Guest Post by Meredith Wood
When you’re working full-time for someone else or freelancing on your own, managing your finances is a fairly simple process:
- Get a check; pay bills and loans
- Spend some of your hard-earned money
- Save some of it for a rainy day (or retirement)
But when you become a business owner, with partners, employees, and vendors, things can get hairy. Your financial considerations become far more complicated. In fact, paying yourself each month can become pretty challenging.
How Much Should Entrepreneurs Pay Themselves?
Entrepreneurs and small business owners are laser-focused on cash flow, fixed costs, sunk costs, payroll, etc. Just consistently making payroll each month can be challenging. It’s very tempting to put everything you earn back into the business to reduce your level of risk as much as possible.
In fact, it’s possible to be making far more money than you ever made as an employee, but actually to be earning less from profits. For example, if you commit to paying all your employees and vendors on time each month, then for every month of payments you get, you may actually have to pay your employees for more than one month’s worth of work (because late payments are a reality for all business owners, too).
Here’s the problem: not paying yourself regularly can do real, lasting damage to both you and your loved ones. After all, you’re only human! You have regular expenses and deserve some down time. If you have dependents, the stress can easily become overwhelming.
If this all sounds like something you’re dealing with right now, then read on. Here are some key tips for how much you should be paying yourself, and how often.
The difference between a draw and a salary
First off, let’s talk about the two main types of compensation for business owners paying themselves: salary or draw.
You already know what salaries are. In fact, if your business is an S Corporation, you will probably pay yourself a set salary* and receive regular paychecks with some withholdings, such as Social Security, Medicare, and—depending on your residence—federal, state, and city income taxes.
Entrepreneurs who are also sole proprietors, partners, or members of a limited liability company (LLC) can draw their pay instead. Since they’re not employees, they won’t have to have a salary in the form of a regular paycheck (e.g., no withholdings).
Instead, these entrepreneurs may draw a portion of money from the business profits, either on a monthly or yearly basis. This has obvious advantages but may also make it difficult for you to pay yourself in a timely and regular manner, especially if the going gets tough (because you’ll think of everyone else, first).
*Note that if you are the owner of an S-Corp, you may also draw money in addition to your regular salary.
How to decide on reasonable compensation
According to the IRS, business owners must pay themselves “reasonable compensation,” which is determined in two ways:
- It must be reasonable
- It must be for services rendered
How do you determine if compensation is reasonable? The IRS considers some factors, such as duties performed, volume of business, local living costs, your abilities and achievements, and most importantly, the proportion of the gross and net income of your business that goes towards your pay.
This is why entrepreneurs who are being funded only tend to pay themselves when the company becomes profitable. There is a consensus that entrepreneurs and founders should have sufficient funds to cover living costs. But until a company starts seeing serious success (read: significant profitability), salary or draw should be kept low.
According to startup advisors, a reasonable countrywide compensation figure is $50,000 per year. Obviously, if you’re living in a city such as San Francisco or New York City, it will be significantly higher.
The most important consideration for business owners
Because month-to-month revenue, cash flow, and even expenses can be very variable for small businesses, some owners opt for a hybrid compensation plan that combines regular, monthly pay with a variable supplement.
In practice, entrepreneurs will pay themselves a small, flat rate each pay period, and add on a percentage of their company’s earnings each month. That way, entrepreneurs can ensure that they won’t overdraw their business revenues—but also that they’ll be paid fairly. That is extremely important if you want to stay in business for the long term.
Another compensation option is comparable pay. How much do the owners of other companies (roughly equivalent in size, revenue, and business model) receive in salary each year? Keep in mind that this number is only a baseline. Your situation is likely different from that of your business rivals, and new entrepreneurs, in particular, may have to operate at a loss.
If the shoe fits…
However you decide to pay yourself, be it through a draw, a salary, or both, understand that as an entrepreneur, you have an obligation to your dependents, employees, and customers. In practice, your pay will be highly variable, especially when you’re starting out. It will rise and fall with market conditions and business revenue.
All the same, make sure you take care of yourself and your loved ones. After all, they’re the reason you went into business in the first place.
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. She is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness and many more. Connect with Meredith on Twitter at @Mere_Wood.