How much should you pay yourself at a startup?
You're the boss. How much should your new company pay you?
It seems like a silly question, but it's one that owners of business startups have to answer. How much of a salary should they receive?
Depending on how the business is structured, the answer can be, "What the market will bear," "Just part of what I'd make otherwise" or even "Nothing at all — at least for now."
What you're really worth
Basically, the owner of a small business who is also an employee should be compensated by a method similar to that used for anyone else. His (or her) pay should reflect some combination of value to the business, the amount of work performed and what it would cost to hire someone totally independent of the business as a replacement.
Owners need to receive reasonable compensation for tax reasons as well as for common-sense ones. The owner of a C corporation who receives a salary that's too high for the work performed could find herself in a fight with the Internal Revenue Service if the IRS feels that the high compensation is an attempt to disguise as wages what should be dividends (which are taxed at both the corporate and personal levels).
Conversely, the owner of an S corporation who has a salary that's too low could find the IRS charging that the unreasonably low salary is an attempt to avoid employment taxes by having the company pass through profits as distributions subject only to a personal income tax.
Nothing, for now
You may be able to calculate what you should get paid, but the truth is that if you're the sole owner of a business startup, you might not receive any salary initially. "They pay themselves, but instead of actually taking a check, they defer their salaries," says Barbara Bird, management at the Kogad School of Business at American University.
The deferred salary becomes a liability for the company — one you should get back at some point with interest, once the company starts bringing in some revenue.
Again, the calculation of that deferred salary should be reasonable and based on your experience and the work you're doing for the business. This is important not just from an accounting perspective but also in terms of having a realistic business model: If you're not figuring on a reasonable salary for yourself, you're underestimating the real expenses of the business and exaggerating the profit potential and worth of the venture.
Generally, a business that cannot pay its owner-employee a market salary over the long term is a business that doesn't have much real value.
Some now, perhaps more later
Taking some salary, but not as much as your "market value," is a more likely scenario if you have investors in your business. The reasoning is that part of your compensation is going to be the growth and increased value of the business that you're going to be able to achieve with the help of your investors' money. Small businesses with investor backing are also better able to pay salaries from Day One than are single-owner bootstrap ventures.
With investors in the picture, you might still have some income deferred on the company books. However, an entrepreneur may instead receive compensation in the form of stock in the company. That way, overall compensation is tied to the success of the company and the entrepreneur can benefit from that success.
"It's not at all unusual for an entrepreneur to take a low salary initially," says Thomas Kinnear, executive director of the Zell Lurie Institute for Entrepreneurial Studies at the University of Michigan Business School. "The rule of thumb that floats around is compensation of maybe 70% or 80% of what you might otherwise get on the open market, although I've seen compensation fall to 50% or less of the market rate while businesses work through rough times."
The compensation issue gets a little more complicated if you have partners. "Usually, particularly with technology startups, you've got a team of people instead of just an individual, and you usually have differences in [financial] circumstances among those founders," says Tom Emerson, professor of entrepreneurship at Carnegie Mellon University in Pittsburgh.
Business planning experts say the time to deal with compensation issues among partners is in the early stages of a business, before any pressures of actually running the enterprise — or any pressures that could threaten the partnership — have time to develop.
Structuring compensation properly at the start can also prevent problems later. "Let's say you've got three people who start a business and one of them is a marketing guy who decides to leave," Emerson says. "Well, you still have to have a marketing guy. The company needs to be able to pull back some of the equity it was giving that initial guy so it can attract a replacement. So in the initial agreement, you want to have the equity vesting over time, and something that gives the company the ability to get that stock back to attract a replacement if necessary."
No matter how well you get along with your co-founders, business experts say you should turn to an attorney when formalizing agreements between partners. Hiring a lawyer familiar with startup issues early in the business development process can help you avoid many headaches later.