How Much Should Small Business Owners Pay Themselves?
First Bank’s John Harrington, Western Region Senior Credit Analyst, is back with this insightful analysis of how to get paid when you own your own business. Previously, he’s shared how best to use a commercial line of credit and real-world examples of what financing your operating cycle looks like.
There are likely many reasons why you started your business. The allure of working for yourself (or perhaps just not working for someone else), the flexibility, the satisfaction of filling a uniquely identified need.
Of course, there is the pay too.
While you may not have started your business for the sole purpose of getting rich, it can be that earnings potential of your endeavor exceeds that of your previous day job.
Yet, you may have been struck by the lack of structure when you first got your business off the ground. There is no HR representative to tell you about your salary and benefits package. You aren’t guaranteed a performance bonus each spring. It’s up to you to come up with it all by yourself.
Factors in Determining Your Salary: Lifestyle or Scalable?
But first, a question. Is yours a lifestyle company or is it something that’s scalable?
A lifestyle company:
- Is usually quick to mature
- Requires little ongoing capital
- Typically, does not make sense to scale
Whereas a scalable business:
- Can continue to mature through multiple cycles of growth
- Requires continual capital investment to fund growth
- Gets more profitable and efficient as it continues to scale
A good example of a lifestyle company could be an artist. While the artist could invest in their own studio and perhaps hire some contractors for mounting and framing their paintings, there is very limited room for growth.
Unless they plan to be the next Andy Warhol, the artist cannot outsource the primary operations of the business, namely making art, to others. The artist can only produce within their own personal capacity. New paintings may come only a few times a year or a series of paintings may burst forth in a few months due to a spark of inspiration.
Either way, there is not necessarily a reason to retain capital within the business. The lifestyle business owner is doing what they do, and after covering business expenses, can pay themselves essentially all of the free cash flow generated.
But what if there is something to build? Then it becomes a scalable business. Here is another scenario based on a true story.
A husband and wife team starts a company that specializes in commercial painting. They start by doing the work themselves and are the ones who come in and put a fresh coat on an office building before a new tenant moves in.
Once the business stabilizes, they have decisions to make.
- Do they simply pay themselves all that they have earned, or do they start saving towards hiring a second truck?
- Do they continue to operate out of their garage, or do they start budgeting for a commercial space of their own?
Depending on what they decide, they have the ability to grow. They can hire more painters, accept more jobs, enter new markets, but they won’t have the capital to do any of that if they pay themselves all of the cash flow they generate.
Regardless of the type of business, the savvy business owner recognizes that a fraction of the income from a larger business usually equals more personal income than all of the income from a smaller business. As they grow, they have to come up with a formula for personal pay versus retained capital for growth. The framework of that formula will be the topic of the next article.