Q. When should a business owner start paying himself or herself a salary? How should you set that salary?
A. When we began working with Joe’s lawn care business, we asked to see the financial statements. He proudly showed us that the company had made a profit of $10,000 to $15,000 in each of its first three years of operation. There was only one problem. Joe hadn’t paid himself a nickel in any of those years. Had he paid himself at market rates for the 60-hour weeks he was working, the business would have lost money in each of those years.
One of the most frequent mistake small-business owners make is not paying themselves. Entrepreneurs should pay themselves at market rates as soon as the business can afford to do so.
Many owners need a paycheck to cover their personal expenses. Beyond that, it’s critical for entrepreneurs to understand when their businesses are profitable. New ventures often struggle to find the right business model. In general, companies shouldn’t expand until the business model is profitable. If it costs you $7 to make a widget that you are selling for $5, you can’t make it up in volume. Unfortunately, if the owner isn’t compensating himself or herself, it can be difficult to know when the business model is profitable.
Further, if the owner is receiving compensation, the business can expand more easily. Many very small businesses struggle with hiring a new employee. They just don’t have the cash flow to do it. If the owner is receiving compensation, it can be reduced for a period of time. This will provide the business with cash to pay the new employee who is performing some of the work that the owner used to do. The owner then has time to grow the company and replace his or her lost compensation.
In general, the business should start to pay the owner as soon as it can afford to do so. A business can afford this when there is cash left over after all of the current liabilities of the business have been met, it is likely that future obligations can be paid out of projected revenue, and there are no investment opportunities that would require leaving cash in the business. Obviously, in making these judgments, the owner will weigh his or her personal need for cash against those of the business.
We advise setting owner compensation at market rates for the job that he or she is performing. If the owner had to hire someone to do the job that he or she is performing, how much would the business have to pay to attract and keep such a person? Once all current expenses of the business are met and the owner is paid a market rate for his or her work, anything left over is profit. Of course, whether the profit is left in the business or paid out as dividends, it belongs to the owner as well. Profit is the benefit the owner receives for accepting the risk of being in business.