Do You Earn What You Should?

What to pay yourself when you're the boss

Written by Sandra E. Martin

Shantal Feltham will always remember how close she was to throwing in the towel. Almost out of funds, she signed up for a conference in Washington, D.C., in a final attempt to drum up contracts for Stiris Research Inc., her London, Ont.-based clinical research business. She had just enough cash to cover registration and hotel costs — but nothing for food. “I grabbed chocolate bars, Life Savers and chips from exhibitors,” says Feltham. “That’s what I lived off of.”

Few entrepreneurs forget that lean startup period, and that leads many to pay themselves too little, says Robert Levasseur, a Toronto-based senior-executive compensation consultant for HR consultancy Watson Wyatt Worldwide. “I find that mentality sticks with them even when their businesses mature.”

When it comes to setting compensation, many entrepreneurs “tend to pick a number out of the air,” says Levasseur. In public firms, the board has a say in, or even sets the CEO’s compensation package. But when the buck stops with you, it can be difficult to know how much, and which combination of salary, bonuses and perks, to pay yourself.

It’s important to get it right: chief executives who pay themselves too much in the wrong forms (for example, salary versus dividends) can pay more in taxes than they have to. And they might be starving the business of retained earnings that could be used as operating or growth capital and would impress lenders and investors. Those who pay themselves too little could live like relative paupers — as Feltham did — and have no wealth to cushion their fall should they lose the business.

So, what, then, is the formula to follow when it comes to setting your compensation? In fact, there’s no formula; it’s more of an an imprecise science. Still, you can arrive at the number that’s right for you and your company by following a few simple principles.

First, don’t confuse compensation with capital. “Owners tend to muddle up ownership and compensation,” says Levasseur. He prefers to split the two, so that entrepreneurs receive, first, a reward for their role as manager and, second, a return on their investment in the business. That’s because regular pay is an entrepreneur’s to keep, whereas ownership is intangible wealth until the company is sold.

Dave Cook, a Toronto-based partner with advisory firm KPMG, suggests you consider how much money the company needs to thrive, as well as how much you need to cover personal living costs and family expenses. As long as your business is generating enough cash flow, there’s no reason to shortchange yourself.

With your living costs comfortably covered, you can then look at whether it makes sense to reclaim some of the company’s capital by, for example, taking a bonus, paying dividends to yourself and any other shareholders, or issuing stock options. Think about it: you likely started your firm with your own money, and to leave it all in the business could expose you to unnecessary personal risk. “You want to protect some of your assets, and it’s not necessarily smart to be betting it all,” says Cook.

That said, you need to keep enough money in the business to achieve the goals you’ve set for it. “When you do your financial forecasts, there’s always one number that makes everything else balance out. For most entrepreneurs, it’s your salary,” says Dave Valliere, chair of entrepreneurship and strategy at Ryerson University in Toronto. In other words, your compensation is what remains after all the bills are paid.

You can change your salary as needed to boost the financial health of your business. Let’s say your company has aggressive growth ambitions. In that case, it probably makes sense to keep your salary low, thus leaving as much capital as possible in the company, so you can afford to handle a sizable contract when it comes your way. “There are a whole lot of companies that got their big break, and it killed them,” says Valliere.

It was about eight years after Andrew Webber made his weapon-sighting systems distribution firm a full-time gig that he finally started drawing a regular paycheque. The president of Halifax-based Armament Technology Inc. had recognized that he needed to keep as much money as possible in his business to build up inventory. His “pay the company first” strategy succeeded: “That equity in the company has allowed us to take a strong stand in negotiations with customers and suppliers.”

Edward Bartucci, a Toronto-based tax partner at KPMG who advises entreprneurial businesses, likes to consider compensation from the perspective of tax efficiency. For example, if your company is involved in R&D, it probably qualifies for juicy tax credits — which are clawed back if you leave taxable income of more than $500,000 in the company. For this reason, entrepreneurs in this situation often “bonus down” the company’s profits to the half-a-million mark. Still, you’d have to crunch the numbers to ensure the additional taxes you’d pay on the bonus don’t cancel out the corporate R&D tax credits.

So, are you paying yourself too little? Perhaps too much? With the new year rolling around, now might be the right time to make some adjustments.

Originally appeared on PROFITguide.com