What is a fair way to distribute profits to employees in exit scenarios?

You've worked hard to build your startup and attract venture capital funding. Now, you're ready to exit and reap the rewards of your efforts. But how do you share the profits with your employees who helped you along the way? In this article, we'll explore some of the common methods and challenges of distributing exit returns to your team.

1 Equity and options

One of the most common ways to reward employees for their contribution to your startup is to grant them equity or options. Equity gives them a direct ownership stake in the company, while options give them the right to buy shares at a predetermined price. Both equity and options can increase in value as the company grows and becomes more attractive to potential acquirers or public markets. However, there are also some drawbacks and complexities to consider, such as the dilution of your own stake as you raise more rounds of funding, the vesting schedule and cliff that determine when and how much employees can exercise their options, the tax implications and liquidity issues of holding and selling shares, and the alignment of interests and incentives between founders, investors, and employees. These potential drawbacks must be taken into account when deciding how to reward your employees with equity or options.

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Anuraag Guptaa

Founder of CEOs Gurukul | Board Member | Mentor-Investor | President & CEO | Listed Unicorn, Pre-IPO Soonicorns | Harvard Business School | MBA-NYU Stern, LSE, HEC | Author Igniting Minds with a Million Views
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A fair distribution of profits to employees during exit scenarios hinges on transparent and equitable criteria. Implementing a well-defined Employee Stock Ownership Plan (ESOP) ensures that employees who've contributed significantly to a company's growth are rewarded. The distribution should consider factors like tenure, role impact, and individual performance. It's essential to communicate the plan's structure clearly to all employees, maintaining transparency about how the benefits are calculated. This approach not only rewards contributions fairly but also fosters a sense of ownership and alignment with the company's goals, encouraging continued dedication and excellence from the team.

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Soorya Ramanj

Co-Founder of Maharh | Head of Finance & Strategy at Renaissance Holdings | Talking about Innovative Indian startups one post at a time!
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Equity & options are still one of the most common ways to distribute profits to shareholders! It is one of the best if not the best way to compensate someone for their work!

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Sagar Agrawal

Founder at Qubit Capital | Investment Banker | Helping Startups Raise Funds Globally
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Distributing profits to employees in exit scenarios can be done fairly through equity and options plans. From my experience, granting stock options or shares to employees aligns their interests with the company's success. When an exit event occurs, those holding equity or options can benefit from the financial gains. This approach is equitable as it typically rewards employees based on their role, tenure, and contribution to the company. It's important to have clear, transparent policies about how these are allocated and the terms under which they can be exercised. This method fosters a sense of ownership among employees and rewards them for the company's success.

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2 Bonus and profit-sharing

Another way to reward employees for their performance and loyalty is to pay them a bonus or a profit-sharing scheme. A bonus is a lump-sum payment that is usually tied to specific milestones or achievements, such as hitting revenue targets or launching a new product, while a profit-sharing scheme is a percentage of the company's profits distributed to employees based on a formula or policy. Both bonus and profit-sharing can provide immediate cash incentives and recognition to your team; however, they also present some challenges. For instance, the variability and unpredictability of the company's profits and cash flow may create a trade-off between reinvesting in the company's growth and distributing profits to employees. Additionally, there may be questions of fairness and transparency when it comes to criteria and process for allocating bonus and profit-sharing, as well as the retention and motivation of employees who may prefer long-term equity over short-term cash.

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Soorya Ramanj

Co-Founder of Maharh | Head of Finance & Strategy at Renaissance Holdings | Talking about Innovative Indian startups one post at a time!
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Bonus is added on when the equity gets taken care of, so make sure you actually understand the way the compensation structure is designed!

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3 Phantom stock and SARs

A third way to reward employees for their participation in your startup is to offer them phantom stock or stock appreciation rights (SARs). Phantom stock is a promise to pay employees a cash amount equal to the value of a certain number of shares at the time of exit, while SARs only pay the difference between the strike price and the exit price of the shares. Although these methods can mimic the benefits of equity without diluting your ownership or creating tax liabilities for employees, there are drawbacks such as complexity and cost of administering and accounting for phantom stock and SARs, as well as legal and contractual obligations and risks. Additionally, there may be potential conflicts and confusion with existing equity holders and investors, as well as lack of voting rights and dividends for employees who hold phantom stock and SARs. Ultimately, you must consider all factors when creating a fair system that aligns with your vision and values, so that your employees can celebrate the success of your startup.

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Soorya Ramanj

Co-Founder of Maharh | Head of Finance & Strategy at Renaissance Holdings | Talking about Innovative Indian startups one post at a time!
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This might not be the best way to compensate them for their hard work! So make sure you understand the nuances & downside of each compensation structure

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Sagar Agrawal

Founder at Qubit Capital | Investment Banker | Helping Startups Raise Funds Globally
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A fair method to distribute profits to employees in exit scenarios is through the use of phantom stock and Stock Appreciation Rights (SARs). Based on my experience, these instruments are beneficial as they offer the financial benefits of stock ownership without actually issuing company shares. Phantom stock mirrors the value of real stock and pays out upon certain events, like an exit, while SARs provide employees with a bonus equivalent to the increase in stock value over a set period. Both options align employee interests with the company’s performance and provide a tangible reward for their contributions, without diluting equity.

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4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What is a fair way to distribute profits to employees in exit scenarios?

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3

4

1 Equity and options

2 Bonus and profit-sharing

3 Phantom stock and SARs

4 Here’s what else to consider

Venture Capital

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What is a fair way to distribute profits to employees in exit scenarios?

1

2

3

4

1 Equity and options

2 Bonus and profit-sharing

3 Phantom stock and SARs

4 Here’s what else to consider

Venture Capital

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