If you’re a business owner or even thinking about becoming a business owner, one of the most important questions you have to ask yourself is, “How much salary should I pay myself?” How much you should pay yourself when you’re self-employed is a complex question. It’s complex because many people struggle with figuring out what they should pay themselves versus what they can pay themselves.
Chances are you didn’t start your business so you could make less money than when you were beholden to an employer. That being said, there is a time to take a conservative wage and there is a time to let your business reward you for all your hard work. Understanding where you land in between that dichotomy is what we’ll uncover in this article.
Here’s a framework for how to figure out the sweet spot of how much salary you should pay yourself.
First Consideration: Are You Building to Sell?
An often overlooked consideration when figuring out how much salary you should pay yourself is whether or not you’re building a business that you can sell one day or not. There is no right or wrong answer, by the way, it’s just something to understand as you figure out how much income your business should generate for you today.
- Are YOU the business? Meaning, if you were to step back from it, could it sustain itself in your absence?
- Or does your business run itself more or less – with a team of people and very clear processes and procedures in place to keep the machine running even if you were to step away?
If your business is you, then you will want to pay yourself as much as possible while you’re running it because unless you alter the business, there is likely no “exit strategy” for you when you decide to step back or out of it.
Generally, when the business is you, you’re not trying to build a business that you can package and sell to someone else one day. Therefore, your business should generate the most personal wealth for you right now as you are operating it.
Second Consideration: What Kind of Business Are You?
The second consideration you have to factor into your salary calculations is what kind of business are you? Are you a lifestyle business or a growth-minded business?
Many people choose lifestyle businesses because you can make a good living and be free to pick up your kid at 2 pm from daycare (or take her to soccer, or whatever). The typical goal of a lifestyle business is to make enough money so that you are comfortable while also having the freedom to create a good work-life balance doing work that you enjoy.
Growth-minded businesses are businesses with scale. Think software or social media or even most companies that make physical products. Some growth-minded businesses are Silicon Valley startup companies They are started by people who are trying to grow it as fast as possible so that they can get to the ppoint where they can attract investors, which will help launch the company in its next phase of rapid growth.
The type of business you are guides how much you pay yourself. As you might expect, a Lifestyle Business should pay right away because that’s precisely what it’s intended to do: create an income that is enough for you to sustain a lifestyle of your design, pay taxes, and save for tomorrow.
The Growth-Minded Businesses are the ones where owners fall into the trap of paying the business and vendors first and may go months without collecting a paycheck. In either case, both types of business owners can make the giant mistake of not taking a salary or paying themselves peanuts.
No one should be overworked and underpaid – especially not business owners.
Third Consideration: How Much Money Do You Want to Make?
Many business owners will figure out how much money they need in order to make ends meet, but operating only on a “needs” basis for an extended period of time leads to financial insufficiency and can be a limiting mindset. Only focusing on what you need to get by can cause you to limit your growth accepting just “good enough” rather than what you really want for yourself and what your business is capable of.
Instead, decide to be rich and don’t be afraid to want more – to expect more. How much salary should you pay yourself? What’s your number? If you were to go into a salary negotiation meeting, you would know your number and confidently defend why you are worth every penny. When you own your own business, it can be easy to let your insecurities get the best of you and limit your wealth potential until you’ve proven something to yourself.
If you’re thinking that way, stop. Decide what salary you want and then figure out how your business can support that salary. One way to come up with an actual number is to figure out what you’d have to pay someone else to run your company if you were to step down.
[Related Content: Download 7 Steps to Wealth and find out how to build true and lasting wealth]
How to Generate the Salary You Want
Spend minimally on long-term assets, focus on bringing in money and pivoting to what your customers actually want. Get yourself to a livable wage as quickly as humanly possible. Start by paying yourself 10% of revenues, then 20%. See if you can get to 25% and then 30%. One way to do this is to set targets each year for increased profits and decreased expenses so that you really are running as efficiently as possible. Pay yourself consistently, every two weeks, like an employee.
Your business needs to have consistency. For many businesses, once you get to a certain size, you start to have real scale potential. For example, a movie theater needs to incur the cost of the theater (real estate), plus a team of employees and the cost to run the concessions, etc. But once that cost is born, you can show thousands of people movies every day. Then the idea is to max out capacity through marketing. That's how you maximize your compensation as a business owner.
Set specific personal compensation targets each year. If you are a serial entrepreneur, then what you want to do is actually build a business that runs efficiently and hire a CEO to run it for you or sell it. To do this, you need your CEO compensation to be a market number. Figure out what CEOs of similar companies are earning and then determine how long it's going to take you to get to that number. For most businesses, you should be at full CEO compensation within 4-6 years.
By Exit Plan:
Mark Zuckerberg made billions when Facebook went public. Whatever the company paid him as CEO before that was a rounding error compared to his proceeds after that IPO day. If you have reason to believe your company could have an IPO in its future, or that you'll get bought out by a profitable giant, then your interim compensation is less relevant and you need to focus on simply not spending more than you make and preparing yourself emotionally and financially for that windfall day.
Avoid the Common Mistakes Business Owners Make When it Comes to Their Own Salary
- Not paying yourself at all is the biggest mistake people make. If you can't pay yourself and you have no profit, you're a full-time volunteer. Everybody has a getting started runway, so maybe you don't pay yourself for six months to get off the ground, but after that, if you can't pay yourself you may need to re-evaluate what you're in business for.
- Minimizing your income in order to avoid paying income tax. They pay themselves 1099 and write-off lots of allowable expenses so that their income is almost nothing. The problem with this is that your income is almost nothing! Paying income tax is a part of adulting, it goes hand-in-hand with having a high income. And having high (relative) income is key to living well today and being able to fund your goals for tomorrow.
- Letting the tax tail wag the dog. I hear LOTS of people saying that they pay themselves $50,000 – $65,000/year and take their remaining compensation in the form of “profit draws” (where instead of running it through payroll they just take it out of their business account). Again, they do this to avoid paying taxes, but the net result of this is that you don't fully fund your Social Security credits, and Social Security Income is a huge asset for most retired people. Many people retiring today who are fully-funded into the system get annuitized incomes of $35,000 – $40,000/year! that's like having about $800,000 in the bank! So the cost of not paying income taxes can be pretty high.
The big idea is that you have to know what kind of business you are running because the future possibilities of that business should dictate how you choose to pay yourself today. The great news is that there is really no limit to your income potential when you’re in the driver’s seat. You decide how much money you’re going to make and then use your talents and business acumen to make it happen.