- Up to a quarter of small business founders, particularly start-ups, do not pay themselves as much as employees.
- This is a mistake that can lead to financial stress and end up having a negative impact on their business decisions.
- Half of business owners take home less than $100,000 annually, and while there’s no one-size-fits-all approach, too many business owners skimp on their own paychecks.
Many small business owners have trouble figuring out a reasonable net pay as the business expands, and some don’t pay at all. These mistakes can easily backfire on the founder and the company.
Understanding how to pay yourself appropriately — even if it’s a small amount that grows over time — is important to a company’s long-term health, according to experts who advise small businesses. “It doesn’t reflect the true health of your business if you’re not taking anything,” said Zahir Khoja, chief executive at Wave Financial, a provider of money management tools for small businesses
Mechanisms are especially important given that 26% of small business owners don’t pay themselves a salary, according to a 2022 Wave small business survey.
Here are four tips small business owners should consider when determining their net compensation.
First, consider the overall financial situation
There is no blanket answer. Founders must consider factors such as their income and expenses including taxes, the organization of the business and their personal financial circumstances. They should use this information to realistically determine how much they could afford to pay themselves without starving the business.
This largely depends on the situation of the founder. Is there a working spouse? Does the founder have dependent children or other family members to support? How about a mortgage, car payments, student debt, credit card debt, business loans, or other significant expenses? Another aspect is the personal savings buffer of the founder.
“All of these things have a significant impact on what you have to pay to focus on your business,” said Waseem Folge, managing director and co-founder of Pilot, a provider of finance, accounting and tax services to startups and growing businesses.
Many founders fear stifling their business by overpaying themselves, but setting the bar too low can be equally problematic as they could easily become consumed by the stress of making ends meet. “If you put so much energy into ‘Should I take a cab or a bus?’ spend, it’s time you don’t spend contributing to the success of the company,”LY said.
Business owners may think that the money could be better spent on hiring marketing help, a website overhaul, or other expenses that can help the business expand. But don’t fall into that trap, he said. “You have to figure out how to make this sustainable for you over the long term, and that probably requires you to pay yourself more than you think,” said Folger. “You have to pay yourself enough to really cover your costs so you can focus on making the business really successful.”
Make pay as regular as you would for any employee
A good rule of thumb is that owners pay themselves the frequency with which they pay other employees, said Chris Ronzio, a serial entrepreneur who founded Trainual, which helps small business leaders streamline their onboarding and training processes.
He didn’t do that with his first company about 20 years ago, and it became more difficult as the company became more established. Gradually increasing the monthly salary as the company grows is more palatable than a lump sum, he said. The goal should be to come to a survival wage that will cover your basic expenses. The next step is to come to a market wage that is comparable to what others in the industry are making. “It’s all about habits,” he said.
Make sure to reassess throughout the year in case you need to make changes, said John Buchanan, chief marketing officer for LegalZoom, an online provider of legal documents for small businesses and families. “By keeping a close eye on your business goals and commitments, as well as your personal goals, you can determine if you need to adjust the amount or frequency of your out-of-pocket payments,” Buchanan said.
Benchmark Founder Fee
Many founders struggle to determine what compensation is appropriate because they don’t understand its value compared to others in comparable roles. To address this issue, Pilot last year began conducting an annual survey to track what entrepreneurs in similar industries and regions and funding levels are paying for themselves. Remarkably, according to the pilot study, half of US founders are paying out less than $100,000 per year in 2022.
Founders funded with venture capital tend to have higher salaries. About 50% of “bootstrap founders” fund themselves between $1 and $100,000 per year. In contrast, more than 60% of VC-backed founders pay out between $50,000 and $150,000 per year, Pilot found. Counselors, other entrepreneurs, online job boards, and industry associations can also be good sources of comparable income data.
Understand the potential tax implications
Depending on your tax structure, you could get into trouble if you don’t pay yourself enough, so make sure you understand the specific rules related to the company you choose. At an S or C corporation, for example, the IRS requires the owner to earn a “fair salary” and pay the necessary taxes that come with those salaries, said Christopher Colyer, a partner at Eisner Advisory Group LLC.
Amount is subjective, but in general owners should consider what they would pay someone else to provide the same services and have some objective measures to back that up in the event of an audit, Colyer said. Upon an audit, the owner could be subject to additional payroll taxes and penalties if the IRS deems the salary improper. “It exposes the company to this potential tax trap if people aren’t prepared for this issue,” he said.