A lot of business owners end up shortchanging themselves and their business by failing to set themselves a market-rate salary. They either overpay themselves by taking too much revenue out of their operation or underpay themselves by not setting aside enough income, thereby distorting their numbers. Either way, this end up harming the business.
The Difference Between What You Do (Salary) and What Your Earn (Profit)
As the owner and the CEO (or sales or COO or insert-creative-titles-here) of your company, you should be getting paid twice - once for the “work” you do and once for the “profit” the business earns. Unfortunately, many entrepreneurs focus solely on the later and neglect the former. This is the core problem that skews the financial data of most small to medium sized companies.
Check this over-simplified income statement out – the one on the left did not account for the owner’s market-rate salary for what he does and the one on the right did.
By simply accounting for the owner’s salary – the company went from a we-are-doing-okay 7.65% in net profit to a dangerous 1.76%.
So? What is the Big Deal?
Many entrepreneurs believe this is not a big deal because they are still getting the money at the end of the day assuming they own 100% of the company. In fact, their cut-rate tax preparers might even be the one advising them to do so to “save a few bucks on payroll taxes.” Well, besides the obvious reason of it being illegal, you are just lying to yourself about the health of your business.
Look again at the example above. The two companies are in vastly different stages based on the story the numbers are telling me.
At the fake 7.65% net profit – I would be lying to myself (and everyone else who rely on these numbers to make decisions) thinking that my company is doing an okay job at surviving. I may even feel like I could afford a little more admin cost to hire that office assistant everyone was asking for. I could be working on scaling my business under this financial model – after all, 7.65% of 10 million sounds pretty good. It certainly beats leaving this money in the bank.
On the other hand. If I am looking at the real number of 1.76% net profit – alarms will be going off everywhere in my company. Something is really wrong here. I would be reviewing my numbers with my entire team to figure out what is broken and the necessary actions steps to turn things around. If I can’t fix it, then I should probably get a job and know that there are tons of opportunity out there that I can make more than 1.76% return on my money.
Clarity and having a clear sense of direction is of vital importance to a business of any size. But for a startup or small business it is absolutely essential that your numbers accurately reflect the state of your business. Without factoring in an owners salary at the market-rate, you are needlessly muddying the waters.