How Much – and When – to Pay Yourself

Let’s face it, every entrepreneur wants (and needs) to get paid. This is the foundation for a sustainable business trajectory.

The difficulty comes in deciding how much your business should pay you. Although there’s no specific formula that covers all cases, the following standard factors can help you make this all-important decision:

Timing

The first element to consider is timing; your compensation as owner must not negatively impact the health of the business. For instance, in the early planning stage, the company has no revenue but probably has lots of start-up expenses. At this point, it doesn’t provide cash to feed you; rather, you are feeding it.

When your operation is generating revenue, sustaining the momentum is paramount. In the first six months or so, the business builds cash for expansion, so you don’t take any distributions in that time period. However, after six months, you need to take a distribution; after spending all your time and resources, it’s crucial to your psychological well-being that you pay yourself something.

You are the most important – and possibly only – employee of your business. Even small recurring compensation demonstrates that the company exists to reward individual effort. This also means that predictable owner distributions become part of the business cash flow along with general operating expenses.

The amount

After a bit of history with your business, you’re able to build a financial forecast. This considers your available resources – especially money – and predicts future revenue along with expenditures. Your owner compensation is one of the cash outflow categories. The budget should allow your pay to be adjusted based on other required costs for business operations.

Not all of the outgoing cash is for recurring overhead expenses. For instance, if your company sells products, funds are needed to replace inventory. Likewise, a service-oriented business may need parts or materials for the projects expected in upcoming months. Or maybe you’ll require extra cash for necessary travel or subcontractors. The company bears these costs prior to getting paid by customers.

The key is remembering that your primary concern is the strength of the business, and you need to have a cushion of cash to reinvest in it. However, one of the costs of conducting operations is your labor. While you don’t want to bleed the company dry, some amount of recurring compensation is reasonable. Find that amount in the company budget and pay yourself consistently. As you reinvest cash for growth, the cash cushion should rise, allowing you to take larger distributions in the future.

The people

Do you have investors or have you borrowed from financial institutions? Investors generally want to know that you are being paid by the business, and will usually set your salary ceiling along with performance goals. Lenders, too, want to see owner compensation as an indication you have an incentive to grow the business. Note that demonstrating sufficient cash flow for debt repayment is easier if your historical compensation is a consistent amount; variances complicate lenders’ abilities to evaluate cash flow.

How to Prevent Common Cash Projection Mistakes

Cash flow is vital to the financial stability of every business – from the smallest to the largest. Therefore, every entrepreneur should become familiar with the cash flow statement.

Forecasting cash flow is a necessary foundation for future planning, enabling you to measure actual results against goals: meeting specified targets validates your initiatives, while missing targets identifies where improvement is needed.

However, a number of common errors with cash flow projections will result in poor strategic decisions. For example, projecting operating income is often the cause of cash flow blunders. This top line of the projected cash flow statement should represent a realistic profit forecast based on available resources.

The best starting point is a separate projection of revenue and expenses, and subsequently, an examination of changes in receivables and payables. This is accomplished by using figures for the average number of days that receivables and payables are outstanding. Cash flow is different from income because of the lag between sales and collection, as well as the lag between receiving a bill and paying it.

Other cash flow variables are investments and financing. These do not appear on the income projection, so they appear on a cash flow forecast. Investment in a new asset – such as machinery or equipment – subtracts cash. Financing these purchases by borrowing adds to cash.

Those entrepreneurs familiar with the components of cash flow statements can recognize the forecasting limitations, and they will seek professional accounting assistance to overcome these limitations.