You're the business owner and you set the budget, so 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 more. For your business to succeed you might consider taking a temporary drop in income. 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 you or potential investors.
Here are the factors to consider before determining exactly how much to pay yourself.
Calculate What You Need
Your salary will depend on your living expenses, financial situation and comfort level with drawing on personal savings. First, put together a comprehensive list of your expenses [see worksheet below]. Be sure to include all annual, quarterly and monthly expenses. These include everything you'll spend money on, such as your rent or mortgage, car payments, car insurance, credit cards with outstanding balances, gym membership and grocery bills. 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 added up your annual personal expenses, divide that number by 12 to come up with the monthly salary you'll need to receive. Next, decide what portion of your savings you'll feel comfortable drawing on during the early stages of your company. These must be separate savings 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. This is your minimum salary range.
Determine What You're Worth
Now you need to figure out what your salary should be given your knowledge and skills, the time you'll put in and the work you'll perform. There are two equally valid methods for computing your market worth:
- 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.
- 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 percent 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.
What Can Your Business Afford?
Once you know the salary you need and the salary you deserve, it's time to balance that figure 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 and other operating expenses.
Ideally, 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 -- anywhere from six months to two years -- plan to start within the minimum salary range. You can ratchet up toward a market-worth salary as your business breaks even 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 course for early-stage companies. 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. These 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 your business is consistently profitable, 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 is 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, 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 is an edited excerpt from "Start Your Own Business, Fifth Edition", published by Entrepreneur Press.