic budget that calculates a profit line distinct from 'gross margin' -- and plan your company's growth!

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Very well put Joseph, thank you. Any recommendations on how to gradually reduce the % of profit shared (from 80 to 10) while at the same time (presumably) introducing actual salaries (thus increasing costs and reducing the profit to be shared)? – Daniel Gill Feb 6 '12 at 12:19
And just to clarify your distinct 'profit' and 'gross margin' lines: [profit = company profits = all revenues - all costs incl. salaries?] [gross margin = all revenues - some base costs (not incl. salaries)?] – Daniel Gill Feb 6 '12 at 12:37
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In general yes. Depends on the business model of course. Sometimes the costs of specific salaries may be included as a cost of goods. But for your purpose the current cost base tech hosting/dmiain costs are certinally in the cost of good. So revenue - those cost of good would be your gross margin. Don't profit share off of gross margin. – Joseph Barisonzi Feb 6 '12 at 17:19
Right, so in this case I should be profit sharing a shrinking percentage of the gross margin (80% now, but hopefully shrinking quickly) – Daniel Gill Feb 6 '12 at 18:01
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Fundaementally that is correct. Right now you are pushing 80% of your gross margin into the profit line. You need to gradually increase your General Administrative costs to include the development of a real business: marketing, R&D, advertising, salaries, legal, office. . . . This will push the profit down as a percentage of gross revenue. The division of profit sharing can stay the same among the owners. – Joseph Barisonzi Feb 6 '12 at 20:25

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