Are You Paying Yourself Enough?
Finally the time had come for Smart Furniture's lowest-paid employee to get a raise. Stephen A. Culp, 35, founder and CEO, had launched his Chattanooga-based modular furniture company in 2001, and for three years he had made sure that every one of his employees was paid well and on time. Everyone, that is, except for himself. For all his efforts to make his company a success, through the long days and nights, Culp had been working for slave wages, literally. Every month, for going on 36 months, he took home the princely salary of precisely nothing.
As a single guy, he was able to live frugally, drawing down his personal savings to fund the necessities: rent on a small one-bedroom apartment, groceries, electricity. Meanwhile, every penny of Smart Furniture's profit went back into the company. The money he could have paid himself funded the salaries of two employees who had had a hand in the company's sales tripling over the previous three years. "It's a prioritization of cash flow," Culp explains. "If I can survive on cereal and take all the cash that I would have spent on a more extravagant lifestyle and put it back into the company, it increases my chances of success." And what's Culp's definition of success? To see Smart Furniture become the "Dell of furniture."
Still, it's not Culp's plan to live on Fruit Loops forever. In November 2003, when he prepared his financials to seek venture capital, he knew he'd have to put something on the CEO's salary line. The question was, how much? He didn't want to pick a number that was too high -- he'd been told that venture capitalists were turned off by entrepreneurs who look as if they're only out to pad their bank accounts. And he didn't want to pick a number that was too low, either -- his savings weren't going to hold out indefinitely. The question was, what, exactly, would be a fair way to compensate himself for his time, effort, and risk?
That question can be excruciatingly difficult for any entrepreneur, whether the business is starting up, starting to grow, or well established. It's especially timely right now, coming off several years of a difficult economy. And yet, says Mark Edwards, founder and CEO of Compensia, a compensation consultancy based in San Jose, Calif., "the fact is, there is no one answer."
Perhaps it's no wonder that many entrepreneurs say deciding on self-compensation can feel like playing a game of "pick a number, any number." After all, you're constrained only by how much profit your company makes. You can take nothing, or you can take it all -- or anything in between. Don't like the number you decided on today? Change it tomorrow. Or next month. Hey, it's your company. You're the boss.
This wouldn't be quite so difficult if compensation were merely another business decision, says Larina Kase, a Philadelphia-based psychologist who counsels entrepreneurs. But it's so highly charged. "All kinds of emotional issues come with anything having to do with money," she says. "Since there are no clear guidelines on what you should be compensating yourself, it's even worse. Uncertainty makes for a great way for all of these issues to come to a head."
This can lead to entrepreneurs behaving badly -- or at least inconsistently and haphazardly -- when it comes to their own compensation, says Tom Kinnear, executive director of the entrepreneurial studies program at the University of Michigan's business school. "I don't think it's good discipline to take money out of the business randomly," he says. Like a well-run family, he says, a well-run company requires consistent cash flow.
The journey from pick-a-number-any-number to the right number starts with pondering why you started your company in the first place, says Howard Anderson, a professor at the MIT Sloan School and senior managing director at Yankee Tek Ventures, a VC firm in Cambridge, Mass. Your goals for your company, he says, will govern how much you take from it.
For the purposes of self-compensation, Anderson says, there are two broad categories of entrepreneurial ventures. There are those that intend to grow, and grow fast. And then there are "lifestyle firms," those run by a breed of business owner some call "intrapreneurs" -- people who start a business because they like the lifestyle of a small-business owner but aren't trying to be the next Bill Gates. These are business owners like Lynn Lewis-Bjostad, president of Premier Meetings and Event Management, an event-management firm based in Irving, Texas. With two employees today, she hopes to increase sales by a modest 35% to 40% over the next five years, adding perhaps one or two more employees. She has no desire to sell the company -- and no plans ever to step aside as CEO and start another firm.
For Lewis-Bjostad, setting compensation is about making sure the company stays healthy, not about funding rapid growth. If you're such an entrepreneur, there's less reason to limit the amount of profits you take out of the company. "It doesn't matter what you pay yourself," says Anderson, "because everything after expenses is yours." Often, such entrepreneurs will simply add up their monthly personal expenses, add a little more for safety, and call that their salary. That's what Lewis-Bjostad has done, right from the time she started her company in 2002. In good months, she doesn't take any more than her salary from the firm, and in bad months, she doesn't take any less. "The consistency is important to me," she says. "I couldn't live any other way." A key point to keep in mind: Make sure, as you take profit out of the company each month, that you leave yourself a reserve for when times turn bad. It should be enough to cover six months' worth of company expenses.
24% of Inc. 500 CEOs reduced their own compensation in 2002.
Things are different if you're in Anderson's other group of entrepreneurial ventures -- if you've got goals for your company, as Stephen Culp has for Smart Furniture. If you're planning dramatic growth or thinking about selling your company to outside investors at some point, you have to consider not just how your salary affects your personal finances but how it will look to venture capitalists or the other money types who will scour your company's financials. Many entrepreneurs believe that to impress VCs and their ilk, they should keep their total compensation as low as possible. This is part of the reason Culp confined himself to a salary of zero for three years. "I knew from the beginning that we were going to be going for venture capital," he says, "and I wanted to be able to show them from the beginning that I was willing to make sacrifices, that I knew the value of a nickel, and that there is definitely skin in the game."
There's something to this, says the University of Michigan's Kinnear: "Investors want to see deep commitment." And many entrepreneurs do take this advice seriously. For example, Christie Stone, president of Ticobeans, a start-up coffee distributor in New Orleans, pays herself just $19,000 a year (with commission, she should make $35,000 this year). The business isn't profitable yet, and she won't take a penny more than she needs to pay her bills and stay off the street. But even entrepreneurs with established businesses tend to linger too long in this mode. For example, Jeremy Shepherd, owner of PearlParadise.com, a Santa Monica, Calif., company that did $3 million in sales last year, is paying himself a salary of $36,000 -- considerably less than he gives his top-paid employee.
Entrepreneurs who own profitable companies should start to think about paying themselves a "real" salary, says MIT's Anderson. Why? First, it's a more accurate depiction of your business expenses -- something that people who are investing in your company or lending you money really care about. "They're going to want to see spreadsheets that make sense, that are, for the lack of a better word, normal," says David Larcker, a professor of accounting at the Wharton School. And "normal" will always include reasonable compensation for the CEO. "Should the company get sold," says Anderson, "you don't want to all of a sudden have this enormous new cost that you haven't had before. You've overstated your profits because there's no expense for the CEO." That's not a surprise that any investor wants to receive, and so investors will eliminate that uncertainty even if you don't want to.
Of course, there's an obvious next question: Just what is reasonable compensation? The task is to determine the market value for your position -- in other words, what you'd have to pay someone to do your job. Let's pause for just a moment: Of course, no one could ever really replace you. Of course, there's no company out there in the whole wide world that's exactly like yours. And, of course, no hired CEO would put in the same effort you do. Understood. Now then, the process of determining market value for your compensation is actually a lot like having your house appraised. You gather "comparables" for homes similar to yours and then you adjust the value up if your house has more bathrooms, for example, or down if the comp has just had its roof replaced.
51% of Inc. 500 CEOs put their net worth between $1 million and $5 million.
In much the same way, you gather information from as many sources as possible about how much owners of companies like yours get paid and then adjust upward or downward for factors such as revenue, profitability, company age, the amount of time you put into the company, and so on. Where do you gather comps? You could start with the website www.salary.com, which aggregates salary data by geographic area. But then -- and there's no way around this -- you just have to ask. Talk to entrepreneurs in your industry and in your area. Go outside your networking circle, and talk to the people at your local entrepreneur-support organizations, your local bank, your small-business development center.
Even when you've got a sense of your market value, the job isn't done. Many experts -- like Kinnear and Edwards -- recommend that you knock your market-value number down by a certain percentage. This is to ensure adequate investment in the growth of the company and to show investors that you're still committed to building an enterprise and not just your bank account. "There's an opportunity cost built into the entrepreneur's salary," says Kinnear. What sort of a percentage should you lop off? Compensation experts differ. Kinnear suggests that you discount it between 50% and 75%, others say 40%, still others 20%.
What to do? You could figure out whom you expect to look at your financials, and then get a sense of what sort of discount they'd like to see. Or you could delegate the whole matter, get yourself a board of directors -- and let them decide what's appropriate. Boards can also help correct errors you might already have made in determining your compensation. For example, when Peter A. Snyder, owner of New Media Strategies in Arlington, Va., started his company, he thought he was doing the right thing by keeping his salary at $30,000. Two and a half years later, his board adjusted his salary, tripling it. "It was a surreal experience," Snyder says. He thought he was "gutting it out," sacrificing his income for the long-term health of his company. His board told him that he was actually undermining the company's financials by taking a salary that was so far below market rate. "Without my board, I would have done that 'CEO-martyr thing' much longer," Snyder says.
Or the board can help you start from scratch. "The compensation committee of our board of directors has established my pay for as long as we've been in business," says Aaron Kennedy, founder, chairman, and CEO of Noodles & Co., a chain of noodle restaurants based in Boulder, Colo., that has 900 employees and logged sales of nearly $70 million last year. "Early on, I received a flat $24,000 a year. That was the same level as all management, including our restaurant managers." As the business grew, Kennedy worked with his board to increase his compensation gradually toward market rate.
Some entrepreneurs feel queasy about giving up control to a board. To make it work, Kennedy suggests establishing a five- to eight-year compensation plan. With such a plan in place, he says, you should be able to anticipate your family's cash flow -- and avoid feeling frustrated while your pay stays lower than you'd like.
Stephen Culp took the route of deciding his salary on his own. He worked the phones, asking his mentors, his friends from grad school, and other small-business owners what they thought was reasonable. Then he knocked the figure down by 30%. "I think a lot of my peers earn too much," he says. "And I'm still trying to show investors that I'm in this for the long haul." He won't share the exact number, but he does say it's less than $100,000. As his company hits certain financial milestones, the number will rise. Last August, he closed on his venture capital -- and received his first paycheck in three years.
31% of Inc. 500 CEOs take more than 90% of their compensation in salary.
For many entrepreneurs, the compensation issue is more emotional than rational and hinges on factors such as how they imagine their employees will view their compensation. When Cynthia Driskill, CEO of Dallas-based CDG & Associates, started her human resources consulting firm in 1987, she paid herself the same base as her employees -- between $35,000 and $70,000 most years. In part, she wanted to keep money in the company so it could grow. But she was also reluctant to elevate herself above her employees. "I just wanted to be one of them," she says.
Indeed, many entrepreneurs feel uncomfortable with the idea of making more than their employees -- after all, they reason, you're working side by side with these people, why should you take more than they do? That's Josh Selig's attitude. Little Airplane Productions, a children's television production company in New York City, expects to gross $8 million this year, but Selig doesn't take a regular salary. In his line of work, compensation is doled out by the project. Selig creates the budget for every project and includes a line for himself as executive producer. While the executive producer is always the biggest line in the budget, he says, he's careful to put himself in for a figure that's only slightly higher than the next person down the line. "I really think it matters to employees," he says. "I was raised to really believe that if you have more than enough, you should share."
While many entrepreneurs won't go that far, they do keep morale in mind when developing compensation targets. Jack Stack, CEO of SRC Holdings, a manufacturing company in Springfield, Mo., pays himself $300,000 a year -- or 10 times the salary of his average worker. "I never wanted my people to think I was making a killing," says Stack. "There was a trust factor we were building."
But do employees really care what the boss makes? As long as people perceive that they're being compensated fairly and that they have opportunity for advancement, says psychologist Kase, it's probably not as much of an issue as many entrepreneurs believe. First, most employees realize that salary isn't all the owner takes out of the company -- you do own it, after all. Second, people usually compare themselves to their colleagues, to other employees, not to the boss. As long as you're not super-obnoxious about it -- rubbing your employees' noses in your mink-lined chair, for example -- morale should not be much of a factor when you decide on your compensation.
In fact, as Driskill discovered a few years ago, keeping your compensation low to stay on the level with your employees can backfire. Driskill doesn't divulge her salary but it happened to come up once in a casual conversation with a senior executive. When the exec heard how little Driskill was making, "she was just astounded and appalled," Driskill remembers. In a later conversation, other employees expressed concern about the health of the company, given that Driskill was taking so little in salary. "Employees want the boss to be boss," she realized. "This was hard for me to grasp." It was at that point that Driskill decided to bring her compensation up to a more appropriate level. With the help of salary surveys, she raised her compensation to a figure that's still below market value but more reasonable for a company that did $7 million in sales last year.
Your compensation is probably most relevant to your employees when times get tough. Do you cut your own pay first? Or that of your employees? And how do you handle it when times are good? Do you reward yourself first? Or your employees? This part actually matters quite a bit to employee morale, says Kase. Cut pay for your staff and leave your salary intact, and you'll likely stir up resentment. Take a hefty bonus and leave everyone else out, and expect to hear muttering. When the tech market sagged four years ago, Frank Collocia, president of Creative Technologies Group, an IT company in White Plains, N.Y., opted to slice his own salary dramatically -- from $100,000 a year to $25,000 a year -- to avoid laying off a single member of his 18-person staff. "It's why I have very loyal employees," he says.
But Collocia also has a family -- a wife and three children, now ages 5, 6, and 9. When the family shifted to living largely off their savings, it wasn't easy for anyone. "When your business goes down the toilet," he says, "it's gut-wrenching at home." Vacations, trips to theme parks, extra birthday presents, extras of any kind, really, all had to stop. Collocia and his wife held regular family meetings to let the kids know what was going on -- part of their first lessons in being an entrepreneur.
Over the past few years, Collocia's sacrifice -- and that of his family -- has paid off. Business has rebounded to where he's planning to take a bonus at the end of the year. But he's not raising his salary...yet. "The goal is to make the business healthy and build it," he says. "I'll get paid by the company's performance eventually."
And that's something to keep in mind. In the final analysis, says Driskill, whatever you don't take from your company today should eventually come back to you. "Really, when I'm ready to retire, the compensation issue becomes moot," she says, "because theoretically I will sell the company back to my employees. That's the nice thing -- it all becomes your money in the end."
Sidebar: What the IRS Is Looking For
One of the hardest truths for entrepreneurs to grasp is this: You and your business are separate entities, with interests that sometimes compete -- especially when it comes to taxes. This is something that the Internal Revenue Service pays close attention to, says G. Michelle Ferreira, who spent eight years at the IRS litigating the compensation issues of small, closely held companies and is now a tax attorney at the Silicon Valley law firm of Greenberg Traurig. Here are two issues to keep in mind:
Reasonable Compensation This is an issue for companies that offer dividends. Because dividends are taxed twice at the corporate level (both as income and when the corporation distributes them to shareholders) while salaries are a tax deduction (as a business expense), companies have an incentive to distribute profits in the form of salary. The IRS has its eye out for this potential loss of tax revenue, and if a salary seems "really out of whack" with expenses, Ferreira says, the IRS may investigate. If a court decides that the salary you received is actually a "disguised dividend," it will disallow the deduction -- and you will pay, big time. In 2004, a federal court decided that a California leasing company had run afoul of this "reasonable compensation" standard. In 1995, the owner of the business received a salary of $240,435 plus a bonus of $180,435. The company deducted this $420,870 in salary as a reasonable business expense and paid just $2,674 in federal taxes. But the IRS determined by looking at comparable businesses that the owner should have been paid a salary of $76,800. The company had to fork over $300,000 in taxes and penalties.
Self-dealing You should also be careful about running personal expenses through your company. Everyone knows this, of course, but it's worth repeating: Don't try to disguise personal expenses as business expenses. It's called self-dealing, and it's not like jaywalking -- it can really get you in trouble. "I've seen it all," says Ferreira. "I had a case where the entire family's cars were being paid for by the corporation. All their kids' college tuitions were being paid out of the corporation. If it gets really egregious, the IRS will assert a fraud penalty that is 75% of the taxes owed."
Alison Stein Wellner is a regular contributor to Inc.