Capital Contribution, Vesting and Profit Sharing

Kalpana Borjha| Kalinga University| 9th June 2020 

Introduction

In this article you will learn about Capital Contribution and its types; Vesting, types of vesting, how vesting works and what are its advantages and disadvantages; Profit Sharing, its types, advantages and disadvantages.

Capital Contribution

What is Capital Contribution?

Capital Contribution, also called paid-in-capital is the asset or money given to a company or organization in exchange of stock by the shareholders. It is the total value of stock which the shareholders have directly bought from issuing the company. Total amount of contributed capital represents their ownership in the company. It includes money from direct listings, direct public offerings, initial public offerings, secondary offerings and issues of preferred stock. Receipt of fixed assets in exchange for stock and reduction of liability in exchange for stock are also included in Capital Contribution. Contributed Capital is reported in shareholder’s equity section of the balance sheet and is usually split in two different accounts: common stock and additional paid in capital account.

Types of Capital Contribution

When a person approaches an investor for capital, they usually order one of two contribution methods, mentioned as follows:-

• Equity Investment: This is the most commonly used method for capital contribution. Equity means the ownership of one or more people over a company or organization. In this type of investment the investors brings more capital in the company and also have share of the profits and losses of the business. Some investors use the capital contribution for stock ownership, i.e., they have low equity in the business and thus they take only the share of the stocks but don’t have share of the profits and losses of the company.
• Debt Investment: This type of investment is similar to a traditional loan. A private investor loans capital to the business and the owner has to pay it off, either with the capital generate by the business or paying it by interest.
• Other type of Capital: Capital does not need to be expressed by money every time. Capital contributions which are injection of cash into a company can come in other forms besides sale of equity. Such contribution are defines as non-cash assets which includes contributing property, buildings, equipment, etc. for the business. The types of investment mentioned above still apply in this scenario.

Vesting

What is vesting?

Vesting is the legal term which means to give or earn non-forfeitable right over present or future payment, asset or benefit. It is commonly used reference to retirement plan benefits, inheritance law and real estate. In context of retirement plan benefits, vesting gives employees rights to employer provided assets over time, giving them incentives to perform well and remain with the company. The vesting schedule determines when an employee acquires full right over such assets. A common vesting period is 3-5 years.

Types of Vesting

     Basically there are three types of vesting that small business and startups generally use:-

• Immediate Vesting: This kind of vesting is very rare. There is no vesting schedule and the employee is 100% immediately vested his/her incentives and assets.
• Cliff Vesting: In Cliff vesting, employees get 100% of their equity or profit sharing after a stated duration of time, all at ones.
• Graded Vesting: This is the most commonly practiced vesting type. Employees receive a portion of their equity or profit share every year, over a period of years until it is being 100% vested.

Working of Vesting

Any money contributed from an employee’s paycheck is always 100% his, but the company’s matching funds usually vest over time, typically either 25% or 33% a year; or all at once after 3 to 5 years. Once he is fully vested he can take the entire company match with him when he parts away with the job. If he isn’t fully vested, he’ll get a portion of the match or maybe nothing at all.

Advantages and Disadvantages of Vesting

• Cash availability: Equity and stock options are forms of compensation to the employees and are also substituted for cash bonuses and rewards. They enable the company to maintain higher cash shares which can be used to pay current liabilities and can be used in case of emergencies.
• Lower employee turnover: By providing incentive of stock option triggered by time based vesting to the employees, the company can ensure loyalty and long term future with such employees whom they wish to retain.
• Terms of Vesting: Harsh vesting terms may cause many high-caliber employees to resign. There must be thought, caution and investment in designing a vesting contract.
• Complexity of Vesting Schedule: Designing and executing a vesting schedule need time and effort of employees, sometimes which may have high opportunity cost, especially when schedules are not successful in incentivizing employees to stay.

Profit Sharing

What is Profit Sharing?

Profit Sharing is an organizational incentive plan through which companies distribute a portion of their profits to their employees in addition to their prevailing salaries. Profit Sharing can generate a lot of benefits to a company such as fostering greater employee cooperation, raising productivity, reducing labor turnover cutting cost and providing retirement security. It gives employees direct stake in profits of the company by creating an environment in which employees want the business to succeed as much as the management wants. The first profit sharing plan was developed in 1961 by Harris Trust and savings Bank of Chicago.

Types of Profit Sharing

There are 3 forms of profit sharing:-

• Cash Plan: This plan distributes cash or stock to the employees at the end of the year. But there is a drawback of this plan, employee profit sharing bonuses are taxed as ordinary income. Even if the distribution is in the form of stock or other form of payment, it becomes taxable.
• Deferred Plan: Under this plan, profit is directly shared into a trust fund on behalf of the employees, which is distributed to them often at retirement. A separate account is managed for every employee.
• Combination Plan: Under this plan, a part of profit share is paid directly in cash and the other is kept as trust fund in employee’s respective account.

Advantages of Profit Sharing

• Motivates employees to work for a common goal and success for the company/ organization become the sole aim.
• Employees focus on profitability.
• Increases in commitment towards the organization.
• Profit sharing bridges the gap between employer and employee.
• Additional income to employees helps them to lead a comfortable and healthy life.

Disadvantages of Profit Sharing

• Sometimes people get their share of profit without any contribution.
• Employees at higher position feel more motivated than the bottom rungs as they might get higher percentage of profit share.
• Salaries of individual employees go up equally, not on the basis of merit or promotion.
• Motivation for work decreases with time and employees take it as their right.

Profit sharing is kind of reward to the employees for their efforts and dedication. They should be motivated to putt in their best rather than taking it for granted.