Drafting a Profit-Sharing Agreement Effectively
In this article, you will learn more about the concept of a profit-sharing agreement, its benefits, provisions, steps for implementation, and its limitations.
Businesses can only survive if they are making enough profit to sustain their operations. In today’s era, it’s essential to recognize the role of revenue sharing objectively. Profit-sharing is one concept that helps two separate companies run a business together without forming any new company. It is always a project-based deal between two companies.
The term “profit-sharing” means distributing the amount of money earned during the operations of any business or entity. It can also be termed as revenue sharing among the company owners, employees and shareholders.
What is a profit-sharing agreement?
A profit-sharing agreement is a contract between two different companies who work together for a similar purpose within a certain period of time. It is also referred to as an incorporated venture, where the companies remain as they are and do not merge as one company. The companies bring different values and skills to each other. Therefore, both are responsible for the division of profits and risk involved while working together. Before entering the partnership, the parties must be aware of the ratios they will use to distribute the profits and how they will spread the losses. Once the terms and conditions are mutually understood by both parties, they can enter into a profit-sharing agreement.
Benefits of Profit Sharing Agreement
Entering into a profit-sharing agreement with another company can bring many benefits to both parties. Profit-sharing resolves the conflicts between the management and provides more apprenticeships to other partners and clients. One approach might be risky, but if the operations run smoothly, both parties can get the benefits and have a better future in terms of revenue. Here are some benefits of a profit-sharing agreement.
- Easy Formation – Just like a sole proprietorship, it is easier to form a partnership. The partnership is easy to form as it involves fewer legalities, and it also helps the partners be more at ease while setting up the goals and ventures.
- Capital Invested – It’s extremely important to decide the ratio of the capital to be invested. When two parties contribute in the financial resources, it is easier and quicker to raise funds for operational costs and business expansion. The combined effort helps to strengthen the business.
- Diversity in Skills and Expertise – Partners tend to share the responsibilities of managing and operating the business. It helps set up goals and manage the entire direction of the project, which helps increase the chances of success. Having two minds in the business can be beneficial for both parties.
- Percentage of Revenue is more remarkable than fixed interest – Revenue sharing always takes a percentage of gross revenue investment to avoid a fixed interest rate debt. If the partners have months of low revenue, their business is less affected.
- Simplicity – Profit-Sharing removes the complexity of equity. The owners become the creditors, and it gives a clear direction for sustainable growth and generates results. It is quite significant when the terms are not complex and are straight to the point.
Important Provisions of Profit Sharing Agreement
The profit-sharing agreement should include equity payments if the current business is operating. This is based on certain objectives which have to be followed by both partners. There are some provisions that must be taken into consideration before entering into a profit-sharing agreement.
A profit-sharing agreement typically imposes limitations on what each partner may do with business assets. It also outlines what one should do if any of the partners pass away. For example, stipulate in the agreement that the remaining partners have the first option to purchase the remaining piece of the business from the deceased partner’s estate. In the agreement, there might be restrictions on the estate that limit the estate’s engagement in the business.
One holds the right to impose constraints on how the remaining partner liquidates the company and divides the earnings. The profit-sharing agreement typically contains the following clauses:
- Profit-Sharing – Provisions should be explicit beforehand in the document about the profit calculation, the timeline in which profit will be shared, how and when the profit will be received.
- Termination – Termination includes the aspects in which parties can terminate the profit-sharing agreement.
- Dispute Resolution – If there is a dispute between the parties, it is essential to have a dispute resolution clause that brings together the parties to chew over the matter before making any claim. It helps to mitigate the risk of prolonged dispute under the contract.
- Confidentiality – Everything should be kept confidential in the clause.
- Indemnities and Liabilities – If there are any issues in the agreement, indemnity and liability clauses outline to which extent each party will be liable.
Steps for Implementing a Profit-Sharing Agreement
Initially, both the parties put forward their opinions and expectations from the partnership. The most crucial step in putting together a good profit-sharing plan is to have a clear vision of what you want to achieve with it. Profit-sharing arrangements are typically set up as a retirement benefit. Companies with an older workforce will benefit from this type of profit-sharing scheme. In a delayed profit-sharing scheme, you can get more people to participate.
Here are the steps to be followed while implementing the agreement:
- Document All Details – The agreement should include information from both partners; the document includes each partner’s details, personal accounts, identity cards, address proof, income tax statement, and assets.
- Specify Investment Amount – Each partner is liable to pay some amount of money initially, which is called an initial investment payment. The further contract is based on that particular criterion where both parties decide the amount of money to be invested during the implementation of the project.
- Clarify Revenue Sharing – Remember to clarify the amount of money that will be distributed among the partners. Revenue sharing can take the form of a profit-sharing system in which each entity is reimbursed for its contributions.
- Set Terms and Conditions– Terms and Conditions can include: the ratio amount invested, information on both parties, and other relevant information that needs to be outlined in the agreement. Once both parties agree and finalize the terms and conditions, it can be put into place once it is approved.
- Be Clear with Payments and Distribution – Profit shares might be distributed immediately, or at a later time, Profits are currently distributed to employees in the form of a lump-sum payment or business equity. Profit shares may be paid into a managed fund from which employees can draw later in deferred payment programs.
- Binding Effect -The contract between both parties acts as a binding effect. The binding effect comes into action only when both the parties approve and are satisfied with the contract terms. The binding effect can be alternated as many times as per the requirement.
- Modifications and Waivers – Modifications can be made initially according to the needs of the party. According to the Revised Uniform Partnership Act, partners can alter their partnership agreement at any time with the unanimous permission of all partners. These measures that require a unanimous decision have the impact of amending the partnership agreement.
- Further Assurance – Assurance can be made if both the partners give some mortgage, but it is not essential.
- No Agency Relationships – No third party can be involved in this agreement. The inclusion of any third party is highly prohibited, and if any of the partners include a third party, that partner involved might lose the partnership.
- Be Clear on the Execution of Each Party – The two partners might have a different perspective on how to run the business. Remember to set boundaries on which party handles what aspect of the business.
- Entire Agreement – The entire agreement has to be checked by both partners before actually signing it. The partners hold the accountability of checking all the aspects and they can change it as many times as they want before signing it legally.
- Consent to the Jurisdiction – Make sure to make the agreement with the consent of certain high courts of that area.
How does a profit-sharing agreement work?
Once a pool has been established, a distribution formula is made. It is a written plan that sets up a trust to hold the plan’s funds and creates a method for keeping track of the activities.
- Responsibilities are Divided – When a partnership is formed, the parties usually know how much responsibility each partner has.
Partner A and Partner B, for example, create a block. Partner A is in charge of the majority of the small business’s day-to-day operations. The partnership agreement is created to indicate that “Partner A shall get 70% of earnings and Partner B shall receive 30% of profits each year” due to Partner A’s increased responsibilities. Partners might select how to split profits based on their responsibilities.
- Contribution to the Partnership’s Capital – When joining a partnership, partners have the option of contributing as much or as little capital as they wish. One partner will frequently contribute more than the other. If this is the case, the partner may want to split profits proportionally to his contribution.
Suppose Partner A invests $400,000 and Partner B invests $100,000. In that case, the partners could include a condition in their partnership agreement that states, “Partners must distribute profits depending on the proportion of capital in the partners’ capital accounts on the last day of the year”. Partner A would receive 80% of the profits, while Partner B would receive 20%.
- Factors in Combination – The profit-sharing ratio might be any figure agreed upon by the partners. This implies the partners can consider the two key elements and develop a profit-sharing balance that benefits both parties. This is how the partners split the profits as long as the terms are agreed upon and in the partnership agreement.
Partner A, for example, invests $400,000 and is responsible for the majority of the partnership’s decisions. Partner B invests $100,000 but does not give anything in terms of partnership responsibilities. The partners can agree that Partner A will earn 10% of profits while Partner B will receive 90% or vice versa.
Limitations of Profit-Sharing Agreement
The profit-sharing agreement has its own pros and cons. We have already discussed what benefits this contract can bring to the parties, but there are also some limitations. Understanding the basic loopholes also enables the partners to make wise decisions while signing the contract. Here are some basic limitations of the profit-sharing agreement:
- Uncertainty of Profits – Profits are never guaranteed. A variety of factors, in addition to personnel, are responsible for a company’s profitability. Yields may be influenced by demand and supply economic considerations, government policies, and other reasons. Despite the most significant efforts of the staff, profitability may be minimal.
- Manipulation of Profits – Management may engage in account manipulation. By undervaluing closing stocks or inflating expenses, profits may not be fairly represented. This frequently leads to conflicts between employees and management.
- Dispute among the Partners – Sometimes conflicts might be made between the partners when they cannot see any progress in the project.
- Loss of Investment – Due to uncertainty, there might be chances that both the partners lose out the capital, which may lead to termination of the agreement.
Example of using a profit-sharing agreement
Two investors running two different businesses came up with an idea to start a new cafe on a profit-sharing agreement. Both of them decided to invest capital of the same amount along with basic assets (space, furniture). Both of them have decided to share the revenue after cutting the operational costs. This should be outlined in a profit-sharing agreement so that both parties have documented the split and know when they receive their profits. The amount of money that they will share will be 100% of the total revenue where both the partners will get an equal split which is 50% each. The further decision will be taken based on the operations of the business.
Profit-sharing agreement vs. 401k: How are they different?
A profit-sharing agreement is a contract between two partners doing a project together to share the profits earned, whereas A 401(k) plan is a tax-advantaged retirement savings plan that is offered by many American companies. It is called after a provision of the Internal Revenue Code of the United States.
When employees enroll in a 401(k), they agree to deposit a portion of each paycheck directly into an investing account. The employee has a variety of investment options to select from, most of which are mutual funds.
A profit-sharing plan is wholly supported by the company, with no payment from the employees. Profit-sharing contributions are optional and depending on the company’s profitability. Both schemes have limitations, according to the Internal Revenue Service (IRS). Both types of plans adhere to the IRS age-based penalty and distribution requirements.
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