You may have decided to take no wages or below-market wages at the start of your business. But, by not accounting for the real cost for your services as if you paid someone else to do your job, you have distorted net income (or loss!) from your business. You are not at breakeven until you are paying yourself a market-based wage and you are profitable.
Salary vs. Return on Investment
Repeat this phrase until you truly understand the concept: “I get a salary for what I do, and I get a return on what I own.” Do not confuse the two. You may be the owner, but you will never grasp the potential of your business model if you combine your salary with your expected profits. Your job role in the business is distinctly different from your role as an owner in the business, and each carries a different expectation of value.
Owner’s Job Role
In the beginning stages of your business, you will likely be in charge of sales, marketing and operations, and in your spare time be CEO. The functions are not worth the same rate of pay and they all vary in the time required.
Past $1 million in revenue, your job role begins to narrow in focus. At $5 million, you likely will still be in charge of either sales or operations, and, if you are, your compensation should reflect a blended pay of both roles based on time spent.
The Tax Games People Play with Owner Compensation
For United States businesses that are S corporations, owners are motivated to avoid a 15 percent payroll tax by taking little to no wages and, instead, taking distributions out of the company for their consumption needs. For warnings on this technique, however, visit the Internal Revenue Service website or just do a Web search on the topic.
Every owner I have convinced to increase his or her wages to market and pay the payroll tax has made a true profit and gotten the full wage. Each saw real net income for the first time and made the decisions to hit the real target instead of aiming low.
Often, two people form a business and decide each will own the same percentage and make the same wage. Bad idea! I have rarely seen any two people worth the same wage. Plus, equity ownership should be based on contribution of equity. If the equity contributed is sweat equity from going without wages, the value must be consistent with the amount of that sweat equity.
Another challenge arises when the owners’ effort is not consistent over the years and they face the situation of a lack of contribution by one or one reaching his or her level of incompetence in the particular role in their company. If you have the hard discussion early, you can avoid this issue and effectively move that owner to a more appropriate role or even out of the business.
It is not uncommon that one owner can cut back during lean times yet the other needs to receive pay to support his or her lifestyle. It is important to settle up quarterly or at least annually. At a minimum, account for the back wages as a liability; preferably, adjust equity and increase the ownership of the person who was willing to cut back.
Demand a Return on Investment
The main reason to pay a market wage is that you (the investor) can hold you (the employee) accountable for market-based performance with no excuses. You may think you are the same person, but you really are two distinctly different people as an owner versus an employee.
A business that is paying a market-based wage to you and returning a pre-tax profit of 10-15 percent is a great business that gives you the best of both worlds — a business that would be great to keep and one that would be valuable to sell.
Greg Crabtree, author of Simple Numbers, Straight Talk, Big Profits!, has worked in the financial industry for more than 30 years. The founder of CPA firm Crabtree, Rowe & Berger, P.C., he leads the business consulting team, helping clients align their financial goals with their profit model and their core business values.