Many small business owners have trouble figuring out an appropriate take-home pay as the company expands, and some don’t pay themselves at all. These mistakes can easily come back to bite the founder and the business.
Understanding how to pay yourself appropriately — even if it’s only a small amount that grows over time — is important for the long-term health of a business, according to professionals that advise small businesses. “It doesn’t reflect the true health of your business if you aren’t taking something,” said Zahir Khoja, chief executive at Wave Financial, a provider of money management tools for small businesses
The mechanics are especially important given that 26% of small business owners don’t pay themselves a salary, according to a 2022 small business survey from Wave.
Here are four tips small business owners should consider when setting their take-home pay.
Consider the total financial situation first
There’s no one-size-fits-all answer. Founders need to consider factors such as their revenue and expenses including taxes, how the business is organized, and their personal financial circumstances. They should use this information to make a realistic determination of how much they could afford to pay themselves without starving the business.
This will depend largely on the founder’s situation. Is there a working spouse? Does the founder have dependent children or other family members to support? How about a mortgage, car payments, student debt, credit card debt, business loans or other substantial expenses? The founder’s personal savings buffer is another consideration.
“All these things materially affect what you need to be paid to be able to focus on your business,” said Waseem Daher, chief executive and co-founder of Pilot, a provider of finance, accounting, and tax services for startups and growing businesses.
Don’t underpay yourself
Many founders are afraid of choking their business by paying themselves too much, but setting the bar too low can be equally problematic, since they could easily become consumed with the stress of trying to make ends meet. “If you’re spending so much energy on ‘Should I take a cab or a bus?,’ it’s time you’re not spending on helping to make the business successful,” Daher said.
Business owners may think the money could be better spent on hiring marketing help, redoing the website or some other expense that can help the company expand. But don’t fall into this trap, he said. “You need to figure out how to make this long-term sustainable for you, and that probably requires paying yourself more than you think,” Daher said. “You need to be paying yourself enough to truly cover your costs so you can focus on making the business truly successful.”
Make pay as regular as it is for any employee
A good rule of thumb is for owners to pay themselves at whatever frequency they pay other employees, said Chris Ronzio, a serial entrepreneur who founded Trainual, which helps small business leaders streamline their onboarding and training processes.
He didn’t do that 20-some-odd years ago with his first business and it became harder to do once the business was more established. Gradually increasing your monthly pay as the business grows is more palatable than doing it as a lump sum, he said. The goal should be to get to a survival wage where you can cover your basic expenses. The next step is to get to a market wage that’s comparable to what others in the industry are making. “It’s all about habit-building,” he said.
Make sure to re-evaluate throughout the year in case you need to make any changes, said John Buchanan, chief marketing officer of LegalZoom, an online provider of legal documents for small businesses and families. “Keeping a close eye on your business goals and obligations, as well as your personal ones, will help you determine if you need to adjust how much or how often you pay yourself,” Buchanan said.
Benchmark business founder pay
Many founders have trouble determining fair compensation because they don’t understand their worth relative to others in comparable roles. To address this issue, Pilot last year began doing an annual survey to track what entrepreneurs in similar industries and geographies and funding levels are paying themselves. Notably, half of U.S. founders pay themselves less than $100,000 annually, according to the 2022 Pilot study.
Founders that are venture capital-backed are more likely to have higher salaries. About 50% of “bootstrapped founders” pay themselves between $1 and $100,000 a year. By contrast, more than 60% of VC-backed founders pay themselves between $50,000 and $150,000 a year, Pilot found. Consultants, other entrepreneurs, online job sites and industry trade groups can also be good sources for comparable income data.
Understand the potential tax ramifications
Depending on your tax structure, you could get into trouble for not paying yourself enough, so be sure to understand the specific rules related to the entity you choose. With an S or C corporation, for example, the IRS requires the owner to draw a “reasonable salary” and pay the required taxes that go along with those wages, said Christopher Colyer, a partner with Eisner Advisory Group LLC.
The amount is subjective, but generally owners should consider what they would pay someone else to perform the same services and have some objective measures to back this up in case of an audit, Colyer said. If audited, the owner could be subject to additional payroll taxes and penalties as well, if the IRS felt the salary wasn’t reasonable. “It’s exposing the business to this possible tax trap if people aren’t attuned to this issue,” he said.