One of the most attractive perks of the entrepreneurial lifestyle is the possibility of not having a cap on salary. As an employee, your salary is determined by your employer. As an entrepreneur, your salary is determined by how well you drive the business. Sounds pretty sweet doesn’t it? Does that mean you can funnel every dollar that comes in to your personal checking account? Not if you want to stay in business and out of trouble.
Last year, a reported 55% of entrepreneurs took a salary from their business averaging $75,970 per year. Although we’re glad to hear that entrepreneurs make on average more than workers in the US, it is a little concerning that nearly half of business owners do not take a salary from their businesses.
In this article, we will answer the questions of how much should business owners, founders, and entrepreneurs of all kinds pay themselves. There is no one simple answer when dealing with compensation for entrepreneurs, but we will give you a lot of information, some things to consider, and some steps to take to so you can make the best decision for you, your family and your business.
Salary Vs. Owner’s Draw
One of the first things you must consider before paying yourself is whether or not you want to take an owner’s draw or a salary. The way that your business is structured will really help determine which is best for you.
Taking a draw from your business means that you periodically pay yourself a percentage of the earnings. Taking a salary means that you pay yourself a fixed amount from the business regularly. When you operate the business as an individual (sole proprietor or LLC) or as a partner with one or more others (multi-member LLC), you will most likely take an owner’s draw from the business. You can, however, still pay yourself a fixed salary. But you will need to consider the tax implications of doing so.
If you operate a corporation (S-Corp or C-Corp) you will most likely pay yourself a fixed salary if your business is profitable. A corporation is owned by multiple people. You can’t take a draw as one of those owners. You will be on the company’s payroll like other employees in the company. The benefit of this option is that typically taxes and deductions are withheld by the time you get your paycheck.
Before making your decision, you should check with your accountant. There are instances when you should consider reclassifying your business in order to save money on taxes.
Some Major Things to Consider
Before you cut yourself a check, there are some major things you should consider first.
Tax implications-Like I mentioned before, you must consider that the way you pay yourself will affect your tax bill. Tax laws are complicated and are not getting any simpler. Because of this, you need to understand how tax laws apply to you. Your best bet is to make sure to talk to an account to make sure you are in the clear.
The future of your business-Consider where you want your business to be in 3 months, 9 months, or even 18 months. Will you need extra capital to take the business where you want it to go? If so, you must consider how much cash should be retained when setting your compensation from your startup.
Sustained revenue-This metric tells us how high revenues can grow at a set margin. Having stable sustained revenue is a good sign for your business and, depending on profitability, will be able allow you flexibility when choosing a compensation structure.
Your value to the company-When deciding how much to pay yourself, you must consider your value to the company. Many entrepreneurs underpay themselves because of fear of the business running out of cash. Others, overpay themselves and put the business in danger in the future. Determine your value to the company to find out what you should be paid for the work that you are doing.
How Soon Should You Pay Yourself?
One of the big questions new entrepreneurs have is “when it is safe to pay myself from my startup”? Mike Michalowicz, author of Profit First: Transform Your Business from a Cash-Eating Monster to a Money-Making Machine suggest that business owners pay themselves the moment the business is profitable.
I would have to agree with this suggestion for many reasons but the major reason to adopt this practice is to build consistency. Entrepreneurs who love their businesses often think about their businesses even before themselves (like a parent with a child). Because of this, many entrepreneurs want the business to succeed so badly that they will deny themselves income in order to keep money in the business. Kind of like a parent making sure a child has food before the parent sits down to eat.
That makes a person a good parent. The problem with this is that often times when the owner does this, they often end up paying themselves less than they should and often not enough. Even when the business can afford to pay more than the owner is taking.
Try paying yourself something, anything, as soon as the business is profitable. This is especially important if you are a new entrepreneur. Not only will paying yourself something help motivate you to drive more revenue, you will also begin a healthy financial habit of rewarding yourself for your hard work.
How Much Should You Pay Yourself as an Entrepreneur?
Ok, first the bad news. There are plenty of circumstances when paying yourself is not the best option. We’ll review these first in order to get them out of the way. It is important that you are able to understand the instances when not paying yourself is the best thing for your business. Ideally, these instances will be short lived. There are plenty of founders and CEOs that take ridiculously low annual salaries but make a killing on bonuses and stock options. But, most likely, you are not currently able to entertain this option yet.
Like I mentioned earlier, about half of entrepreneurs don’t pay themselves for the hard work they put in. There are a lot of reasons why this is the case.
Not Yet Profitable–Most startups that take venture capital usually have an issue with becoming profitable in their early years. Because of this, many startup founders will avoid taking a salary from their business. Choosing this option may be necessary in the early stages of your business. However, you should soon be working towards profitability in order to begin giving yourself a paycheck.
Working Part-time or have other income sources–Another reason to consider not paying yourself is if you are trying to escape your 9-5. If you started your business but are still working a full-time job, not paying yourself in order to use the cash flow from the business is a wise move. Your business’s income can also be used as reserve cash. This is important in case you have a slow month or if you decide to take the leap into full-time entrepreneurship. Because you do “need” the income since you have a job, it may be best to let that money collect so that you have cash to reinvest in your business.
Your business is in trouble-If your business falls on hard times, you may need to cut costs in order to keep the business afloat. When GoPro’s stock price plummeted after announcing it was exiting the drone business, the company laid off around 200 employees and founder Nick Woodman slashed his salary from $800,000 (plus bonuses) to $1 in cash. It may be necessary to cut your salary in order to insure that you will have a salary in the future.
All of these options, of course, should be temporary. Unless your business is a passion project, you should be seeking to get compensated for your work. In fact, one of the clear signs that you are running a healthy business is the ability to have that business support you financially.
50% of Profits
A popular option for some business owners is to pay themselves 50% of the profits and allow the rest of the profits to be used for taxes, employee bonuses, or investment cash. Some sole props pay themselves as high as 70%. A higher percentage may also be a good idea if your business is new and profits are small and the business is lean.
Starting out at a higher percentage allows you to adjust the percentage as profits increase without affecting your monthly personal income.
For example, if your business makes a profit of $7,000 in January and you pay yourself 50%, your take home pay would be $3,500. If the following month, your profit increases to $9,000 you can lower your pay to 40% which would bring your compensation to $3,600 and allow the rest of the profits to remain in the business if you so choose.
Matching Industry Averages
If it is still unclear what you should be paying yourself from you business, another way to decide is to look at what the average salaries from leaders in your same industry. This may be difficult to do if you are in a space where salaries can vary. However, understanding the salary ranges will give you a good idea of what to expect.
Keep in mind that entrepreneurship is a very broad profession so there is no one “right” salary. But getting a good idea of what a person makes for running their own business is a great start.
Sites like Indeed and Salary.com will give you some information on what income looks like for entrepreneurs or even employees that work for a company but still work in your business’s industry.
If you are a startup founder that has raised an initial round of funding you may be fine paying yourself $50,000 a year as 66% of founders in Silicon Valley paid themselves this reasonable salary last year. Most founders see a salary increase during future rounds with the average salary ranging from $75,000-$90,000.
Paying Incentives for Yourself and Team
One last option for determining your own salary or draw is to set up a commission or incentive structure. CEOs of large corporations usually make most of their money on bonuses paid out when key performance metrics are met. You can do something similar when running your own business.
For example, as a salary, you can pay the minimum amount you need to pay your bills, save for emergencies and retirement as well a little extra spending. However, you can set quarterly or monthly revenue and profit goals for your business. If you achieve those goals, you can incentives yourself by dropping a bonus once those goals are met.
If your business is cash flow positive and you have other growth goals, you can incentivise yourself for meeting non-monetary goals. As the leader of your business, you can bonus yourself for recruiting, marketing, or even leadership metrics that are met. Just make sure to have those KPIs and incentives bonuses established ahead of time.
- Sales-related bonuses
- Annual performance bonuses
- Project milestone bonuses
Sales related is the combination of base salary, commission, and incentives that are used to drive the performance of sales within your business. Giving yourself and your team sales related bonuses means that you and your employees would get a bonus when the company is profitable and sales goals are met or exceeded. To add an extra level of motivation, you can create tiers for the sales bonuses. In other words, the higher the sales, the higher the bonuses.
Annual performance bonuses
Another type of sales bonus is an annual bonus. The obvious difference is that annual performance bonuses would be paid out if annual sales goals are met or exceeded. This will help you stay focused on annual sales instead of monthly or quarterly goals.
A good addition to an existing incentive plan is the project milestone bonus. This bonus focuses on critical deadlines are met. This type of bonus works best with teams as a motivator for working together to get a project completed in time and under budget.
Compensation structure for yourself is something that can be tricky to understand and manage especially for new entrepreneurs. On the one hand, you don’t want to limit the amount of money you earn in order to sustain your lifestyle. One the other hand you don’t want to overpay yourself to where you are hurting your business or making the IRS angry.
This article should give you guidelines to follow if you are just getting started but will also help those seasoned entrepreneurs who have questioned if their current compensation structure makes sense.