Profit Sharing Agreement Formats Explained: A Step-by-Step Guide

The Basics of a Profit Sharing Agreement

The general definition of a profit sharing agreement, or sometimes known as a joint venture agreement, is a legal contract between two parties wherein any profits made in accordance with the terms of the agreement are split and shared as determined by the terms of the contract. This can often be a high-level document that doesn’t detail too many specifics, but is more about the intention of the parties than the actual minutiae of how the profit-sharing agreement will work.
Profit sharing agreements have their use in business sales, joint ventures, partnerships, investment contracts, employee share schemes and in general day-to-day operations for a variety of business arrangements. Such agreements are not limited to the sale of a business. Examples of a profit sharing agreement can include:
• When one business/party provides some form of physical asset to another in return for a share of profits
• When one party shares intellectual property with another in return for a share of profits
• In a general partnership between two businesses
A profit sharing agreement clarifies in writing the relationship between the two parties. In order for a profit sharing agreement to be valid, each party has to clearly understand the agreement and its terms, and ideally, it should be signed off by any relevant partners.
In the context of a business sale , a profit sharing agreement may be understood to be a form of deferred payment agreement. This usually involves the seller receiving payments for a business or business assets in returns for ongoing payments from profits made in the future. How the two parties benefit from this is fairly simple. With the seller deferring full payment for the business, the buyer can make a new investment and more easily take ownership (of a business or business asset). This means that overall cost to the buyer is less (as they can defer a proportion of a costly purchase) and that the buyer can therefore invest more cash into running their new business. As the seller is receiving staged payments, perhaps interest-bearing or otherwise, there is arguably less risk involved for the seller as compared to a single lump-sum payment.
For the buyer, a profit share agreement often becomes a form of incentive to buy a business or business assets. Such agreements often encourage buyers to make a purchase that they may not have originally considered viable. At the same time, buyers can make a "safer" investment, as they have assurances that they can pay back any money borrowed, provided profits are made.
As previously mentioned, profit sharing agreements are not limited to business sales. The terms of such contracts can also be used when one party gives everything to another that’s needed to start a business, and the one party then gradually pays back "its" investment to the other as the business makes profits. This could be a good example of student-led business ideas or parents certifying a loan for a child’s new business, for instance.

Components of Profit Sharing Agreement Format

An important aspect of negotiating a profit sharing agreement format is ensuring that the key items that make the agreement work are included. These should address both the substantive issues – how profits will be distributed – and administrative issues, such as how the agreement will generally operate in practice.
First, what is a "formula"? The formula is the system or methodology that is used to allocate profits among the parties. It is necessary for each party to have a good understanding of how the allocation will occur under the formula. It is also advisable for the formula to clearly state what is supposed to be included in profits. If the House loses a game of poker that was hosted at the venue, their losses should correspondingly be deducted from any amounts owed to the House in the event of a revenue sharing scenario. Another item that should be explicitly addressed is how the formula will apply in the event of tied games. How are profits shared among the different parties when there is a tie? The formula should explicitly state how such a situation will be handled, and these provisions should be consistent with industry standards for similar games. For example: an MTT house may get 10% of total winnings, less a % of the payout to the 1st place winner, but if there is more than 1 first place winner, of more than 1 % of the payout to the 1st, 2nd, and 3rd place winners. But what if there is a tie for 2nd place? Or a tie for 3rd? The Agreement should address these issues.
The agreement format also needs to address certain administrative issues. Who appoints the auditor and how? How will disputes between the parties be resolved? What happens if a party does not pay a bill for services on time? What criteria will apply to the payment of personal expenses on a Company credit card and will those be deducted from profits? What if a "change of control" event occurs and the management structure changes; how are profits to be allocated in that situation? A good agreement format will thoughtfully address these and other issues.

Different Kinds of Profit Sharing Agreements

Types of Profit Sharing Agreement Formats
A profit sharing agreement can take many forms. The most basic structures are the fixed percentage agreement and the variable percentage agreement. A fixed percentage agreement provides that each party will share in a pre-determined percentage of the profits, and the percentage generally does not change from year-to-year. In a variable percentage agreement, the parties may agree to a different percentage each year, depending on factors set out in the agreement or based on informal agreements between the parties. Variable percentage agreements are most common when a party’s investment (capital and/or effort) in the business varies from year-to-year, and where the parties want to take that into account in determining their compensation. For example, if one party has increased its capital contribution that year, or if one party contributed less time than another during the course of the year (or a combination of the two), the parties may agree to a lower percentage payout to that party. A milestone-based agreement is one where payments are triggered upon achievement of specified milestones. It is often used in situations in which completion of the sale of a property or property project is anticipated.
It is important to think through the structure and terms of the profit sharing agreement, which will often need to be negotiated at the outset to avoid future disputes and to identify the circumstances under which future changes of the agreement may be made.

How to Write a Profit-Sharing Agreement

A profit sharing agreement is a vital aspect of structuring compensation for partners both mathematically and behaviorally. You must be extremely precise in how you draft the document. This is a work in progress but can give you and overview as to how to structure your agreement.
Basics of Drafting Each partner needs to receive a specified distribution in routine situations and then share the bonus pool using a formula agreed upon in advance. This is usually based on a formula which includes some combination of: Contribution to the firm (seniority, origination, and other factors) We do not draft a specific formula as that formula is not the most important part of the process. The agreement must specify a specific amount for each partner per quarter/per annum and a specific way to allocate bonuses each quarter and per annum.
A properly drafted profit sharing agreement includes: Distinctions which help avoid and/or resolve conflicts Client origination, ownership or sharing Contribution to client relationships, including depth of relationship Share of business from referrals Quality of work Mergers and acquisitions Management roles held Firm origination Management and administrative duties Contribution to the firm’s direction and strategy
Drafting the Bonus Pool While the points, or how each partner qualifies for their "shares" may vary based on the expectations of the firm, we know that:
How to Draft an Agreement This is the easiest: Have a standard form of business entity in the jurisdiction where you practice and the jurisdiction where your clients are located If in non-tax states have a C Corporation, otherwise have an S Corporation designated through IRS Form 2553
Other Notes As far as software goes: We have a simple highly useful excel based system with pre designed formulas. With few changes you can create a basic formula by entering each partners name and their performance.
Finally, and this is very important, we run everything through the tax departments overseen by the controllers to make sure that all issues impacting accounting are addressed.

Frequently Made Mistakes With Profit-Sharing Agreements

It’s a well-known phenomenon that the best of intentioned agreements can end up being of little or no value to the parties unless the details are all fully fleshed out. A profit sharing agreement is one such type of contract that can either pay great returns or end up being a loss of time and resources on both sides depending on the attention to detail and the scope of the profit sharing language.
Some of the most common mistakes in profit sharing agreements include:
The terms are so vague that the profit sharing agreement leaves more questions than answers.
There is no clear definition of profit. Without a set standard for what constitutes profit , a party could cut costs on their side to reduce profits and, thus, reduce your share.
Failure to run the agreement through an attorney. A qualified business attorney will be able to pinpoint potential problems and address them before they arise.

Legal Aspects and Checklist

Even though profit sharing agreements are very much a private affair between the parties, their implications can often go beyond the parties to affect third parties, particularly Taxation, Intellectual Property, Employment Law and Pensions Legislation.
Any one or a combination of these areas may need to be addressed prior to implementing a profit sharing agreement. For example, in addition to identifying the employer and employee, the computation of remuneration for an employee can also be based on bonuses or other consideration not immediately identifiable as remuneration. Therefore the written job specification defining the duties of each employee or director can require review in order to ensure that the levels of remuneration and bonuses paid to those individuals comply with Employment Legislation.
Agreements that are implemented require careful drafting and consideration. An agreement should detail the valuation process and be carefully worded so as to ensure that there is no unintentional tax charge under Capital Gains Tax upon the transfer or sale of shares from one party to another. Legal advisors should be consulted to ensure that the valuation and rights (or lack thereof) in the profit sharing agreement are as the parties intended and to minimise exposure to Capital Gains Tax.

Profit Sharing Agreement Format Template

Expressions of profit amongst partners are done through a profit sharing agreement format. This also goes for joint ventures and shareholders. For each business entity, different diagrams and formats are used. A sample profit sharing agreement can be drawn for any type of business activity that is in partnership. When partners or shareholders sign the profit sharing agreement, they consent to the agreed terms until it is reviewed again.
This is the template section layout for profit sharing agreements:
A) The Title
B) The Declaration
C) The Provisions of the agreement
D) Special clauses (Optional)
E) The Execution section
Let us use an example of an agreement between two partnership individuals or partners.
a) The Title, Section A: This could be written as, Mr X and Mr Y’s profit share agreement formula.
b) The Declaration, Section B: We hereby declare that we will share profits on a 60:40 basis or whatever divide is agreed upon.
c) The Provisions of the Agreement, Section C: This section would enumerate the shares issued to each partner. In this case, the provisions themselves are not for the individual who signed the agreement, but also their heirs or beneficiaries.
We can now see from the example above how the sections function. For the special clauses, it could have been specified that at any point if a partner wishes to revisit the agreement, they will be prioritised in re-evaluating the terms. There may also be complex financial terms or formulas.

Profit Sharing Agreements: When and How to Revise

It is a good idea to periodically review profit sharing agreements to determine whether they need to be revised. Significant changes in business circumstances or relationships may warrant negotiation of revised agreements.
To the extent an ownership interest is subject to restrictions under an agreement, care should be taken that the restrictions are valid and enforceable. For example, if a corporation was organized to provide medical services and physicians’ shares were transferred to a corporate entity, a provision in the shareholders’ agreement that prohibits the voluntary transfer of shares to any nonphysician may be a restraint on the practice of medicine and unenforceable even if the corporation was permitted to engage in business with nonphysicians as of the effective date of the agreement. After the change in the law, the agreement could be revised to remove the restriction on transferability. On the transfer of ownership interests, other provisions, such as a reciprocal buyout upon the occurrence of certain triggering events, may cause unintended consequences. Such provisions should be reviewed to ensure the intent of the parties is carried into effect.
In the case of a multiowner entity, relationships among owners may change over time. The departure of an owner, change in leadership or ownership, sale of stock back to the entity at fair market value, admissions, or the addition of an owner may alter relationships sufficiently to merit a review. If there is no existing agreement, each of these events may require renegotiation to resolve issues as to compensation and governance . If an agreement exists, the parties should consider if it needs to be updated to reflect any changes or to be flexible to account for future developments.
Another reason for revisiting profit sharing agreements is to ensure they comply with relevant tax rules. The nature of the relationship among the owners may have changed. The most common form of entity for joint enterprises is the pass-through entity, which permits taxation of income and gain at the owner level and not at the entity level. If an entity was formerly a C corporation, but now meets the requirements of S corporation status, the old C corporation form of agreement may be inconsistent with the S corporation rules.
If a partnership or an S corporation was formed as a result of contributions of appreciated property, special rules apply to limit the amount of gain that is allocated to the contributing partner or shareholder and the consequences of a subsequent sale of the contributed property by the partnership or S corporation. An agreement that does not take these rules into account may unfairly allocate gain or losses among partners or shareholders.
Another tax concern is whether the tax rules governing compensation paid by an entity are up to date. Compensation may take the form of salary, deferred compensation or an equity interest. New rules with respect to reasonable compensation apply to corporations and partnerships. The applicability of each of these forms of compensation and the specific requirements vary depending on the type of entity involved. Existing agreements that do not conform to the new rules will not necessarily be affected but new agreements should take these rules into account.