We get asked this question a lot. And for good reason, it’s not always clear how much you should be taking home as an owner. Too much and you will starve your company of cash. Too little and you might as well just get a job. It’s a tough balancing act, but this article will give you a framework to answer the question for yourself.
Before I begin, this is not a tax article. For more information on how to pay yourself for tax purposes, check out our article on that subject. This post will cover off how much to pay yourself from an operational side so you don’t distort your income statement.
First, understand you are two people
You are two people to your business: employee and owner.
Gets paid for work they do in the business
Payment is called a salary or wage
Is considered an expense when calculating profit or loss
Gets compensated for the equity they own in the business (i.e. the investment they have made)
Payment is called a dividend
Is not considered an expense, but rather a reduction of equity
“Pay” yourself a market-based wage
The word pay is in quotes because early in your business, you will not have the cash to pay yourself what you deserve. That doesn’t mean you shouldn’t be compensated. It’s a subtle mental shift, but you should still keep track of what you should have been paid and start calling this “sweat equity” pay.
You could even go as far as asking your bookkeeper to start posting this pay as an expense so you can see your true profit or loss on your income statement. Why? Because if you are not able to pay yourself a market-based salary, it is a pants-on-fire emergency that needs to be remedied quickly (i.e. in the first two years of business). After all, you still need to eat right?
Now, this is not a license to pay yourself a salary your business can’t afford (I have seen this concept used to give the owner a pay bump they didn’t have the cash for). This is a concept that should change your thinking from “hey, I made 10K profit last year!” to “Oh my doff, we are still a ways from profitability - without my free labour we would have lost 50K last year.” You can now use this information to sort out why your business depends on you so heavily and start doing something to fix it.
What is a market-based wage?
That depends greatly, but a good indicator is the opportunity cost of running your business. If you were to go out and get a job right now, work 40 hours a week and get a steady pay cheque, what would it look like? I am not saying you would want to, but it’s a good indicator of what you are worth and it’s a good start. Another way to approach this is to ask yourself what you would pay an employee to do the work that you are doing. You will be doing lots of different things, but some of it will be pretty mundane, so factor that in.
When You Are Profitable
Once you hit profitability while paying yourself a market-based wage, how much you take out of your business as a dividend will depend on a number of factors:
How much cash do I need to leave in the business to maintain or grow my business?
How much of my investment do I want to cash in to fund my lifestyle?
What other investments can I make?
Are there other investors in my business that want to start realizing a return?
The idea here is to not starve your company of working capital by removing too much cash. The balance is between using the profits to fund the lifestyle that you have worked for and reinvesting them into the continued growth of your business.
What to do about it
It’s common for business owners to take the weight of the world on their shoulders. They do the extra work and get little compensation. They make sure their employees get paid first, they work long hours, etc.
By understanding the value of your labour in your business, you can get a true picture of its profitability and start taking action based on that information. The key is to not kid yourself about how your business is performing: profitability means more than just taking what is left over while working yourself to the bone. After all, the ultimate goal is to have a sustainably profitable business that can provide you with time, money and purpose.