Profit Sharing in Lieu of Bonuses & Equity
Yesterday I read a blog post from the CEO of Mercury titled “How I CEO: Why I don't believe in bonuses”. In this blog post he calls out 3 types of bonuses and why he feels these bonuses aren’t in the best interest of the company or the employee.
These are the 3 types of bonuses he discusses in the blog post:
Company-wide bonuses: This is basically that everyone gets a fixed bonus — let’s say 20% — and it's just a thing that the company does (often but not always tied to company performance).
Performance-based bonus: This is usually something that’s happening on top of a company-wide bonus, so maybe it's 20% for everyone and then another 5% on top of that based on a great review or something like that.
Role-based bonus: This a bonus that’s tied directly to the nature of a particular employee or team’s function, like a sales bonus, or maybe a project bonus.
He argues that monetary incentives don’t do a lot to unlock creativity. And that if your goal is to build a company where creativity and innovative thinking are encouraged across roles, that matters a lot.
He proposes this alternative to bonuses:
A better alternative to a bonus-based structure — regardless of the specific type of bonus we’re talking about — is to just give people fair compensation and ownership through equity. This is how you’re going to build a culture where people actually care about doing great work for the sake of doing great work, not just because there’s some monetary benefit attached to it. And equity, I think, is just a lot more long-term and people-building.
Okay, let’s start with where I agree with him.
I completely agree (of course) that people should be given fair compensation.
I also agree that the types of bonuses he outlined aren’t in the best interest of the company or employee.
Here’s where I disagree.
I materially disagree that equity is a lot more long-term and people-building for the following reasons.
Lack of transparency
In nearly all companies, employees don’t have visibility into the # of shares, the breakdown of common vs preferred shares, investor preferences, debt, etc.
There’s no way to tell the true value of your equity at future exit scenarios.
Lack of liquidity
To realize gains from your equity as an employee in a company, there needs to be a liquidity event at a higher valuation than you were granted the shares.
These liquidity events rarely happen and if they do, they usually take 7-10 years. Equity is highly illiquid and most employees depend on cash compensation to support their families.
Pay to play
As an employee, you either have to buy your shares at the current price or you have to pay taxes on the shares that you were granted.
In a lot of cases, this forces employees to stay at companies longer than they want to because they can’t afford to pay to exercise their options if they leave the company.
The solution: Profit Sharing Plans
The bonuses that he outlined in his blog post are mostly arbitrary. They don’t pay out based on any set goal or milestone. And the distribution of these bonuses amongst employees don’t have clearly defined rules. This is flawed.
Bonuses need to have defined rules in place and pay a distribution based on the rules and criteria set forth in the plan. This needs to be established upfront and employees need to have transparency into these rules and criteria.
Most of the time this ends up being a profit sharing plan with minimum milestones that need to get hit in order to trigger a distribution.
The calculation of profit sharing distributions for employees needs to be clearly defined. Most companies use a formula that factors in tenure, salary, role/level, or other similar criteria.
Profit sharing aligns employees with company goals.
Profit sharing is liquid.
Profit sharing is a form of cash compensation that employees can use to support their families.
Profit sharing is not a lottery ticket.
I also think that for most companies, equity just doesn’t make sense. There’s not going to be some crazy exit in the future. The value of the business is in the cash flow.
Interested in profit sharing?
My company ShareWillow is a platform for companies to design, launch, and manage profit sharing plans.
You can sign up for a free trial here.