In the early days of CourseHorse, a New York City company that helps people find local educational classes, CEO Nihal Parthasarathi and his co-founder took no salaries, supporting themselves with part-time jobs earning about $20,000 a year each. After landing $75,000 in seed money for the startup, they quit their part-time jobs and started paying themselves $24,000 a year—still a pittance in costly New York.
"Our salaries started about as low as they could go," Parthasarathi says.
Now, nearly five years after startup, as the company's finances improved, they've given themselves raises to $30,000 and then $36,000. "We're higher than that now, but we still pay ourselves less than anybody else on the team," Parthasarathi says. "I still don't make close to a market rate."
Parthasarathi acknowledges that his parsimonious self-compensation doesn't make for a comfortable lifestyle, but claims the co-founders aren't in it for the salary. They're in it for the exit. "For my partner and I, it's mostly about the equity," he says. "That's our savings account. The dollars and cents we'd pay ourselves now pale as an outcome at the end of the day."
Parthasarathi reveals that CourseHorse's investors want the founders to take larger salaries, out of concern that personal financial worries will distract them from running the company. But he feels paying themselves below-market wages helps to set a frugal atmosphere that is appropriate for a young company. And employees, who are also being asked to take part of their compensation in equity, appreciate knowing that the founders aren't over-paying themselves, he adds.
Do You Deserve a Raise?
Many business owners puzzle over how much to pay themselves and when to give themselves raises. While labor markets largely dictate compensation practices for employees, it can be less clear how much owners should be paid. Atlanta management consultant David Nour suggests that whether owners plan to cash out through an eventual exit or are lifestyle entrepreneurs seeking to earn a living without necessarily building large enterprises, they should avoid under-paying themselves.
"Either way, pay yourself first," Nour says. "And pay yourself a market rate." Nour, who runs a one-man business with contract workers to help execute engagements, pays himself a combination of regular salary plus quarterly performance-based bonuses.
"If I hustle and the business has a good year, I should be compensated more," he says. "On the other hand, if the economy is tough, I get lazy or don't produce results for my customers, I shouldn't have as good of a year personally."
David Worrell, who advises growth-oriented companies with Fuse Financial Partners in Charlotte, North Carolina, claims owners who don't take adequate salaries are merely subsidizing ineffective businesses. "The owner cannot take more than the business can afford to pay—but must also make a fair compensation part of the business budget," Worrell says. "Too many business owners take little or nothing, thinking that they are ‘investing back into the company,’ when what they are really doing is creating an unsustainable business model.”
How to Pay for That Raise
Rules of thumb can be used to suggest whether the owner needs a raise. For instance, owners may compare their compensation to benchmarks such as 20 percent of profits, 2 percent of gross sales or a maximum of four times the next-highest employee's pay. The most widely used best benchmark is probably what CEOs of similar companies are getting. This information may be available from trade associations or the Small Business Administration.
The Internal Revenue Service may take an interest if the owner of a corporation takes a salary it deems excessive. At the other extreme, a small-business owner who takes no salary may risk having it deemed a hobby business by the tax authorities.
If cash is in short supply, owners can give themselves perks in place of money. For instance, Nour says a hard-working owner may take his or her spouse or family along on a business trip as a non-financial reward for performance.
In the end, there may be as many approaches to giving yourself a raise as there are business owners. While employers, investors, partners and tax collectors may need to be considered, the final decision is up to your goals and the effect that a higher salary could have on your business.
Sometimes taking a salary can take a back seat to building a business, as in the case of Parthasarathi, who left a high-earning consulting job to become an entrepreneur. After five years at CourseHorse, he's still trying to get back to where he was, salary-wise. He says, "I still don't make as much as I made right out of college."
Read more articles about cash flow.