Start-ups and businesses often want to collaborate with other businesses or individuals. In such situations, sharing profits from the collaboration can be a great way of incentivising both parties to ensure the project succeeds. In order to set up this kind of collaboration, you should always enter into a formal profit-sharing agreement. This article will explain when a profit-sharing agreement can be used and how it can benefit both parties.
What is a profit-sharing agreement?
A profit share agreement is a contract between multiple parties where a service provider is entitled to receive a share of the profits from a project or task in exchange for its contributions. This is different from a usual services agreement which usually compensates a service provider through a fixed fee or an hourly rate. It is also different to a commission agreement, which traditionally rewards the service provider through a percentage of the total sale value (ie, the ‘gross’ amount), as opposed to profit (ie, the ‘net’ amount).
When is a profit-sharing agreement used?
There are a lot of situations where a profit-sharing agreement is used, but we can separate them into two broad categories:
- Where a business collaborates with another business in relation to a project and they decide to share profits between them;
Example: EasyBooks is a SaaS platform for accountants. They reach an agreement with a large accounting firm called AccountantsRus for AccountantsRus to hold an event at their offices and invite all of their networks to test out EasyBooks. In exchange, EasyBooks agrees to pay 30% of the profits generated at the event to AccountantsRus.
- Where a business incentivises an employee or other staff member by promising them a share of the profits (whether from a specific project, certain customers or even all of the trading activity of the business).
Example: Chelsea is the general manager of EasyBooks, but she does not own any equity in it. The founders of EasyBooks want to retain her and incentivise her, but unfortunately, they cannot offer her equity at this time. EasyBooks decides to give Chelsea a 10% profit share from any profits of the business so long as she continues working.
What are the pros and cons of a profit-sharing agreement?
A profit-sharing agreement has a lot of advantages to founders, particularly ones running with small budgets. We will focus on a few of them here.
Firstly, a profit-sharing agreement is a great way to align the service provider’s interest with your success. Since the service provider’s remuneration is based on profit, they will want to ensure that the project or business is very profitable. This is materially different from someone getting paid a fixed fee or an hourly rate, who have no direct interest as to whether the project or business succeeds.
Secondly, profit-sharing carries less risk than traditional remuneration methods or even commissions. Commissions are usually calculated based on gross sales, which means that you essentially carry the risk of any expenses or unforeseen costs. A profit share ensures that if you are not making money, neither is the service provider.
Thirdly, when compared against giving away actual equity or entering into a joint-venture agreement, a profit-share is much cheaper and easier to both put in place or exit if the arrangement isn’t working. Equity can be very difficult to take back, whereas a profit-share is a contract which should be easily cancellable if the service provider is not performing their obligations.
In terms of negatives, probably the biggest negative is that a profit-sharing agreement is not a commercially attractive proposition for some service providers – because they are taking on a lot of the risk. Also, it may be difficult to predict what is a fair profit share percentage at the outset, which may lead parties to be disgruntled with their share later on.
What should be in a profit-sharing agreement?
A good profit-sharing agreement should contain the following provisions in order to ensure it can effectively facilitate a profit-sharing arrangement between two parties and minimise risk.
- Roles and Responsibility
Like most contracts, the profit-sharing agreement needs to adequately outline the roles and responsibilities each party has. When roles and responsibilities are poorly defined, it becomes difficult to argue that a party is not properly performing its obligations, and thus to deny payment or terminate the agreement. As much as possible, profit-sharing agreements should include easily measurable KPIs.
Example: the start-up EasyBooks has entered into a profit-sharing agreement with Tony. Tony’s responsibilities are vaguely defined as “onboard new customers, build an online presence and improve brand recognition”. Tony does some work for EasyBooks, but the results are not great and EasyBooks does not feel that he should be entitled to receive his profit-share. They also want to terminate this agreement. However, since the responsibilities are so vague and there are no measurable KPIs, it’s more difficult for EasyBooks to confidently say that he has breached his agreement. If the roles and responsibilities included defined metrics such as minimum new customers onboarded, minimum hours of work per week and minimum increase to web traffic, EasyBooks would be well placed to easily terminate the agreement.
- Deciding what constitutes a profit
The definition of how ‘profit’ is calculated under a profit share agreement is a vital component. Firstly, is profit determined with reference to particular transactions or a particular project (eg, ones contributed to by the service provider), or is it over all activities of a business? If it is the former, which expenses will be calculated for the purposes of determining profit? If it is the latter, does the business require a base level of profit to be excluded as savings for working capital?
Example: EasyBooks’ agreement with Tony covers all of the business activities of EasyBooks, which means all income and all expenses are counted for the purpose of calculating the profit share. However, EasyBooks include a protection that the first $20,000 of profit each year is excluded from the calculation since EasyBooks needs to save a minimum amount of money for cashflow reasons.
- Time and Frequency of payments
When will the profit share be paid, and at what frequency? Generally, it is favourable for a start-up to have payments done annually at the end of the financial year, after they have had the chance to produce final accounts. If the profit-sharing agreement provides for instalments throughout the year, the contract will need to set up an adjustment system after final accounts are prepared, so that any extra expenses are properly reflected in the profit share paid over the entire financial year.
- Review and acceptance of profit share
Once a profit share is fully calculated, the service provider should be required to review and either accept or reject the profit share within a set period of time. An accepted profit share should be deemed as final and not subject to claims later on.
- Audit Rights
Approaching the profit-share from the service provider’s perspective now, it is important for the service-provider to insist on being able to audit, inspect and review any documents which may impact the payment of profit share. Otherwise, the service provider has no real way of knowing whether they are being paid the right amount.
- Termination clause
One of the advantages of having a profit-sharing agreement as opposed to handing out equity or entering into a joint venture is that it should be fairly easy to terminate. In our opinion, being able to quickly exit an arrangement that is not producing the desired results is one of the most important things in any contract, and a profit-sharing agreement is no different. A profit-sharing agreement should implement a well-constructed termination clause that allows a party to terminate in the event of a breach, or even without cause.
- The usual suspects – intellectual property, confidentiality and limitations of liability
These are clauses that should be in every agreement. A start-up should always have strong protections for its IP rights and confidential information, because those items usually constitute the main assets of a tech start-up. A good limitation of liability clauses gives founders the peace of mind that there is a maximum amount of risk they are taking with any arrangement.
- Profit-sharing agreements are used between two businesses or a business and a staff member to share profits from a particular project, certain transactions or even all of the business’ activity
- Profit-sharing agreement can be a powerful tool to align interests between the two contracting parties, since they are both directly incentivised to generate profit.
- Profit-sharing agreements are easier to implement (and exit) and carry relatively low risk compared with some other ways used to incentivise service providers. In particular, profit-sharing agreements are a lot more founder-friendly than giving out equity.
- Profit-sharing agreements should include defined and measurable responsibilities, a clear definition of what constitutes profit, payment terms, audit rights, termination clauses and other protections common for most commercial contracts.
If you are planning on using a profit share agreement to facilitate a relationship between your business and another entity it is advisable to seek legal advice. A good start-up lawyer can help draft a profit share agreement that minimises both the commercial and legal risks to your business. That is why if you need any legal advice or help drafting a profit share agreement you should get in contact with one of our start-up lawyers, or call us on 9343 0381.