In the entrepreneurial journey, one of the most overlooked aspects is the importance of paying oneself a salary. “To take or not to take salaries” has been always debated. Many entrepreneurs make the mistake of not accounting for their own compensation, which can jeopardize both their personal finances and the overall sustainability of the business. This detailed guide explores why paying and accounting for your salary is crucial, how to determine an appropriate amount, and how to handle situations where funds are limited.
Table of Contents
The necessity of paying yourself a salary
Understanding the Costs and Opportunity
Entrepreneurs must account for their salaries as part of the total cost of running a business. This includes not only the direct salary but also the opportunity cost of their time—what you could potentially earn if you were not running your startup. Ignoring this aspect can distort your understanding of the business’s financial health and sustainability.
- Opportunity Cost: Your time and effort have value. By not paying yourself, you are effectively working for free and potentially giving away equity without adequate compensation.
- Financial Discipline: Paying yourself a salary enforces financial discipline, ensuring that you account for all expenses and understand the true cost of running your business.
- Business Structure: Incorporating a salary into your business model promotes a more robust corporate structure and encourages proper financial management.
Why you should pay and account for your salary
- Ensures Sustainability: Including your salary in the business’s financial planning ensures that the company’s unit economics are accurate and that the business remains viable in the long run.
- Establishes Professionalism: A structured salary reinforces the professional nature of your role and separates personal finances from business finances.
- Facilitates Transparency: By accounting for unpaid salaries, you create a transparent financial structure that can be critical when seeking investment or dealing with financial audits.
- Accounting for Investment: Entrepreneurs should account for their investments even it is their time. An entrepreneur does not work for free. Accounting for time and expertise should result in salary.
Advantages and Disadvantages of paying a salary
Advantages
- Clear Financial Picture: Regular salaries provide a clear picture of the business’s financial state and ensure that all costs are accounted for.
- Legal and Tax Compliance: For many business structures, paying a salary is a legal requirement and helps in adhering to tax regulations.
- Increases Business Credibility: Demonstrates commitment to the business and reinforces its legitimacy in the eyes of investors and partners.
Disadvantages
- Cash Flow Constraints: In the early stages, paying a regular salary can strain the business’s cash flow, especially if revenues are inconsistent.
- Potential for Overhead Costs: If not managed properly, salaries can lead to increased overhead costs that may affect profitability.
- Administrative Burden: Managing payroll adds administrative tasks and requires compliance with tax regulations.
Determining the right salary
- Market Research: Research industry standards and salary benchmarks for similar roles to set a reasonable figure.
- Assess Personal Needs: Align your salary with your personal financial requirements while considering the business’s financial status.
- Evaluate Business Performance: Base your salary on the company’s revenue and profitability, ensuring that it aligns with the business’s current phase and performance.
Calculating the Right Salary
- Market Value vs. Business Volume: Understand that your market value may be higher than what the business can afford to pay in its early stages. Balance between paying a reasonable amount and ensuring the business’s survival.
- Correlation with Business Phase: Adjust your salary based on the business’s performance phase. Avoid paying excessively when revenues are low, and do not work for free if the business can afford a salary.
- Equity vs. Salary: Recognize that while your equity compensates for some of your initial investments, your ongoing work and efforts should also be reflected in your salary.
Adjusting Salary Based on Company Growth
- Performance Benchmarks: Link salary adjustments to business performance metrics such as revenue targets or profit margins.
- Incremental Increases: Gradually increase your salary as the business grows and becomes more profitable, ensuring that it does not jeopardize cash flow.
- Regular Reviews: Conduct regular reviews to adjust your salary based on the company’s financial health and market conditions.
Handling Shortages of Funds
- Expense Review: Cut non-essential expenses and prioritize critical needs to manage cash flow effectively.
- Seek Funding: Explore options such as loans, investor funding, or grants to address short-term financial challenges.
- Adjust Compensation: Temporarily reduce your salary or defer payments if necessary, but ensure that these adjustments are documented and planned.
Accounting for Unpaid Salaries
- Record Unpaid Salaries: Treat unpaid salaries as liabilities on your balance sheet. This practice ensures accurate financial reporting and future accountability.
- Plan for Repayment: Develop a strategy to repay any deferred salaries when financial conditions improve. This makes the system transparent and balanced.
- Separate Personal and Business Finances: Treat yourself as a resource to the company, and ensure that your salary is accounted for separately from your equity stake in the business.
Conclusion
Paying yourself a salary as an entrepreneur is not merely a matter of personal preference but a fundamental aspect of maintaining financial discipline and ensuring business sustainability. By understanding the importance of a structured salary, accurately determining your compensation, and properly accounting for unpaid salaries, you can achieve a balanced approach that supports both your personal financial needs and your company’s long-term success.