Many people become entrepreneurs because they don't feel they're getting paid enough for the work they do in the corporate world. Ironically, they may find themselves even lower on the salary scale when they open their own business.
"They've made hundreds of thousands, even millions, for people, and just made a salary, so they go into business for themselves," says Jack Chapman, author of Negotiating Your Salary: How to Make $1,000 a Minute (Ten Speed Press, 1987), now in its 7th edition. "But then it becomes difficult to know how much to take out of the business, especially in the early days."
When trying to figure out your salary, consider how much your time is worth, whether it's a good time to take money out of the business, and whether there are alternative ways of making ends meet for now. These 10 questions can help you settle on the right amount for you and your business:
What do other people in top management make?
Chapman says you can find some pay parameters by checking out various online sites to see how much other executives are being paid. He recommends Salary.com, which gets its data from larger corporations, PayScale.com, whose information comes from the executives themselves, and Glassdoor.com, a free jobs and career community that includes employee-generated content. "While these sites are not targeted to entrepreneurs," he says, "you can find a business similar to yours, see what people are getting paid, and use it as a benchmark for what to pay yourself."
How will other employees react to my salary?
Startups, often strapped for cash, sometimes attract and retain key employees by offering them equity and other types of non-cash compensation. If that's the case for you, your employees may react negatively if you collect a fat paycheck. Employees -- and investors -- expect the founder or founders to apply the same compensation policies to themselves, says Joan Farre-Mensa, assistant professor of business administration at Harvard Business School. "If the entrepreneur is drawing a big salary, this can be interpreted as lack of confidence in the future prospects of the company, negatively affecting employee morale."
How many jobs am I doing?
If you're acting as CEO, purchasing agent, salesperson and social marketer, you deserve to be paid for those jobs, or at least a portion of what it would cost to hire people for those jobs, Chapman says. "If say you're doing jobs that would cost you $250,000 to hire out, you might keep 50 percent of that for yourself -- if the business can handle it."
What is my cash flow, now and in the future?
Your salary will, of course, depend on cash flow -- not only current cash flow, but even more important, future cash flow, says Steve Trojan, a CPA who specializes in small businesses at SMT & Associates, an accounting firm in Crystal Lake, Ill. He recommends that before starting a business, you develop financial projections to help understand how much cash flow will be generated over time, how much will be needed to expand the business, and how much might be available for your personal expenses. This will help you understand how much money you should set aside for living expenses before starting the business and whether you might need a part-time job in the early stages of your startup.
What does my company's growth rate allow me to take in salary?
If a company is growing rapidly, you need to put any profits in the business and limit your salary. If you have a $3 million business that's poised to become a $6 million business, it needs every bit of the capital it's generating. "Growing businesses are generally cash flow neutral or negative during their formative stages, and as a result, there's no cash to take out," says Douglass Tatum, associate professor at Middle Tennessee State University. "The entrepreneur has to reinvest into the business."
Can my family afford to live on a small paycheck -- or even no salary?
Young entrepreneurs with no dependents can more easily limit their living expenses than those with children or other dependents, Farre-Mensa says. This is why many first-time entrepreneurs choose to start their businesses when they have fewer responsibilities. But if you happen to be an entrepreneur with dependents, make sure that your co-founders and early employees understand your circumstances and don't interpret your salary as a lack of commitment to the company.
Can I receive some of my compensation in a form other than salary?
Once the business is on its feet and the owner is able to start taking money from the business, the structure of these payments can be important from a tax perspective. If during the startup days, the owner loaned the company money for working capital, he can start to pay himself back when cash flow allows, Trojan says. "Making payments to owners via shareholder distributions -- if the company is an S-corporation -- also can reduce taxes, but you have to be mindful of the IRS requirements that active owners must take a reasonable salary." While the IRS has not defined "reasonable compensation," a common definition is a wage you would pay another person for the job you are performing, he says.
Should part of my salary be based on the distribution that other investors share?
There can be some serious conflicts with investors and shareholders over compensation, but these issues can be minimized if a significant portion of the entrepreneur's cash compensation is based on the company's performance, Tatum says. If the company has professional investors, they're going to make sure the compensation plan rewards the founder's performance appropriately, with anything leftover going back to the investors. If the investors are friends and family, they should be given the same courtesy, Tatum says. "In other words, treat them as if they had appropriately negotiated their investment positions as professionals. This could significantly reduce some of the tensions around the issue of compensation. This is a good idea even if the investors are unsophisticated and have not pushed the issue with the entrepreneur."
Do tax considerations enter into my compensation?
Tax evasion is obviously illegal, but tax avoidance is good business, Tatum says. A good tax advisor can develop ways for an entrepreneur to increase or defer compensation in a tax favorable manner. Be sure to consult with a tax expert sooner than later, Tatum says. "More times than not, an entrepreneur shows up at the last minute with ideas for his accountant, and it's too late to implement them. A little bit of thought ahead of time can save a lot of money."
Have I put down in writing what I expect to be paid?
It's critical to document compensation agreements when you have to answer to other people -- whether business partners, a board of directors or investors. "If you're at a board meeting and someone says, 'You should get 10 to 15 percent of the profits,' ask them if they mind if you put that in writing," Chapman says. "Write it down, get it notarized and file it, so there are no questions later. The clearer you are about money up front, the better off you will be on the back end."