Equity Compensation vs Profit Sharing
Written By Ethan King
Whether you are an employer or employee, you have likely discussed ways to increase someone’s compensation, even if you are not ready to give a larger salary or cash bonus.
Maybe you’re thinking about the equity granted to the early employees of Apple and Microsoft. Or maybe you are a small business owner that wants to compensate your employees more, but you cannot commit to upping their salary until you know how the business performs.
Determining whether to offer Equity or Profit Sharing starts with the definitions.
Equity Compensation Defined
Equity compensation grants employees an ownership stake in the company through instruments like stock options, restricted stock units, stock appreciation rights, or employee stock purchase plans. These are non-cash benefits aimed at aligning employee interests with the company’s long-term growth.
Timing and Liquidity
Equity generally vests over time -- usually three to five years -- and will become most valuable during an exit event, such as an IPO, M&A, or when there is a secondary market for shares. Equity keeps employees invested (literally) in the company’s long-term success. If the company’s value grows, so does the value of the equity each employee holds.
Profit-sharing payouts occur more frequently, often quarterly or annually, and are paid as cash or deposited into retirement accounts. Because employees can benefit financially immediately from profit sharing, this form of compensation can boost motivation and collaboration. It is usually used when looking at a short-term outlook.
Pro tip: Companies and their executives must consider what additional type of compensation they would like to offer (if any) to ensure the company attracts the best talent.
Facilitation
Equity plans involve significant legal and tax complexity, including valuation mechanics, vesting schedules, and compliance with securities laws. Think of a multi-page document listing how much your equity is now, what it could be if you held it for five years, and what happens is you leave early, what taxes you need to pay and other legal filing requirements to ensure everything lines up properly.
Profit-sharing plans are simpler to administer but still require clear formulas, compliance with regulations (e.g., ERISA in the US when tied to retirement accounts), and accurate profit accounting. Both the Company and the employee(s) should work with trusted accounting advisors to ensure that all necessary tax documents are given and filed.
Pro tip: Make sure you understand your potential tax and administrative burden before agreeing to a form of compensation in addition to your salary.
Final Thoughts
Choosing between equity compensation and profit sharing depends on the goals of the business and the goals of the employees. To build for the long term, especially if cash is tight, a company may want to offer equity. Other companies may be fearful of giving up ownership control, so the better option may be to offer profit sharing to employees. Even if the goal is long term growth, companies may withhold giving additional compensation to employees until the company becomes profitable.
Ethan King is a business lawyer experienced working with start-ups, nonprofits, consulting firms, and mid-large size businesses in a variety of transactional matters. His experience working in-house provides him with a unique perspective to analyze risk, consider the regulatory environment, understand business strategies, and break down complex legal issues into simple terms.
Ethan has negotiated numerous types of agreements, including, but not limited to consulting agreements, products, software, engineering services, influencer agreements, profit sharing, and more. His office can be reached at (303) 736-9634
