With the introduction of the MARE to the small business world, many employers have questions about what the tool does and does not provide. The MARE includes phantom equity and profit sharing tools that provide both long and short-term employee incentives. This blog post focuses on the phantom stock component.
Designing Your Profit Sharing Calculator
Step 1: Determine the size of your company’s profit sharing pool
The first step in calculating and allocating profits for each employee is to take a broader view of your business finances and decide on the size of your overall profit sharing pool. While a common pool size ranges from 5% to 15% of annual profits, every company is different. Some factors to take into account include your company’s general financial health, short and long term business goals, and, of course, your actual net profits.
Step 2: Decide which employees are eligible for profit sharing
Some businesses allow all employees to participate in company profit sharing plans. Some gate profit sharing for certain seniority levels or titles. Other popular eligibility requirements include a condition to meet certain performance metrics or be employed at a given company for a certain length of time before enrolling in their profit sharing program. The most important aspect of this step is to define clear eligibility criteria, regardless of what those criteria are.
Step 3: Establish your profit sharing distribution formula
Similar to eligibility requirements, your company’s profit sharing distribution formula will vary based on a variety of factors. Common inputs include job levels, tenure, and even age of individual employees. However, the most common approach to standardizing a formula is to allocate shares of the profit pool based on each eligible employee’s salary. This is called a pro-rata plan, and it’s the one that is most commonly used within the MARE.
Example Formula
The default MARE profit sharing formula is:
Annual profit sharing pool divided pro rata based on relative salaries
Here’s an example of how that might play out at a small business:
Company A has net annual profits of $500,000. The company’s owner decides to allocate a profit sharing pool of 5% of the company’s annual profits, which amounts to $25,000.
The owner wants to enroll three employees in Company A’s profit sharing plan. They spend a total of $160,000 on annual compensation for these three employees. The employees’ salaries are the following:
- Sarah: $45,000
- Alex: $50,000
- Chris: $65,000
Here is how each employee’s profit sharing allocation would be calculated:
- Sarah: ($25,000/$160,000) X 45,000 = ~ $7,000
- Alex: ($25,000/$160,000) X 50,000 = ~ $7,800
- Chris: ($25,000/$160,000) X 65,000 =~ $10,000
In the above example, each employee receives an annual profit sharing bonus equal to approximately 15% of their compensation.
While a pro-rata salary-based formula is the most popular option with small business owners, the MARE also allows for custom performance or milestone-based profit sharing formulas.
