One of the nice things about being a business owner is that, as your own boss, you'll never need to ask for a pay rise.
You'll have to answer the question..
How Much Should I Pay Myself As The Business Owner?
You will have conflicting feelings as you wear both the hats of the employee and the employer.
As the employee, the salary and benefits package you receive will determine your standard of living.
Benefits include things that you could buy as a private individual but the business pays on your behalf. In the UK this includes costs like company cars and medical insurance.
As the employer, you'll be aware that there are many other calls on the money a business has at its disposal:
- Your staff want to be paid more.
- Your suppliers want to be paid faster and they want higher prices.
- Your customers want you to reduce prices and add more free services or better service.
- And of course, the taxman will want his fair share.
I've discussed the opportunity cost approach in the article
I've also had a much deeper look at it in my free report, The Profit Tipping Point.
The gist is that there are two market rates available to act as your guide when thinking about how high (or low) your salary should be:
- How much you can earn doing something else. It doesn't really make much sense that you should build a business that pays you a lot less than you could earn if you worked for someone else.
- How much you would have to pay a general manager or chief executive to manage your business if you weren't there.
As you can see, the twin hats of employee and employer are coming together here to give you an approximate range of how much you should pay yourself.
There is also the issue of how much is the work you are doing really worth. I mentioned earlier paying yourself as a chief executive but what if you're doing much of the work of an administrative assistant.
It's hard to justify a salary the equivalent of £100 per hour if you spend much of your time photocopying and filing!
The Three Big Questions To Answer When Deciding Your Own Pay
The three questions to focus on are:
- How much do you want?
- How much can the business afford to pay you?
- How much are you worth?
That third question is not a particular problem if you own your own business 100%.
It becomes much more of an issue if you have one or more other partners or investors in your business.
Suppose you find yourself involved in a management buyout. One person has been the CEO earning £100k p.a. and there are three other senior managers who used to earn between £40k and £60k p.a..
You have provided different amounts of the finance based on your own personal financial situations and to cover the inequity, you've agreed that any profit above the base salary and agreed bonus will be paid as dividends back to the people who provided the finance.
Since you're all working full time in the business, do you all receive an equal salary or do you recognise the market assessment of your previous worth?
I suspect your answer and assessment of fairness depends on whether you are the CEO or one of the other managers.
Do You Pay Your Salary First Or Earn The Profit First?
This is a controversial issue and you will read different views on the best approach. I'll try to present a fair summary and give you my own particular solution.
If I could think of clever names, I'd create a 2 x 2 matrix to show the main four situations with Profitability Before Owners Salaries on the one axis and Owners Salaries and Benefits on the other.
There are four basic situations:
- High Profit - High Salary
- High Profit - Low Salary
- Low Profit - Low Salary
- Low Profit - Profit Salary
Let's take a look at each in turn.
Situation 1 - The Business Earns A High Profit And The Business Owners Earns A High Salary
Here the business is performing very well and the business owner deserves the rewards of the success.
Taking a generous but affordable salary and benefits package out of the business is the ideal situation.
The format of the profit extraction is best agreed with your tax advisor to minimise the overall tax paid by the business owner and the business. Anything else damages your overall wealth.
Situation 2 - The Business Earns A High Profit But The Owner Pays A Low Salary
Some business owners don't want lavish lifestyles with big houses and fancy sports cars and may not see any need to pay themselves a big chunk of the profit.
This makes sense if the business has third party borrowings that can be reduced or if the business needs the money to expand.
It's also OK to have some rainy day money in the business that protects its future.
However it is unwise to leave too much money in the business. Basic wealth management principles emphasise the need to spread risk with a diversified portfolio of investments.
Businesses can suddenly run into financial trouble because of changes in the wider political, economic, social and technological environment.
If you take money out, you always have the choice of investing it back in the business.
Situation 3 - The Business Earns A Low Profit And The Owners Earns A Small Salary
The business owner has adjusted the salary to reflect how the business is performing by not taking out any more than it can afford.
Many will argue that this is responsible ownership, cutting the cloth to make sure that the business remains viable while steps are taken to improve profitability.
Others say that the business owner should pay themselves first. Before employees, before suppliers, before the government. They argue that the owner didn't go into business to live on a subsistence wage.
Situation 4 - The Business Earns A Low Profit And The Owners Earns A Large Salary
In this situation, despite the fact that the business is struggling, the owner continues to take out a high salary that the business cannot afford.
Some argue this is the right thing to do. It shows the business is making a loss and that should motivate the business owner-manager to take corrective action.
Others say this is irresponsible and threatens the future of the business because the owner refuses to recognise the real situation and is blindly continually to live a lavish lifestyle despite the business problems.
I want to delve into this debate much deeper.
First I'll declare my own position so that you can allow for any bias.
I believe a business owner should cut back salaries and benefits. In fact, I go further. I think the business owner should take out a small amount to live and then take a bonus when the business is doing well. This way, the rewards automatically adjust for the performance of the business.
Does Your Salary And Benefits Package Make Sense Financially?
I've seen business owners do two strange things to fund their salary payments when the business is just starting or struggling:
- Invest a significant amount at the start and then pay a generous salary in the early months before the business gets into profitability.
- Make regular loans back to the business to top up the cash flow and to keep the business within its bank overdraft limits while drawing a big salary and large benefits.
This doesn't make sense financially.
In the UK, when a person earns a wage or salary above a low level, it has to pay PAYE (income tax) and national insurance (social security costs). The business also has to pay employers national insurance.
While rates vary depending on the value of salary, you can find the business owner trapped in a situation where it lends the company 100% and receives back as salary 50% to 60% and pays the remainder to the government.
This is crazy.
It's wealth destruction and financial suicide.
What Will Cause The Most Pain To Help You To Focus On Fixing The Underlying Performance Problems?
This sounds masochistic but the best solution to the "how much should you pay yourself as a business owner" question, if your business isn't doing very well, is whatever the salary that will motivate you enough to take the right actions.
The downsides of the issues with solutions 3 and 4 are obvious.
If you pay yourself a high salary while profits are low, you are eating into the time you have to turn your business around by consuming valuable resources. Worse, you may not know you're doing it if you don't have regular financial information or perhaps you're in denial about the situation and you don't care because you believe the business will get back to profitability on its own.
If you pay yourself a low salary and your business trades just above the break even point after paying you a pittance, you may put up with the situation for years.
That's exactly the trap many business owners find themselves in.
They believe they are being financial responsible by cutting back on their own pay and benefits but they don't find the motivation to make changes. Instead, they get used to the struggle.
Saving money, in their personal and business lives, becomes the norm. They refuse to speculate to accumulate.
It's one of the reasons Why Don't Business Owners Buy More Business Advice.
It's well established that the desire to move away from pain motivates people to action. If it doesn't, then the problem isn't painful enough.
People tolerate all kinds of problems until they reach the time when they say "enough's enough."
Nearly every business can be improved if you're motivated, if you diagnose the problems correctly and you find the right ideas yourself or you get help.
To help you make the right diagnosis, please read 21 Reasons Why Your Business Isn't As Successful As You Want It To Be
What Do You Think?
Do you have a policy for how much you should pay yourself?