We don’t often talk about employee compensation in the bootstrapped space, as many businesses have few employees, and only start hiring when it’s absolutely necessary. So making sure our employees are properly compensated for their work beyond their regular salary isn’t one of the most prominent themes we have to think about.
In a recent conversation with a founder who is contemplating his first hire, we weighed the employee compensation options that we have in a low-funding, sustainably growing bootstrapped business: equity and profit-sharing.
The common way to have employees participate in the upside of a business is through handing them some kind of ownership, usually in the form of shares. That model is used by all businesses alike, as it’s the traditional approach to incentivize long-term thinking and sticking around with a business. Extensive vesting schedules and retention clauses turn equity-as-employee-compensation into a complicated legal labyrinth.
And then there is profit sharing. In the bootstrapped community, ConvertKit has been a forerunner of this kind of compensation. In fact, CEO Nathan Barry has written a guide about this topic. Profit-sharing programs are usually quite straightforward: any profit that happens beyond a certain amount is shared with the employees of the business. They don’t own the business, but they participate immediately in its success.
Which one would work better for you, your employees, and your business? Let’s take a look at both through the lens of a bootstrapped business.
In particular, I want to focus on incentive alignment. Just like with co-founders, you really need your employees’ goals to be aligned with the goals of the business. For most bootstrapped businesses, that would be sustainable growth, a long-term perspective of making a difference in the lives of a well-defined audience with a critical problem that you can solve reliably.
Equity in a business is relevant in two situations: when dividends are distributed and when the business gets sold. Dividends are tricky while a business is growing, as they are most often reinvested or deferred. As a minority shareholder, employees won’t have much say about if they ever see any money from this, and it wouldn’t be a lot, to begin with. That leaves the exit: the happy event when the business is sold for millions of dollars—a once-in-a-lifetime for most businesses. And then there are options, liquidation preferences, dilution, a lot of taxes, and many legal tripwires.
Equity incentivizes building a lot of value in hopes of a singular, far-in-the-future event at which the employee hopes to get a large amount of money, maybe. That’s a lot of uncertainty, both about the present as well as the future. This results in a number of alignment issues for your bootstrapped business.
Strategic decisions are heavily influenced by the potential long-term yield they might generate. Big bets look enticing, with a lot of upside for the future valuation of the business, but with an equal amount of downside, threatening sustainability goals. The one clear alignment overlap is that employees who are also eventual owners of the business they work for will come up with long-term strategies, as those are much more likely to lead to increased share value.
Multi-year vesting schedules are supposed to strengthen this particular alignment. They force employees to stick around for a long time in hopes that they deserve their slice of the pie after having proven themselves to be “loyal enough.” Complicated legal systems need to be set up to stop them from quitting the day after they receive their shares. To me, this doesn’t particularly yell out “alignment of interest.”
If things go well, the fully vested employee will have helped generate sufficient value to warrant handing over what is effectively a lump-sum payment. But what if their performance was not as stellar? Transferring ownership of an often significant part of the business to someone who burdened much less or none of the risk involved doesn’t sound too good even in the best cases.
Profit-sharing looks much more compatible with the long-term strategy of running a bootstrapped business. In a way, profit sharing is the employee-compensation-version of recurring revenue. Instead of counting on the one big payout, employees are regularly sharing in the profits of the business they work for. Instead of hoping for a future event, profits are shared repeatedly, in short- or mid-term timeframes. Long-term strategies are encouraged just like with equity, but another critical concept is at play here: if you expect to get a profit share every few months, you won’t go for short-term gains that threaten long-term goals, and you won’t set long-term goals that threaten short-term wins either. Your employees will try to generate reliable, sustained upside along the way. They’re working in the present moment, not some nebulous future.
At the same time, there is no singular point in time where the payout is complete in the same sense as fully vested equity can be considered “done.” There will always be more profit to be shared. Long-term employee retention is not a carrot-on-a-stick play; it’s an organic result of a sustained and ever-increasing flow of monetary compensation.
However, Profit sharing isn’t risk-free, so it’s only fair to mention a few issues that it may cause for you, the founder, your employees, and your business.
The world of venture capital has created a legacy of inflated expectations about the value of stock options and owning equity in a business. If candidates expect you to offer equity in some form, they might be less interested in joining your business when you “only” offer them profit sharing, no matter how much more they would benefit from that. Retaining one hundred percent of the ownership in your business might also make you look greedy and over-possessive, particularly when compared to many VC-funded founders who consider sharing equity a necessary evil. Of course, this is a psychological bias, but you will need to be able to address it nonetheless.
The most obvious point of contention with profit sharing is that it will result in less cash in the business. If you distribute profit to your employees, it can’t be reinvested into growth efforts. The perception that this is a problem also stems from the legacy of Venture Capital funding, where growth at all costs has, for the longest time, been regarded as the prime operational principle. In a slow-growing, sustainable, bootstrapped business, sharing the spoils and carefully fuelling growth are not as exclusive as many people might think. It definitely requires everyone involved to adapt to unexpected circumstances, like recessions or severe market disruptions, but sharing profits and growing your business at the same time is a realistic possibility.
I enjoy seeing more and more businesses experimenting with profit-sharing instead of convoluted equity arrangements for employee compensation. In some way, this is not much different from the Shared Earnings Agreement used by Earnest Capital as a means to fund bootstrapped companies without requiring the fund to own shares. Income Sharing Agreements works well on the investor level, and create a lot of alignment between capital and business: profitable businesses pay higher dividends, right here and now. This is the kind of alignment that profit-sharing can create between your business and your employees.
The same kinds of Income Sharing Agreements are being used successfully as a payment method for coding bootcamps, deferring paying for tuition until a student has a full-time job. Moving away from “all-upfront” and “all-immediately-after” towards a time-dispersed approach seems to be a common theme in all kinds of compensation.
Shared earnings, profit sharing, and income sharing all revolve around one core principle: long-term relationships built on mutual trust and the belief that small recurring compensation events are more reliable, inclusive, and empowering than one-off lump sums. Risk is spread out, optionality increased, and alignment is synchronized at any given point in time.
If you’re a bootstrapped founder considering compensating your first employees, consider profit sharing. Equity is a great option too, but by far not the only one. Whatever approach you prefer, make sure it aligns the goals of your employees with the goals of your business. After all, that’s the point of compensation.