Your business is growing. You’re expanding into new markets, hiring new employees, and seeing a significant return on your investment. Finally, after months of hard work, you’re generating enough revenue to cover all your expenses and pay yourself something.
Now, comes the difficult question: how do you set your salary as a small business owner.
It seems rather easy at first glimpse: your salary should be your profit minus your costs and taxes, right? However, things tend to get a bit complicated when you start considering all other factors, such as a potential partnership, your company’s valuation or market changes.
Deciding how much you should pay yourself as a business owner is a tricky task. To avoid long-term hurdles and to minimize the chances of slipping in the red, you’ll need to be strategic about how much money you cash out of your company. That means:
- Asking for professional help
- Considering all the significant factors
- Forecasting your annual personal expenses
- Adopting the right pay strategy
The purpose of this article is to help you make an informed decision and set a salary that will meet both your business and personal needs.
First Thing First: Should You Ask for Help?
As a business owner, there are two ways to cash out: a draw or a salary. Both options are viable and have their pros and cons. The main point of difference between the two are the taxes that you must pay.
Let’s say that you’re the sole proprietor of your business. Then, you can withdraw your profits at any point, without having to pay any initial taxes on your retribution. Don’t get the wrong idea, though: the checks you’ll write for a draw will not take into account the appropriate taxes, but you’ll still have to pay them at some point.
On the other hand, if you pay yourself a salary, then your income will be subject to federal and state tax deductions.
So, which option should you choose?
Well, while it may sound counterintuitive, the fact of the matter is that a salary is a more tax-efficient option. That’s because the fines for payroll tax “errors” can bury your business.
The intricacies of setting your salary and complying with federal tax and rules can feel pretty overwhelming, especially if you’re a first-time entrepreneur. A professional accountant can help you factor all the variables that come into play when determining the size of your paychecks, such as taxes, employees’ costs, loans, your personal financial needs or future investment plans.
But, if you can’t afford to hire an accountant, you can use one of the many tools available to business owners. A free payroll tax calculator, for example, can help you get a clear perspective on your salary’s withholdings, such as social security, Medicare, federal and state taxes, and so on.
How to Determine the Right Paycheck Size
No secret formula could help you determine how much you should pay yourself. As a rule of thumb, you should aim for a reasonable paycheck size. Sure, every entrepreneur dreams of driving an expensive car, wearing designer clothes, and flying first class, but these perks may jeopardize the success of your business in the long run.
So, take a look at your competitors and try to find out how much business owners in your industry are paying themselves. Research recruitment websites and talk to your fellow entrepreneurs to take the pulse of the industry and determine what the average salary is.
Consider the development stage of your business, as well. If you’re running a start-up, you may have to settle for a modest lifestyle and cash out only after you’ve covered all expenses and investments. More often than not, it won’t be very much, especially since most start-ups operate at a loss in the first year or so. If you’re just starting out, then you may not be able to grant yourself an equivalent salary just yet, so you just have to settle for a compensation that is lower than average.
Don’t despair, though: once your business hits the ground running and starts generating consistent ROI, then you can increase your salary according to your company’s annual growth rate.
Pay Yourself Enough
Especially in the start-up phase, many business owners tend to sacrifice the comfort of their personal lives in favor of their business’ welfare. Accepting a drop in income can be the right choice sometimes, but there’s no point in handling this kind of stress outside extraordinary situations. Consider alternative startup financing options when confronted with harsh situations.
You should pay yourself enough so that you don’t strive to meet your monthly needs, whether we’re talking about food, paying the bills or treating yourself and your family with dinner and a movie. Avoiding stress and problems in your personal life will positively impact your productivity. In fact, living a comfortable life is a prerequisite to making good business decisions.
That said, when setting your salary, consider all your living expenses. Put forth a comprehensive annual estimated expenses list and include everything from your rent, car insurance, gasoline bills and even groceries. Divide it by 12 to obtain your ideal monthly salary.
Adopt the Appropriate Pay Strategy
Depending on the development stage of your small business, you can adopt a variety of pay strategies. Typically, start-ups have a variety of one-time expenses, such as the acquisition of equipment, investing in marketing and websites, rent and legal costs, and so on. All these expenses can lead to a negative cash-flow in the first years.
When you’re in the “start-up mode,” you come prepared with a full business plan (including a cash flow forecast), and with a personal backup plan if your retribution is too light. Start-up mode means living on the edge if you don’t make the proper arrangements.
You have to be prepared for this tough stage because, as your business starts to generate consistent ROI, you can establish a set salary plan that meets your financial needs without affecting the profitability of your company.
Conclusion
Whether you choose a draw or a salary to compensate yourself, you need to ensure that you’ll be able to live somewhat comfortably. At the same time, you need to consider your business’ growth opportunity and sacrifice some perks to get your company to the next level.
Setting a salary as a business owner is a balancing act that requires careful thought and consideration. Hopefully, these tips will come in handy.
