The holiday season is of course about giving and the holiday spirit. It’s a time of year when most are less concerned about themselves and more concerned about their families, the spirit of giving, and being thankful.
As we enter a new year, however, it is also a good time to reflect on the risks and rewards that we all experience as small business owners. Most entrepreneurs have a strong passion and belief in their businesses, but too few are reaping the rewards that they hope or expect to see. In fact, in our ongoing survey of small business owners, we find that most are not only concerned about having enough cash to sustain their businesses over time, but we also find that most are dissatisfied with the level of personal income they are making from their efforts.
This may not be surprising on the surface, but it is a bit concerning since most entrepreneurs start businesses to create wealth for themselves and their families. This is typically not the only reason for starting a new company, but it is an important one. Combine this desire with the level of risk that entrepreneurs face – whether it be risk of financial duress, legal issues, or the possibility of failure – and there is clearly a disconnect between what entrepreneurs should be earning and the pay they actually take home for themselves.
So what’s the right answer? Unfortunately, there is no single answer for all entrepreneurs since every small business is different, but here are four questions you should ask to determine the “right” amount to pay yourself:
- Evaluate the risk you are taking with your small business. Some small businesses are riskier than others, and those taking on the larger risks should be compensating themselves for that risk. For example, if you are in a high-risk industry, such as financial services where default rates are high, you would be more likely to want to compensate yourself beyond what the average entrepreneur makes. Grocery stores are notorious for low margins – around 3% on average – but that is partly because they are not as risky as some other enterprises where the risk is greater.
- Revisit your small business costs. Subpar profitability is one of the main reasons why entrepreneurs don’t pay themselves more. After all, if your business isn’t producing a significant profit, there will be less left over for you to take home. With this in mind, it is critical that you increase your profit margins to the point that you can compensate yourself accordingly. Too often, entrepreneurs overpay employees, suppliers, and put themselves last. Instead, it can be helpful to determine the minimum that you are willing to take home, then reengineer your cost structure to accommodate those financial needs. It may seem easier said than done, but it is critical to adopt this mindset if you are ever going to create true wealth for yourself. This is an area that good small business consultants can help with.
- Analyze your financial ratios. Most entrepreneurs struggle with (or don’t like) accounting and bookkeeping. Even the ones that have figured it out, though, don’t adequately analyze their true financial position beyond simple profit and loss. When analyzing your financial results, it is important to also evaluate your current and quick ratios on your balance sheet to determine how much cash you can reasonably take out of your business without jeopardizing its financial stability. In other words, once you subtract all of your liabilities from your cash and liquid assets, you will better understand the amount of cash that you could potentially take out of the business at any given time. This is something that can easily be done with good small business software.
- Determine how much money you need to grow your business. Small business owners too often feel as though they need to put most of their company’s earnings back into the business to fuel small business growth. This may be true if you have high working capital needs due to growth or increasing inventory, but many entrepreneurs err too far on the side of leaving money in the business because it feels safer that way. However, it is important to recognize that you are actually putting more of your money at risk, so there is something to be said for keeping as little cash as you need to in your business. You should consider taking most of it off the table by compensating yourself.
Obviously, entrepreneurs don’t want to take so much out of their companies that they can’t continue operating. However, we find that this isn’t the problem with most. Instead, the bigger risk is that they aren’t taking enough for themselves. With all the risk and hard work that comes with owning a small business, it is important to reconsider your current level of personal compensation.
Learn more about how to better analyze your financial situation by attending our free online Small Business Boot Camp training course.