How much should you pay yourself?
It’s not what you think.
Many small business owners struggle with their own paychecks because of all the needs of the business.
There’s the need to keep enough cash in the business. How much is enough?..
There’s the idea that the long hours and taking the risk should pay off, eventually.
There’s the fact that you bring intangibles to the business; but for your vision and way of doing things the business wouldn’t exist.
There’s a formula to deal with all of these concerns.
Remember that as a small business owner you’re compensated in four ways:
First, through your base salary;
Second, through the tax treatment of several personal expenses;
Third, with your owner’s draw;
And lastly, through the value of your equity in the business.
As a well-paid small business owner you’ll often receive a salary, an owner’s draw, and you’ll benefit from things like expensing the lease, fuel, and insurance on your luxury sedan, and probably your spouse’s too. And when you’re finally done, you’ll cash out your shares for a pretty penny…
What’s behind the formula?
Before we get into the nuts and bolts of the formula though, let’s talk about the one assumption I’m making and goal of the formula.
I’m assuming that your business has made it through the first two or three really tight years when you couldn’t pay yourself much at all. You’re off the launch pad and beginning to experience some flexibility.
The ultimate goal is to make your business financially durable over the long haul so that you can trust it will last.
Because of this goal, how much you can pay yourself is based on a few things: the market value of the job you perform in the business along with the debt load and the business’ cash position.
The formula has some requirements
First it requires that you keep enough cash in the business to make sure that the little bumps that always seem to happen don’t turn into BIG roadblocks…
This formula keeps you clear of some bad decisions that happen during short-term cash shortfalls.
It also requires that you don’t live in debt. If you’re constantly drawing on your line of credit to make payroll then you’re paying last week’s employee with next week’s sales. That isn’t a good long-run formula for success.
The formula makes you move your business to a place where you can take advantage of opportunities when they arrive; and it allows you to keep it there.
And finally the formula is designed to set you up to easily transition to the day when you have a General Manager or CEO running your business – if you so choose. And it’s designed so that neither your lifestyle nor your business takes a hit when that happens.
I eat my own dog food. In fact, I achieved this perfectly just before two publicly traded multi-nationals made simultaneous offers to buy the business. I would never promise you that this will happen for you just because you execute the set of guidelines we’re about to talk about. However, we all know that well-run businesses are easy to spot.
Let’s talk about you
You may need to tighten the reigns a bit…
The biggest mistakes I see have to revolve around business owners who pay themselves too much too soon and/or run too many personal expenses through their company books.
So here’s a pointed question;
How much would you pay a manager or executive to do your job?
And here’s the follow-up question…
Would you let him or her expense the lease, fuel, and insurance on their spouse’s luxury sedan?
Very likely not. You’d expect them to live within the paycheck you’re providing. Good leaders don’t ask their teams to do things that they themselves aren’t willing to do first.
I see you squirming in your seat, “yeah, but my accountant said I could do it!”
This is where you need to appreciate the difference between operational accounting and tax accounting. Tax accounting can make it okay to do things you really shouldn’t do operationally. Sometimes it can talk you into doing things that are very bad ideas.
What sort of bad ideas?
Buying or leasing cars you don’t need because you can take a deduction is a bad idea. It’s a bad idea because the monthly payment takes real cash out of your business – cash you need for operations.
If you can’t afford the luxury car within the market-based salary you’d pay a hired GM or CEO (or whichever role you perform) then you shouldn’t buy it. If you can, that’s great! Either way, whichever car you buy, your accountant will still be able to give it the same tax treatment at the end of the year.
Remember, the idea of paying yourself a market-based salary and then giving yourself a car on top of that doesn’t work if you still owe too much on your debt and don’t have enough cash in the business.
Avoid the temptation to super-size the expense just because there’s nobody there to check you…
Is that it? Nope.
Let’s talk about the business
Sometimes at the end of the year you may be tempted to buy a piece of equipment so you can expense it and reduce or avoid paying taxes. You’re motivated to do this because the business’ taxes and your personal taxes come out of the same hide at the end of the year.
But your business isn’t a tax shelter, it’s a profit center. Profit centers pay taxes. Profits become deposits in your retirement account. No profits, no retirement.
To avoid this temptation, you should only ever buy a piece of equipment when the Return on Investment is two years or less and there’s a justified need in the business. Never buy equipment just to avoid a tax bill.
If you didn’t sit down with pencil and paper to calculate and properly justify the return on investment, then don’t buy it.
So what does this formula look like?
Let’s go back to your base salary.
One of the problems with being a small business owner is that you own the business, and so you feel like you’re entitled to pay yourself whatever you think you’re worth.
And so you do…
But that’s not the best practice…
I’ve already said it once, and I’ll say it again. Your base salary should be capped at what you’d be willing to pay someone else to do the job you do inside your company.
When times are good and profits are proper and stable you’ll be able to take a draw in addition to your salary, but only after a few other conditions are satisfied.
Why limit your pay to that?
When you get ready to reduce your role in the business you need someone to take on your responsibilities. And you don’t want that event to change your budgeting and profits.
By paying yourself what you would pay a general manager or CEO to run your business, you’re setting up that line item in the budget. You’re making space for the future when all of your cash compensation will come from the real profits instead of fitting inside the expenses.
Each month when you get the financials from your CEO they should line up with how they looked when you were in that role. If you’d been over-paying yourself before it’ll be difficult to make an apples-to-apples comparison.
When you reach semi-retirement and someone is running your business, you’ll be getting paid a draw from the profits. You’ll move away from being paid based on your performance of a specific role in your business.
If your goal is to sell the business, then you’ll be able to show a would-be acquirer that you have good managers who are properly paid and the buyer will see that they’ll get paid from the profits just like you were.
Look at it like this. Your salary funds your lifestyle and your draw and equity build your wealth. When it comes to your base salary, treat yourself like an employee.
How big is my owner’s draw?
To talk about your draw, we’ve got to talk about the debt and cash in the business.
How much debt should your small business have?
If you’re like many small business owners you’ve likely got a line of credit, maybe a small business loan, and couple credit cards that you owe on. A few of you may even have some off-balance sheet debt to friends and family. And I’m sure that somewhere in all of this there’s a personal guarantee on file.
I hate dept. I loathe it. I like to know that I can go borrow when I want to borrow for something important. I like my banker to call me and check to see if I need some more money. You can’t be in that position if you have a pile of debt.
Your ability to borrow helps create a great amount of flexibility for your business. In business, flexibility and security go hand-in-hand. If you owe $99,000 on your $100,000 line of credit then you don’t have either.
Before you take a draw you should have your line of credit paid down to less than 10%; owe nothing on credit cards; and your accounts payable should be current to less than 30 days. I don’t worry about long-term debt as long as the ROI is justified and it doesn’t take the business too far below the 10% pre-tax profit you want to have.
A word about your accounts payable…
Accounts payable is debt.
I know many business owners prefer not to pay their payables until they’re 60 or 90 days old. They think of it as having the money earn interest for them and not their vendor.
Stop and think about this for a moment. Your vendor is a creditor, and you want your creditors to be flexible with you. If you have a reputation of always being current on your payables then it’s a lot easier to get flexibility from your suppliers when you truly need it.
Short-term debt should always be kept to a minimum.
Moving on to cash
A word about your accounts receivable…
Work to keep them current. Don’t get lazy and allow your clients to stretch beyond their negotiated terms. Keeping an eye on your A/R will help you identify struggling clients.
Taking this approach to debt and cash management creates a buffer between your personal finances and the business. Remember the goal is to separate your personal checking account from the business checking account.
If you’re paying yourself an inflated salary while carrying a pile of debt then you’re cash flow rich and not balance sheet rich. Cash flow rich is risky because you’re just as broke as anyone else; you’re just broke at a higher level of income. If your cash flow changes quickly in the wrong direction you’ll fully understand what I’m saying.
If you find yourself transferring money from your personal accounts back to the business to make payroll then ask yourself if you’ve been following the rules we’ve discussed so far.
How much real cash should I keep in the business?
Real simple. You should keep two months’ worth of operating expenses in cash in your business.
What?!
Yep. Two months.
Sounds like a lot to some folks. Yet imagine this and what it creates. I’m assuming that your credit line is large enough to pay for at least one month of operating expenses but I’ve always pushed for larger amounts from my banks. So that gives you at least a month. Then your A/R gives you another month. And your cash gives you two months.
So with all of that you’ve got at least 4 months of visibility into the future and no short-term or revolving debt to speak of; you can sleep at night.
With all of that, you’ll have time to react, time to project, time to plan, and the ability to take advantage of opportunities when they land on your doorstep. Most of your competition won’t be in such good shape.
There’s nothing that says that from time-to-time you can’t violate this rule set. In fact, periodically you’ll have to. Just know exactly how long it’s going to take you to recover…
When you do violate this rule set do so because it’s going to give your business an advantage whether that’s adding new people with fabulous skill sets or taking advantage of some other opportunity.
The Answer
After you’ve paid down all your short-term debt, set aside two months of operating cash, and your payables are current, it’s time to consider any projects that you have coming soon…
How much cash will they take? What’s the return on investment for the money you’re thinking of spending? Are you faced with competing investment requirements? Then go with the one that has the better return on investment.
If these investments are big enough, you may need to set aside some cash to pay for them. You don’t have to set it all aside at one time; you can do it over many months. This may be one of those times when you dip into your credit line for a few months. But if it’s paid down, at least you have the choice.
Once you’ve got your major projects funded, 4 months in cash; receivables, and credit; and very little revolving debt; you can take a draw. You can take whatever cash is left.
If after all of this, your draw is small, this may put a spotlight on your profit margins. A solid profit margin allows you to take a nice draw and fund any major projects you have on the horizon.
The Summary Points
- Don’t pay yourself more than you would pay anyone else to do the job you’re doing.
- At least in the early years don’t spend money on personal benefits that you wouldn’t let a hired executive also do.
- Never buy any equipment that doesn’t have a hard-justified ROI.
- Have your Line of Credit paid down to less than 10%
- No credit card debt.
- Current A/P and A/R
- Have 2 months operating expenses cash in the business.
How long will this take to achieve?
I took the helm of a cash-strapped business that had zero cash flexibility. We had a maxed out credit line; maxed out credit cards; off-balance sheet debt; the works. It took 3 years to achieve what I’ve just described from that starting point. During those three years we grew the business 50% every year, increased our credit lines, paid off a ton of debt and increased salaries across the board for everyone.
The only thing keeping you from achieving this situation is discipline.
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