September 16, 2020
 
There are a lot of reasons why we all started our own businesses, from serving clients, to doing what we love, to getting out of the corporate grind. But ultimately we’re all here to make money. And if you’re not making enough money, then you won’t be able to stay in business.
 
As an accountant, I see a lot of business finances, and can tell you that the vast majority of business owners are not paying themselves enough, if anything at all.
 
We’ve previously answered the HOW for LLC owners and sole proprietors. Now we’re going to talk about HOW MUCH to pay yourself!
 
It doesn’t matter what size business you have – whether you’re in the startup stage, a solopreneur, or you have employees. Everyone needs to pay themselves a decent salary on a regular basis – not only so you can buy nice things for yourself, but because financial stability is important for your mental, financial, and emotional well-being.
 
Before we dig into the details, I want to point you all to “Profit First” by Mike Michalowicz. I really like the principles he teaches in this book, and I use a form of his methodology tailored to my clients to make sure that they’re profitable and paying themselves. He also has lots of free resources which you can find here, including some I reference below!
 
Salary vs distribution
As a business owner, you have two hats. One you wear when you work IN the business – actually doing the work. The other you wear when you work ON the business – in your role as CEO, growing the business, setting goals, and making decisions.
 
Think about large corporations – they all have employees that work IN the business doing the day-to-day work, who receive regular salaries and bonuses as their compensation. They also have boards of directors that work ON the business, who primarily receive shares of the corporation and profit distributions (dividends) as compensation. As a business owner, you are both of these types of people. The goal is that over time as you grow your business, you’ll become more of a director/CEO type and less of the employee type, but realistically you’ll probably always do both.
 
Because you are in both roles, you should be paying yourself 1) a regular salary and 2) profit distributions.
 
How much can I pay myself?
Of course, you need to be profitable to make sure that you can pay yourself and keep your business running. One of the major premises of Profit First is that business owners need to… wait for it… put their profit first, instead of just waiting to see what they have left over after they pay all their expenses. This is because most people will spend whatever money they have in their accounts on expenses, including on things they probably don’t need, leaving next to nothing with which to pay themselves. By using this method, you are ensuring that you’re profitable, because you can only spend the amount of money left in your operating expense bucket after you take your owner compensation and profit.
 
The easiest way to make sure you get paid is to pay yourself first, every time you make a deposit in your bank account. Notice I said deposits, and not net income. You should pay yourself whenever you deposit money from sales, before you even think about expenses. This is backwards from the way that most people run their business!
 
At whatever frequency is easiest for you to keep up with (I recommend twice per month, but some of my clients like to do this weekly) you should set a money meeting with yourself on your calendar and review your finances. Then, take a percentage of your deposits and set that aside in four different buckets – owner pay, taxes, profits, and operating expenses. Note that expenses come last!
 
Again, I recommend reading the book, but it recommends that you actually set up five different bank accounts – one for your deposits, and one for each of the additional buckets. Then you physically transfer the money you allocate to each of the buckets into the separate bank accounts, and it’s easy to see exactly how much money you have in each bucket.
 
Profit First has recommended target allocations based on the size of your business (download the Instant Assessment here). I find that setting the percentages for owner pay and profits is the hardest for my clients, because the target percentages are usually way far off from what they’ve historically done. So, we start small and work up to the target allocations over time, with a goal of being as efficient with expenses as possible and paying the owner as much as possible!
 
For businesses with up to $250K in revenue, Profit First recommends:
  • 50% of your revenue goes to owner compensation.
  • 15% goes to taxes (including business taxes and personal tax on business income).
  • 5% goes to profit – every quarter, pay yourself half of this balance as a profit distribution, and leave the rest as a cash cushion.
  • 30% goes to operating expenses.

 

Example

This concept is much easier to understand with an example. For this example we’re going to start with revenue for the last 12 months – even if last month was really great, you need to look at your historical average so you account for ups and downs, and don’t base your plan on your high income months only.

Ralph’s Landscaping brought in $120,000 in sales in total for the last 12 months. Target allocations for the whole year are:

  • 50% owner comp = $60,000
  • 15% taxes = $18,000
  • 5% profit = $6,000
  • 30% expenses = $36,000

Ralph decides to pay himself twice per month. For owner comp, Ralph is going to set his annual salary at $60,000 based on his allocations, which equates to $2,500 per bimonthly pay period.

At Ralph’s next money meeting, he reviews his deposits and finds that he made $6,000 in sales. He then allocates his money to four buckets:

  • 50% owner comp = $3,000
  • 15% taxes = $900
  • 5% profit = $300
  • 30% expenses = $1,800

Since Ralph has $3,000 in his owner comp bucket, he has more than enough to pay himself his $2,500 bimonthly salary. Yay! He leaves the remaining $500 in the account. That way, if he has a dip in sales prior to his next money meeting, he has some cushion and can continue paying himself a regular salary.

He also has $300 in his profit account, so at the end of the quarter, he gives himself $150, or half, as a profit distribution. He leaves the rest in the account to use if crap hits the fan.

The next quarter, Ralph runs his new 12 month numbers, and updates his allocations based on his latest average revenue. If revenue is up, he gives himself a raise!

 

In Summary

Definitely read the book. I found the writing to be very informal and easy to read, but I think the principles are easy to implement if you start small and improve your allocation percentages over time. And no one can complain about actually paying themselves!

  • Make it a goal to pay yourself a regular salary and quarterly profit distributions.
  • Set target allocation percentages that work for your business. Try to improve them over time!
  • Always pay yourself first, even if you can’t pay yourself as much as you’d like right now. Start small, and work to become more efficient with your operating expenses so you can increase your pay over time.
  • Set up a regular money meeting with yourself to review your financials and transfer your deposits to your owner comp, tax, profit, and expense buckets.

And if this system sounds good to you but you aren’t confident you can implement it on your own, contact us to discuss how we can help you implement this system as part of a monthly bookkeeping plan!

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