EMPLOYEE OWNERSHIP: CASH NOW OR CASH LATER?
“Is rewarding my employees with company stock better than profit sharing?”
This is a question that comes up a lot when we talk to founders, owners, and executives considering alternative ownership.
First off, if you are thinking about ways to share ownership and financial rewards with your employees, we applaud you! The share of national income generated by labor has dropped almost 10% over the last twenty years, while capital’s share has grown. Sharing business ownership and profits with employees are both effective ways to address wealth inequality and its negative consequences for individuals and society. It is proven that companies that share ownership and profits with employees have higher engagement which leads to higher retention, productivity, and innovation.
Vehicles for sharing ownership with employees include:
STOCK-BASED VEHICLES:
Employee Stock Ownership Plans (ESOPs) in which workers hold individual share accounts. Stock is held within qualified retirement plans until workers reach retirement age and/or leave the company, then vested stock is redeemed at fair market value.
Stock Options and Employee Stock Purchase Plans (ESPPs) in which workers can opt to buy a number of shares at a fixed or discounted price for a defined number of years.
Restricted Stock Units (RSUs), in which select workers can buy or receive shares as a gift once certain performance targets are hit.
Phantom Stock and Stock Appreciation Rights (SARs) in which workers do not hold stock, but instead receive a bonus for the increase in stock value.
PROFIT SHARE-BASED VEHICLES:
Worker Co-ops, in which workers hold voting member shares. When there is profit or “surplus” workers receive “patronage dividends” paid in a combination of deposits into individual accounts (internal cash reserves held by the coop) then a vested portion gets paid when workers leave the coop, and annual profit sharing (by law, at least 20% of patronage must be distributed directly as cash).
Employee Ownership Trusts (EOTs) in which workers do not directly own shares. Rather, company stock is held long-term in a trust for the purpose of providing ongoing benefit to those actively working in the company, typically through cash profit sharing. There is flexibility in how the profit-sharing is designed; this could be formula-based, or paid out at Board discretion.
Given all these options, why might a company choose to do simple cash profit-sharing with employees vs allocating company stock?
BENEFITS OF STRAIGHT CASH PROFIT SHARING:
1) Profit Sharing allows more choice and flexibility for a diverse workforce
Companies with a diverse workforce have more divergent compensation needs and preferences across the workforce. Imagine the young employee on the shop floor just out of high-school saving for college or a down payment on a first home (most Americans’ single biggest asset), vs a senior manager who is 10 years away from retirement and focused on maximizing a conservative savings portfolio. These two employees might have very different views about receiving company stock as compensation, especially stock that has restrictions on redemption or transfer, such as an ESOP which is paid when you retire or leave the company.
Cash profit-sharing bonuses provide employees with greater flexibility by allowing individuals to determine how to best use the cash compensation they receive – be it paying down high-interest debt, and/or building wealth through making investments that suit their personal financial goals.
2) Profit Sharing recognizes that what is most “tax-efficient” varies from person to person
One downside of cash bonuses is that they may increase individual tax liability. However, this varies greatly by individual circumstance. In some cases, the added tax might be minimal compared to the savings (for example, from paying down high-interest debt) or earnings (through compounding interest) made from the use of the bonus cash. The company can help those looking for tax deferral options by allowing employees to allocate some or all of their bonus into a qualified retirement plan such as a 401K. Employers can also direct some or all of a profit sharing plan directly to a company 401k plan.
3) Profit Sharing often leads to more optimal asset diversification
Receiving company stock as compensation can be a great motivator, as employees who receive stock now have “skin in the game” and benefit from company growth and profitability. Of course, when company performance falters, the stock value can also go down. This poses less of a challenge for employees who have a longer career runway in front of them, but can be challenging for those who are nearing retirement and have a significant portion of their retirement nest egg in the basket of company stock. ESOPs have a solution to ameliorate this: after age 55, qualified employees can elect to diversify into another qualified retirement plan. Cash profit sharing offers even more flexibility for employees to diversify their investments. The recent rise in roboadvisors and online brokerages has made it easier and less expensive than ever for individuals to take control of their own portfolios, and cash can be used for other hard asset investments such as real estate.
HOW STRAIGHT CASH PROFIT SHARING CAN BENEFIT EMPLOYERS:
1) Profit Sharing can reduce cost and complexity
The administrative requirements of employee stock plans can be burdensome, as they are regulated by the Department of Labor Employee Retirement Income Security Act of 1974 (ERISA). Setting up individual stock accounts, determining qualification thresholds and vesting schedules, conducting regular stock valuations, and planning for repurchase obligations can be a lot to manage. In fact, many ESOP companies hire third-party firms to manage aspects of these duties as required for annual valuations.
Conversely, profit sharing plans can be fairly simple, administered through payroll, and flexible in design. For example, some companies such as John Lewis Partnerships in the U.K. determine the annual bonus based on total workforce payroll, so all employees receive the same percentage cash bonus on their annual base pay. Others, like Organically Grown Company, base profit sharing on a formula that favors tenure and hours worked, in addition to base pay.
2) Profit sharing may be more suitable for small companies
Due to administrative and compliance requirements, as well as the buy-back obligations tied to employment, employee stock plans may not be suited for smaller companies with fewer than 20 employees. Size does not similarly impact the ease of administering profit sharing.
3) Profit Sharing means you ”pay as you go” versus creating future obligations
The logic of stock plans is that the value will appreciate over time and that someday the employees will cash in their shares. When this happens, the company will either need to generate the cash to buy the stock back or find investors to buy the stock. Some call this the “stock buyback treadmill.” In essence, this stock is equity on the books, but it is also a hidden future liability. Phantom stock and SARs can create similar challenges in that they are not necessarily tied to real money in the bank.
With profit sharing, cash is shared with employees once it has already been earned by the company. Once paid, there is no future underlying obligation. Typically, it is up to the company leadership and Board to determine how much of company earnings to retain and how much to payout. In some companies, especially EOTs or co-ops, there might be a predetermined formula in which profit or dividends are shared.
4) Profit sharing creates a tangible connection between the work and reward
Another benefit for companies (and employees too) is that cash profit sharing may feel more tangible to employees than a unit of stock. Cash profit sharing is often paid out on a more incremental time scale such as quarterly or annually, and it has a clear current value, as opposed to stock, which might be worth an unknown amount in the future. As one employee noted, “It’s cash in the wallet versus a piece of paper.” As such, profit sharing might be a better tool for incentivizing improved work performance and driving results, rather than retirement contributions, which may seem further removed from today’s work.
Conclusion
Profit sharing and employee stock plans are not mutually exclusive. There is no reason why companies cannot look at a blend of both in order to take advantage of the benefits of each tool in motivating and rewarding employees.
