A common theme that occurs on many business owners’ financial
statements is that the owner’s pay distorts the actual profit of the company. We often see owners paying themselves too low of a salary (more common) or too high of a salary. This discrepancy in salary results in the overall profit of the company not being accurately reflected in the books.
Remember, you are paid a salary for the work you do, and as an owner you get paid a distribution on the profits the company makes.
Let’s begin with underpayment of salary, as this scenario seems to happen more frequently. There are usually a few common reasons an owner underpays themselves.
- Tax purposes
- Bootstrapping, or Growth Mode
- Company is not profitable
There are tax structures out there where you are incentivized to pay yourself a low salary. We have no problem with this and believe tax savings are an excellent way to help you generate wealth. However, if this is the reason you are paying yourself a low wage, you need to look at the financials under the scrutiny that the proper wage would bring.
Here is an example:
Your company had a profit of $200,000 for the year. Your salary was $75,000. In reality, a true market-based wage to replace you in the company would be $150,000. When analyzing the true profitability of your company, you need to keep in mind that your position should be costing the company another $75k per year. The real profitability of your business would be $125,000 and not $200,000.
If you aren’t paying yourself a low salary for tax purposes then you need to consider how your business is truly performing. Are you not getting a reasonable salary because you are in growth or startup mode? Or have you been in business 5-10 years and just simply aren’t that profitable?
We also have no problem with people putting some sweat equity in their company. That is how our company got started, and is the same for many of the clients we work with. Sometimes as a business owner, however, you need to take a long hard look in the mirror and determine if you have an underlying business issue resulting in low profitability.
If a business issue exists, the good news is that you have the power to fix it. You may even be able to hire a consultant to help you, bounce ideas off of a local entrepreneur group, or find some people who have already “been there and done that” and see if they could take a dive into your company and provide some insight. As a side note, one very common problem we also see with small businesses who aren’t profitable enough is simply this: they price their products too low.
Back to sweat equity. Almost every start up or early-phase company doesn’t have the money to pay themselves a competitive wage; and that makes sweat equity a fine thing. But you have to remember it can’t go on forever.
You’re going to need a real wage in order to get any sort of return on your investment. And you need to consider that sweat equity is the value in your business through unpaid work. Here’s an example to make this crystal clear:
If the job you are doing is worth $100,000 per year and you are getting paid $50,000, it means you are putting $50,000 of sweat equity in your company per year. How many years can it go on like this? If you are 5 years into your business and are still in this same scenario, you have a problem.
The flip side of the above scenario: overpaying yourself. Just because you made $200,000 a year when you were in Corporate America doesn’t mean that should be your starting salary when you launch a new company.
Most likely, as an owner, you’re doing a lot of administrative tasks that typically a $40k to $60k a year employee would perform. You are going to have a hard time justifying your $200,000 salary relative to this fact.
To conclude with owner’s pay, remember: if you’re paying yourself a below-market wage, your profit is going to be artificially inflated. And if you’re paying yourself too much of a salary, your profit is going to be artificially deflated. Don’t let your salary distort your company’s actual profit. Know what your true pay as the owner should be.
And the best way to think of the true salary is this:
Imagine that you were hit by a bus and killed on the way to work. If you had to replace yourself in your position with a market-salaried employee, what would that employee’s wage be?
Now for the main event: determining each person’s pay when there are multiple owners.
It often gets a little tricky when a small business is calculating pay in relation to multiple owners or partners. I have personally never seen two people that are valued at the exact same salary and I sure as hell haven’t seen three people valued at the same salary. Ego has to be put aside and salaries need to be adjusted accordingly based on each particular owner’s role in the organziation. The CEO is almost always the highest-paid individual. The only exception may be if there is an “eat what you kill” sales model and a sales person may be able to earn more than the CEO.
We often see people take the snowflake mentality, and as a result, a company formed by three people all have the exact same pay. The issue here is you get into the “management by committee” zone, which never plays out well. We have seen this numerous times with clients and I have personal experience in this exact scenario. Management by committee does not work. Leave a comment if you disagree – I would love to learn how you did it.
Whether you want to admit it or not. There always needs to be a top dog in some form, whether in a sports team or in business. And if your group of partners refuses to pick a top dog, then you at the very least need to establish a clear division of labor in terms of company responsibilities. At least come up with something, even if it’s simple. Here, I’ll give you one: Partner A is responsible for revenue, and Partner B is responsible for operations and controlling expenses.
Transitioning to the final point. I want to talk about people that are potentially stepping out of the business. This usually occurs later in life — near retirement age — and the obvious choice for the “most likely to retire soon” award goes to Baby Boomers.
A huge issue we’re seeing at Upside is that companies are having a lot of problems selling their business or ensuring that it continues without them. This is another by-product of these owners not paying themselves a market-based wage. As a result, their financials were always skewed and the company never had a true picture of the actual profitability year over year. Now they want someone to run the business and truly retire (but still be an owner and receive dividends, profit sharing, and all those nice things).
The glaring issue is their company doesn’t have the money to go out and grab the right individual who can effectively run the business. They can’t continue the business without themselves as the CEO, and, as a result often end up having to just to get a lump sum payment when they eventually sell their company. Often times this lump sum payment is less than they think it should be.
Instead of riding off into the sunset with a really nice stream of passive income because they had a second in command who could run the business or were profitable enough that they could hire a new CEO upon retiring, they are left with an underwhelming payout and a bitter taste in their mouths.
What prevents this? Pay yourself a market-based wage.
All of this is to say that it is extremely important to pay yourself a market-based wage. If you aren’t doing this because of tax purposes, you need to understand what the company looks like if it were paying you a real wage. Market based wages will show you, the owner, how your company is actually performing and clear away the distortions. It is critical that you know your true numbers to make your company more profitable.
Agree? Disagree? Give me your thoughts.