Profit Sharing: An incentive based compensation
program to award employees a percentage of the company's profits.
How does Profit sharing work?
The company contributes a portion of its pre-tax profits to a pool that
will be distributed among eligible employees. The amount distributed to
each employee may be weighted by the employee's base salary so that
employees with higher base salaries receive a slightly higher amount of
the shared pool of profits. Generally this is done on an annual basis.
Advantages
- Brings groups of employees to work together
toward a common goal (the success/benefit of the company).
- Helps employees focus on profitability.
- The costs of implementing the plan rise and
fall with the company's revenues.
- Enhances commitment to organizational goals.
Disadvantages
- The pay for each employee moves up or down
together (no individual differences for merit or performance).
- Focuses only on the goal of profitability
(which may be at the expense of quality).
- For smaller companies, these plans may result
in drastic swings in earnings for employees which the employees may
find difficult to manage their personal finances.
- Adherence to the FLSA requires employers to
recalculate each worker's "regular rate" of pay. To
overcome this limitation, employers may restrict this type of
compensation to exempt employees.
Stock Options: The ‘right’ to purchase stock
at a given price at some time in the future. Stock Options come in
two types:
- Incentive stock options (ISOs) in which
the employee is able to defer taxation until the shares bought with
the option are sold. The company does not receive a tax deduction
for this type of option.
- Nonqualified stock options (NSOs) in
which the employee must pay infome tax on the 'spread' between the
value of the stock and the amount paid for the option. The company
may receive a tax deduction on the 'spread'.
How do Stock options work?
An option is created that specifies that the owner of the option may
'exercise' the 'right' to purchase a company’s stock at a certain
price (the 'grant' price) by a certain (expiration) date in the
future. Usually the price of the option (the 'grant' price) is set
to the market price of the stock at the time the option was sold. If
the underlying stock increases in value, the option becomes more
valuable. If the underlying stock decreases below the 'grant' price
or stays the same in value as the 'grant' price, then the option
becomes worthless.
They provide employees the right, but not the
obligation, to purchase shares of their employer's stock at a
certain price for a certain period of time. Options are usually
granted at the current market price of the stock and last for up to
10 years. To encourage employees to stick around and help the
company grow, options typically carry a four to five year vesting
period, but each company sets its own parameters.
Advantages
- Allows a company to share ownership with the
employees.
- Used to align the interests of the employees
with those of the company
Disadvantages
- In a down market, because they quickly become
valueless
- Dilution of ownership
- overstatement of operating income
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Rules
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