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Logically and intuitively, you would think that instituting a bonus or profit sharing plan would be a gesture of goodwill that would do nothing but inspire appreciation and greatness from your employees.  But, in my experience, this can be a very tricky endeavor that requires you to step carefully.

As you dig deeper into thought, you find many questions arise; How much?  What am I rewarding?  Who should be included?  How often should distributions be made?

It seems, many business owners are under the impression that profit sharing plans (sometimes termed bonus plans or incentive compensation plans) are fairly cookie cutter, and that CFOs will be familiar with plans that work and can suggest one.  I would strongly caution you against any advice that tells you that “this is the best plan”.  The truth is, the best plans are customized to the individual business, its goals, its culture, and the desires of the management.  There is nothing wrong with getting the input of your more trusted or intelligent employees.  These employees will give you insight into how to design the plan more effectively.

The typical amount to start with is 25% of profits.  You will need to ensure that you are able to retain sufficient cash for working capital, future investment, debt service, and/or any investors.  After this, you need to consider if 25% will mean anything.  Will it be a material amount to the employees that it will actually mean something?  Will it actually incentivize behavior?  To do what?  Or, at least, will it build loyalty?  Will it reward short-term goals and results, and sabotage the long-term strategic plans of the company? These are just some of the things you will need to work through and make sure you think through carefully.

Personally, I like to see profit sharing distributions on a quarterly basis.  Waiting until the end of the year makes it difficult to tie the rewards to the work done that has earned the rewards.  On the flip side, distributing bonuses on a monthly basis can be an arduous administrative process and can reward very short-term thinking, where one month might show profit and the next might show a loss.  Then what!?  The best plans allow for carryforward of losses to future bonus periods until those losses are made up.  But, be careful with this.  If the losses are not likely to be overcome, or if you have new employees entering the pool who first need to make up the losses, it can kill morale and make you look bad rather than generous and fair.  Best to probably start from zero each year…if one year has losses in the mix.

You should certainly exclude yourself from the profit-sharing.  You can easily adjust your salary to ensure you are compensated fairly, and this will adjust the profits to be shared as a result.

You need to decide who will participate.  Everyone?  Management?  A certain department?  The more transparent and fair you can make the plan, the more you incentivize teamwork.  Some owners like to include everyone.  I don’t necessarily subscribe to that.  I don’t see the benefit in including people who do not have a direct impact on profits or people who are not all that driven by money.  Giving bonuses to people who don’t have much impact on profits or are incentivized by money seems like a waste of money to me.  Save that money.  Design your plan better and give more to the people that have more impact on your business’ profits.

Lastly, be ok with the fact that although you are doing this with good intentions, there will be people that will get upset or feel unfairly treated by the plan.  Don’t let this deter you.  After all, maybe those employees should not be at your company.

I feel very strongly that incentive compensation can be effective.  However, it is only effective for certain people.  And, it has to be in line with the goals of the company, in a healthly balance of both short-term and long-term goals.  Take the time to carefully construct a plan that will work well for your business.

Dan Lucas
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