How Much Should You Pay Yourself as a Business Owner?
In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors offer easy-to-follow advice to help you set your salary as a business owner.
It’s your business and your budget—which means the size of your paycheck is entirely up to you. But while the freedom of setting your own salary sounds great in theory, in practice, most business owners find it a tough call. Should you pay yourself what you need to cover expenses? What your business can afford? The salary you left behind to launch your business?
Your best bet is to factor in all three—and a whole lot more. Obviously, you want your business to succeed and may be willing to accept a temporary drop in income to make that happen. On the other hand, paying yourself far less than you’re worth, or nothing at all, paints an unrealistic picture of the viability of your business for both you and any investors you hope to appeal to now or in the future.
Your salary needs will depend on your living expenses, financial situation, and comfort level with drawing on personal savings. The first step in planning your pay is to put together a comprehensive list of your expenses. Be sure to include all annual, quarterly, and monthly expenses, including your rent or mortgage; car payments, car insurance and gasoline bills; credit cards with outstanding balances; gym membership; grocery bills; and everything else you’ll spend money on in the coming year. Underestimating personal expenses is one of the biggest mistakes a new business owner can make. If you slip into the red, chances are your business will, too.
When you’ve computed your annual personal expenses, divide by 12 to come up with the monthly salary you’ll need to receive to keep from dipping into your savings. Next, decide what portion of your savings you’ll feel comfortable drawing on during the early stages of your company—these must be savings separate from the funds you’ll use to launch your business. If you plan to keep your job, add your annual salary to the personal savings figure. Subtract this number from your total annual personal expenses, and divide by 12. This gives you the minimum monthly salary you’ll need, even if you choose to supplement your startup salary with personal savings or employment income. Now you have a range that runs from the minimum salary needed to cover all your personal expenses to the bare minimum salary you can afford to take by supplementing your income—your minimum salary range.
There are two equally valid methods for computing your market worth:
1. Open market value. Given your experience and skills, what would you be paid by an employer in today’s market? While this salary won’t take into account the additional time you’ll put into a startup, the income you’re sacrificing to start your business is a useful benchmark in setting your salary.
2. Comparable companies. What do the owners of similarly sized firms in the same industry and geographic region pay themselves? To get comparable salaries, check with trade associations, other entrepreneurs in your industry, or the local Small Business Development Center.
Neither of these methods takes into account the additional work you’ll be taking on as an owner nor the risk you’re taking in starting a business. Some entrepreneurs boost market-worth-based salaries by 3 to 5 percent to offset the added responsibilities and risk. Others look at the potential long-term advantage of owning a successful business as compensation for these factors.
Once you know the salary you need and the salary you deserve, it’s time to balance those figures against your business’s finances. You’ll need to check the cash-flow projection in your business plan to ensure that you have enough money coming in to cover your own draw in addition to your other operating expenses. In an ideal scenario, your cash flow will have a surplus large enough to pay your market-worth salary, reinvest funds in the business, and leave a little margin for error. Unfortunately, that’s unlikely. Since most startups initially operate at a loss—generally for at least six months and possibly for as long as two years—you should plan to start with compensation within the minimum salary range. You can ratchet up toward a market-worth salary as your business reaches a break-even point and continues to grow.
Because your business income may ebb and flow initially, a base salary with a bonus structure that kicks in when your business reaches the break-even point is usually the best way to handle owner’s compensation in an early-stage company. You might, for example, decide that when your business moves into the black, you’ll take a percentage of profits every fiscal quarter as a bonus. Bonus percentages range widely, depending on an owner’s goals for the business, personal financial needs, and philosophy on reinvesting business earnings. But while your aim may be to reach your market-worth salary rapidly, it’s a good idea to leave some profits in your business as a safety net and to fund future growth.
When the business reaches a point of consistent profitability, it’s time to re-evaluate your salary. Typically, this means taking a salary increase equal in percentage to the business’s annual growth rate, then reinvesting the remaining profit in your business. But as with your bonus structure, there’s no silver bullet equation for determining the appropriate salary hike. You’ll want to factor in the nature of your industry and your business goals. For example, if you’re in a turbulent or cyclical industry, you may want to retain the quarterly bonus structure and the flexibility it affords. Or, if your business has the potential for rapid growth, you may want to forego the salary boost and use the extra capital to fund new products, expansion plans, or marketing initiatives.
Whatever you decide in the early phase of your business, plan to reassess your compensation every six months. As your business evolves, its cash-flow model and capital needs may change dramatically—as may your own. A regular assessment enables you to adjust accordingly.
This article was originally published at entrepreneur.com.