As a small business owner, you need to decide how much money you should put back into your business, how much cash on hand you need, and how much to pay yourself. In this episode, hosts Elizabeth Larkin and Gene Marks answer the question:
“I just started my business. I think I can afford to take a salary, but I’m not sure what to pay myself. Are there particular guidelines I should follow?”
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Elizabeth: Okay, so Gene, last time you gave me some TV recommendations. I’m going to give you two book recommendations.
Gene: Good, and I have book recommendations later on. Go ahead.
Elizabeth: Okay, alright. So mine are Life After Life-
Gene: Oh, that’s a great one.
Elizabeth: -by Kate Atkinson.
Gene: Yeah, it’s a great, great book.
Elizabeth: Have you read it?
Gene: I did. It’s a fantastic book. This is where the woman, she keeps reliving during World War II.
Elizabeth: When did you read it?
Gene: I don’t know, like a year or two ago.
Elizabeth: Oh, okay. Maybe you told me about it.
Gene: I’ve read some of her other books, like Behind the Scenes at the Museum is really good, by Kate Atkinson. But fantastic, well-written. She keeps reliving it, being bombed in London.
Elizabeth: Oh my God, it’s so good.
Gene: Yeah, it’s a great book.
Elizabeth: Really good. And the other is Dark Matter, which is very popular right now.
Gene: Very familiar.
Elizabeth: It’s kind of the same thing.
Gene: Who wrote it?
Elizabeth: It’s… Oh, I can’t remember who wrote it, but it’s someone reliving the same thing over and over again, but very… It’s kind of science [fiction], but you can enjoy it if you’re not a science fiction person.
Gene: Okay. Alright, cool. Alright, those are great.
Elizabeth: Those are two good ones.
Gene: Thank you.
Elizabeth: We’re going to jump right into our question, because it’s a good one that I think a lot of small business owners are going to be very interested to hear the answer of this. It’s how much should I pay myself? We’ll be right back.
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QUESTION: As a Small Business Owner, How Much Can I Afford to Pay Myself?
Elizabeth: Okay, this is from Cynthia in Arkansas, and she’s a life coach, and her question is this:
“I just started my business. I think I can afford to take a salary, but I’m not sure what to pay myself. Are there particular guidelines I should follow?”
Gene, I’m going to let you answer this.
Gene: I’m thinking a million dollars a year. What do you think? Does that sound like a good round number?
Elizabeth: I’m pretty sure-
Gene: Cynthia, does that help? Cynthia, it’s a million dollars a year. Start there, and then just increase is like 10% every year and you’ll be good. Next?
Elizabeth: So you have your revenue, you have your profit.
Gene: Yes. And then what?
Elizabeth: And then you have your net.
Elizabeth: So how much of that, I think is she asking?
Elizabeth: What percentage?
Gene: Yeah, well first of all, I don’t even know why that question comes up for a person that’s just sort of a life coach.
Elizabeth: Because she might be employing other life coaches.
Gene: That’s the issue. If she’s going to grow her business and become more formalized, fair enough.
Elizabeth: Well let’s say both scenarios. A, she’s just a sole proprietor and basically what she’s asking is how much money, how much of my profit should I keep for myself, and how much should I put back into my business?
Gene: So, for starters, let’s talk a little bit about having cash in your business. Generally, and it does change a little bit depending on businesses, but as a benchmark, you should have six months of cash in your business, just available cash in your business.
Elizabeth: And that’s for every industry?
Gene: It varies per industry, but on average across all industries, it’s six months is usually the number that you should be looking for. So, whatever Cynthia’s going to be taking out of her business as a life coach, she wants to make sure that she’s keeping that much in reserves. Now, the question is, how does she figure out six months of cash? She has to figure out what her expenses are.
Elizabeth: Which have to be pretty low.
Gene: Probably, but she needs to sit down and figure out what her expenses are. She has to calculate that what they are per week, per day, or per month hopefully, and ultimately she has to end up per month. And then she has to say for me to fund this business and keep it going, I’m going to need this amount of money that’s sitting there in the bank. That’s what she needs to do.
Elizabeth: That’s so annoying.
Gene: Why? That she wants to-
Elizabeth: No, just having to figure that out.
Gene: Yeah, right, well it’s called math and that’s what people that run businesses do, as spoken as an employee of The Hartford.
Elizabeth: I just hate the tracking part, like oh, I just bought this new computer. Does that have to go into my monthly expenses?
Gene: Yeah, you got to kind of like chart that stuff when you’re running a business. So yeah, you got to do that. So anyway, she figures that out. If she’s a sole proprietor, there’s no salary she needs to pay herself. From a tax perspective, she could be filing a Schedule C on her, which basically means that whatever income is coming in, she’s recording it on a spreadsheet somewhere. She’s got expenses recorded as well. That’s all going on her Schedule C. And whatever cash is in the bank, feel free to… You don’t have to pay yourself. It’s being taxed.
Elizabeth: Yes, but she could also take some of that money and say put it into a marketing budget.
Gene: She could. So she could take some money out and spend it or invest it or whatever. But again, she wants to just make sure that she’s keeping about six months of cash on hand. Everything else is up in the air. And by the way, she doesn’t have to keep it… If she wants to keep two months of cash on hand, and she wants to do that’s fine. I’m not saying this is written in stone, but that’s generally the rules that you’re going to follow.
Elizabeth: Best practice.
Gene: Correct. So that’s if you’re a sole proprietor.
Elizabeth: What if you have employees?
Gene: So now, if you want to grow your business to a certain level, then you’re building organization and structure. And you start hiring people, and you do want to pay yourself a salary. First of all, from a tax perspective, you won’t be a sole proprietor anymore, you are going to be an owner of a corporation, an LLC, an S Corporation. So there are some benefits to actually having a salary on the books, where you get payroll taxes withheld. You’re then able to contribute to things like 401(k) plans. You’re able to then have… you would pay into Social Security taxes and Medicare, so you can get those benefits if you’re a salaried person. So you’ve got to figure that out.
Now, the goal is, when you’re paying a salary is that it really should be commensurate with what somebody at your level is paying. So it depends, if she’s running a coaching firm, so she’s a service firm, she’s the CEO of a service firm, with less than five employees, less than 10 employees, right? Go to a site like Glassdoor, for example. You’ll be able to see comparable salaries for CEOs of firms that are somewhat or indirectly connected to your industry. And then see what those CEOs are making, and at least you know that’s what I should be paying myself. Now, again, the six month rule still applies. If you can’t pay yourself that salary yet, fair enough, then only pay what you can afford, leaving that six months of cash in there. But your goal should be that you should be getting a market rate for running your business.
Ultimately, Cynthia, if you’re running a realistic organized business, your goal should be that you’re getting paid at a market rate and then you’ve got your other expenses, and then you’ve got profits at the end of the year after your salary, which are then, profits are being used to reinvest back into your business and all of that.
Elizabeth: Now, what if you’re the owner and you need a little extra cash? Say your kid’s going to college.
Gene: Yeah, right, just by coincidence. So what do you do?
Elizabeth: Can you like dip into-
Gene: Take the cash, of course. You can do whatever you want. It’s your business. So you don’t have to worry. People get confused about the taxing thing. Trust me if you’re the owner of a business, whatever the profits are of your business, that’s what gets taxed. But then you can pull money out of your business whenever you want, as a distribution it’s your business.
Elizabeth: That’s separate from payroll.
Gene: Yeah, it’s separate from payroll.
Elizabeth: So how is that taxed? Like a bonus?
Gene: No, it’s not taxed at all. It’s already been taxed.
Elizabeth: Oh, right, okay.
Gene: So if my business came in with $100, and then I had $10 of expenses, so there’s $90 sitting there in cash in my bank-
Elizabeth: That’s technically just your money.
Gene: It’s my money, and I’ve been taxed already on that $90, because I have $90 in profits, $90 is sitting in my bank. I can take all that $90 out. I’m not going to be taxed on it again. I get taxed on the profits of my business. So those are sort of the guidelines that she should follow.
Elizabeth: So you could take that out and pay for sushi?
Gene: For sushi, every Friday night. That’s exactly right. Or even a movie once in a while. You could do that too, if you so wanted to venture out of your apartment like we did last weekend to see an actual movie.
Elizabeth: Gene actually left his apartment and went to a movie.
Gene: It was three. Three movies in one weekend, my wife and I. It was a binge.
Elizabeth: And you went to all of them.
Gene: In movie theaters with people.
Gene: It was incredible. We had popcorn and everything.
Elizabeth: Did you interact with people?
Gene: No, I didn’t want to do that. Let’s not go overboard here.
Elizabeth: Did you smile at anyone.
Gene: We kept to ourselves. No, it’s dark. Nobody sees you. But we fully and thoroughly enjoyed… Going to the movies is great. It’s really-
Elizabeth: It’s really fun.
Gene: Yeah. And I find myself when you go to a movie, that you watch a movie, you pay way more attention to a movie in a theater than you would at home in front of a TV. So it really is a lot… We ought to do that again, go to a movie.
Elizabeth: Yeah, you should do that. Three in one weekend, that’s-
Elizabeth: That’s nuts.
Gene: Pretty good, huh?
Gene: Pretty good. Yeah, we’re very impressed.
Elizabeth: Okay, so wrapping up Cynthia’s question …
Gene: The bottom line is this Cynthia: six months of cash you want to leave in your business. If you’re a sole proprietor, take whatever money you want out of the business, and keep… as long as you’re trying to keep around six months of cash in there. If you’re building up your business and creating an actual organized entity or structure, go to a site like Glassdoor. You’re going to have a benchmark, a targeted salary that you should be paying yourself as the CEO of a service firm, and that’s what you want to work to.
Elizabeth: Okay. Alright, we’ll be right back with Gene’s Word of Brilliance.
WORD OF BRILLIANCE: Freebies
Elizabeth: And we’re back. Gene, what’s your Word of Brilliance?
Gene: Freebies, Elizabeth. Do you believe in giving out freebies to customers?
Elizabeth: Like sample-sized stuff?
Gene: Samples and free product.
Gene: So, there is a woman who runs a bakery in England, who was very much in the news of late, because she had a viral post that went out.
Elizabeth: A lot of stuff coming out of England lately.
Gene: I know, and Australia. But anyway, this woman is… she’s running … she got sick of giving out free cakes. She makes cakes. Giving out free cakes. And she was pushed over the line. Apparently, a very popular show there is like X Factor, is one of the popular shows in England. And they asked, they were having a wedding on the show, and they asked if she would contribute a cake to the show in exchange for they’ll promote, they’ll mention her on their social media channels. And she went on social media, she said that she refused to do it. She wants to get paid for the cake, and she’s fed up with giving away stuff for free.
Elizabeth: Oh, I thought you meant… Like how much is she giving away?
Gene: Well, she goes it happens a lot. She says like church groups come, non-profits, organizations. She’s actually quite good and she has like celebrities. Believe it or not, these celebrities that are making $20 million a year, excuse me, 20 million pounds a year if you’re in England, and they don’t want to pay for a cake, in exchange… Give me the free cake and then I’ll mention you in my Twitter, or whatever. And she’s like I’m fed up with this and I’m not going to do it anymore. And she made a big post that went viral to all small business around the world, don’t give into this stuff. You work hard. She works 17-hour days, and she says she’s sick of giving stuff away for free.
Elizabeth: I disagree with the charity stuff though, I mean, that’s just good business.
Gene: Well, but yes, it is good business, but there is a limit, isn’t it? There’s people that come-
Elizabeth: I wouldn’t give any-
Gene: She’s getting people coming to her all the time, like Girl Scout groups and this and… give me… donate and we’ll mention you to our friends and our whatever, and you know. Anyway, I think in the bakery business, it depends on your business, I think giving away stuff for free is pretty critical. I think it’s very, very personal and very… You know, people taste your stuff, and let’s face it, if somebody likes your cake, they’re going to come back and get more cake, and recommend you to friends. So I don’t think you can give away enough free stuff, I really don’t. Now, I commiserate with her because she works hard and she hates giving away her cakes for free.
So, I do have a suggestion for her, and for you, if you are giving away products for free. It doesn’t have to be free. And my suggestion when I was… You know, to her is that if she took a year, over the next six months up to a year, and whenever she was giving away something for free, she makes a note of it in a spreadsheet, what the cost is to her. So over the course of the year, she should come up with what her expense it. It’s a marketing expense. During every year, I spend 5,000 pounds or dollars in costs for free stuff that I’m giving away. That’s what I’m generally spending. Build that expense into your overhead, have it as a line item, and then just adjust your pricing overall, for all your cakes and cupcakes and whatever, by the extra couple of pennies required to cover that extra expense, because it’s a marketing expense.
Elizabeth: But as a consumer, then I have to pay so a celebrity can get a free cake?
Gene: You know what. Okay. Really, if you’re going to go and get a cake, and she’s going to be like it’s 15 pounds for this cake, or it’s 15 pounds 20 pence for this cake, you’re really going to make… You’re not even going to know the difference. Meanwhile, she’s covering her costs. And that’s what companies do. Every big company, whenever there is extra costs.
Elizabeth: I think she should cover her costs, but I draw the line in giving away free stuff to celebrities.
Gene: Listen, I don’t, because I think it’s a marketing thing, and I think that… Look, she’s giving this to the X Factor, and if the X Factor’s going to promote her product on their social media, maybe it’ll generate more work for her, so that’s a good thing. But it doesn’t have to be free, is all I’m saying. She can give away this cake and still get paid. She can have her cake and eat it too.
Elizabeth: Oh, my god.
Gene: That’s what she is… That’s what my advice to her is.
Elizabeth: Okay, on that note, we’re going to close it out before Gene utters any more-
Gene: Yeah, I’m in the mood for cupcakes. Don’t even bring up that cupcake place in Hartford that you always bring up. Don’t you love it? What in this now?
Elizabeth: It’s doughnuts.
Gene: Is it doughnuts? Is that what it is.
Elizabeth: Now I want pie. Alright, we’ll be back with another episode in a couple days.