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In their book Start your own business, the staff of LikendisLike Media Inc. guides you through the essential stages of starting your business, then helps you survive the first three years as a business owner. In this edited excerpt, the authors offer easy-to-follow tips to help you set your salary as a business owner.
It’s your business and your budget, which means that the size of your paycheck is entirely up to you. But while the freedom to set your own salary sounds good in theory, in practice, most business owners find it difficult. Should you be paying for what you need to cover your expenses? What can your business afford? The salary you left to start your business?
Your best bet is to take all three into account, and much more. Obviously, you want your business to be successful and can accept a temporary drop in income to make it happen. On the other hand, paying yourself much less than what you are worth, or nothing at all, paints an unrealistic picture of the viability of your business, for you and for all the investors you hope to call on now or in the future.
Your salary needs will depend on your living expenses, your financial situation and your comfort level thanks to your personal savings. The first step in planning your payroll is to make a complete list of your expenses. Make sure to include all annual, quarterly and monthly expenses, including your rent or mortgage; car payments, auto insurance and gas bills; credit cards with outstanding balances; gym membership; grocery bills; and everything you’ll spend for the coming year. Underestimating personal expenses is one of the biggest mistakes a new business owner can make. If you slip into red, it is likely that your business will too.
Once you have calculated your annual personal expenses, divide by 12 to calculate the monthly salary that you will have to receive to avoid plunging into your savings. Then decide what part of your savings you will feel comfortable with in the early stages of your business – it should be a savings separate from the funds you will use to start 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 will need, even if you choose to supplement your starting salary with personal savings or employment income. You now have a range that goes from the minimum wage needed to cover all of your personal expenses to the minimum wage you can afford to supplement by supplementing your income – your minimum wage range.
There are two equally valid methods for calculating the value of your market:
1. Open market value. Given your experience and skills, what would you be paid by an employer in the current market? Although this salary does not take into account the additional time that you will devote to a startup, the income that you sacrifice to start your business is a useful reference for fixing your salary.
2. Comparable businesses. What do owners of similar-sized businesses in the same industry and geographic region pay? For comparable salaries, consult professional associations, other entrepreneurs in your industry, or the local Small Business Development Center.
Neither method takes into account the extra work you will take on as an owner or the risk you take in starting a business. Some entrepreneurs increase market-based wages by 3-5% to compensate for additional responsibilities and risks. Others are considering the potential long-term benefit of owning a successful business to offset these factors.
Once you know the salary you need and the salary you deserve, it’s time to balance these numbers with your business finances. You will need to check the cash flow projection in your business plan to make sure you have enough money to cover your own drawdown in addition to your other operating expenses. In an ideal scenario, your cash flow will have a surplus large enough to pay your market wages, reinvest funds in the business, and leave a small margin of error. Unfortunately, this is unlikely. Since most startups are initially operating at a loss – typically for at least six months and perhaps as long as two years – you should plan to start with compensation in the minimum wage range. You can increase your salary based on the market as your business breaks even and continues to grow.
Since the income of your business can fluctuate initially, a base salary with a bonus structure that occurs when your business reaches breakeven is usually the best way to manage the owner’s compensation in a start-up business. You could, for example, decide that when your business goes black, you will take a percentage of profits each tax quarter as a bonus. Bonus percentages vary widely, depending on the owner’s business goals, personal financial needs, and the company’s revenue reinvestment philosophy. But while your goal is to reach your market salary quickly, it’s a good idea to leave profits in your business as a safety net and fund future growth.
When the business reaches a point of constant profitability, it’s time to reassess your salary. Typically, this means taking a salary increase equal in percentage to the annual growth rate of the business, then reinvesting the remaining profit into your business. But like your bonus structure, there is no miracle equation for determining the appropriate salary increase. You will want to take into account the nature of your sector and your business objectives. For example, if you are in a turbulent or cyclical industry, you may want to keep the structure of the quarterly bonuses and the flexibility it offers. Or, if your business has the potential for rapid growth, you may want to forgo the increase in wages and use the additional capital to finance new products, expansion plans or marketing initiatives.
Whatever you decide at the start of your business, plan to reassess your compensation every six months. As your business grows, so does its cash flow model and capital requirements, just like yours. Regular assessment allows you to adjust accordingly.