Our Small Business 101 series is for anyone who owns a small business and for anyone who's thinking about starting a small business. It draws from lessons we've learned while working with thousands of Canadian small business entrepreneurs over the years. It's the class we wish we'd taken before starting Origami. And the night class you should be taking right now.
Kris Sparrow, an Origami co-founder and CPA, explains what small business owners need to know about compensating themselves at different stages of their business:
The basic principle is that your small business should offer a return on your investment of time, money, and effort. It should first pay your bills, then support a lifestyle, and, finally, fund your retirement. This happens in stages — and not always on schedule — and there are compensation priorities and issues that come up in each stage.
OK, Kris, I just started a new business. Let’s say it’s a retail store. What do I need to know in my first year about paying myself?
I would say that, regardless of the business, Job 1 is to pay yourself a market rate. Because, if you can’t do that, what’s the point? You’re doing something that has an opportunity cost. You could be doing something else and be better off.
Now, if you’re capable of being a heart surgeon and you really want to operate a boutique, your opportunity cost for this purpose shouldn’t be $800,000 a year. It should be what a well-paid boutique manager should receive.
If I can't pay myself a market rate in year 1, is that a signal?
It is, but not necessarily a strong signal. The reality is it often takes more than a year to pay yourself a market rate. In my experience, it could take up to five years. Sometimes it takes over a decade.
Wow. That’s no good for me, is it, making less than I could for so long? Why do I keep going for over a decade if the business clearly isn’t working for me?
It’s a sensitive area. Essentially, you’re dealing with people’s dreams. At least, I feel that way. And there are often other people involved (employees, investors, family), other psychological factors. Our approach at Origami has been to come at it obliquely, with the first step being to convince entrepreneurs to pay themselves a salary rather than a dividend (which is often just a kind of make believe in the small business world — take what I need from the company and try to settle it up at the end of the year). And then work their way toward paying themselves a market rate salary.
Right. The salary vs. dividend thing. But you’re talking about it as a mindset rather than the usual pros and cons from a tax perspective.
Yeah, from a tax perspective, paying yourself a salary is pretty much on par with a dividend, as far as taxes owed. And, unless you believe the CPP is going to collapse, a salary has a favorable tax treatment and is unambiguously better for most situations. A big positive is that when you pay yourself a salary, you pay your taxes as you go, as opposed to taking money out of the company bank account as you need it and then having to come up with money for the surprise tax bill at the end of the year. A salary makes it easier to budget, because the taxes are already taken into account. In addition to that, a salary gives owners a more accurate view of how their business is doing.
NOTE: Dividends are a means for corporations to return money to their shareholders. If a business makes an after tax profit, its owner(s) can decide to keep those profits in the business (as retained earnings) to fund growth, or distribute those earnings to shareholders as dividends. How the dividend route usually works in a startup small business is the business owner takes money out of the business as they need it throughout the year to pay their personal bills. On the books, this represents a loan from the business to the shareholder.
At the end of the fiscal year, this shareholder loan is cleared (it has to be cleared by CRA rules) by issuing a dividend to the shareholder, i.e., the shareholder repays the loan via their share of the business’s profits, after corporate taxes have been paid. From a Canadian tax perspective, the taxes owed on money taken as a salary or as a dividend work out to roughly the same for Canadian small business owners, with one difference being salaries are subject to CPP and dividends are not.
Because if it’s not me receiving the salary, it would be someone else who would be getting paid to do the job that I’m doing in the business. It’s a real expense.
That’s right. The Income Statement is meaningful now. If I have a loss because I’m paying myself a market salary, I know very clearly I need to increase my sales. But if my company has a positive net income because I’m not paying myself a market wage, then I know I’m not quite there either. It’s another level of thinking.
Even if I didn’t need the money from this business as a regular salary, if I just take a dividend out of the company’s profits, those profits are overstated because they don’t account for my role in the business. They don’t account for the compensation I should’ve received for that role.That’s right. Dividends can come later when the business is doing really well. But, at the start, almost all owners should pay themselves a salary and they should target paying themselves a market rate as soon as possible.
OK, but you’ve said that it takes up to five years to be able to pay myself a market rate, sometimes longer. Entrepreneurs are putting blood, sweat, and tears into a business for years just to get to the spot they’d have been at years ago if they’d taken a job! Why? It seems like they’re falling behind financially.
If they are falling behind and losing confidence that they’re ever going to make it up, it’s usually employees. No, it’s almost always employees. There’s a certain obligation small business owners feel toward employees. People hire too soon and they take too much off their plate too soon. We were guilty of that. It’s not so much laziness, or they’re doing it to unload their own work, it’s more they anticipate growth that doesn’t happen. I’m not sure which business guru mentioned it, but you don’t hire until it hurts. Until you’re working ten, twelve hour days non-stop because there’s too much work. At least in the startup stage.
Because, if you go the other way and hire too soon, you have to keep paying that person. It’s a decision that’s not easy to undo.
Yeah, there are legal reasons it’s hard to unravel that, and there are also psychological reasons. It’s hard to let go of somebody who’s a hard worker and is doing a legitimately good job. Obviously, situations are different with respect to hiring employees. You can’t start a restaurant without employees. You need cooks and wait staff. You need capital. But if you’re a service provider, a PR person, a management consultant, or an accountant, you just need a smile and a good manner on the phone. You are the business. Whereas, if you’re starting a retail store, you need inventory and a couple of staff. The more capital required, the harder it is to start. And sometimes you need employees at the start. But you should look for the minimum effective dose.
In the startup stage, money’s tight, I’m trying to keep up with my own bills on top of what I have to deal with in the business. I think I’m not going to file my corporate taxes this year, because that’s one more thing I can’t deal with right now.
Bad idea. But the reality is that it’s a common decision that startup small business owners make. It puts you in a hole that, in my experience, is very hard to dig your way out of. The CRA has lots of collection powers, they charge market interest rates and significant penalties. They also do these nasty things called audits that take up a lot of time and energy, and the audits are invariably triggered by not paying and not filing. That’s the surest way to get audited.
You have to be prepared for it going in, then. As a small business owner, you have to stay on top of and fulfill your tax responsibilities. Because, in the business world, you’re the one player who can least afford to get on the wrong side of the line; because you have the least resources and defenses.
Let’s get on the happy path. I started my business. Year 1 was a struggle. Maybe Year 2 as well. I paid myself less than I should have, given what you’ve told me about paying myself a market rate. But I figured things out in my business, and there’s more money available now. I can pay myself a market rate. Should I?
You should. Remember that paying yourself a market rate salary is Job 1. The sooner you do that, the sooner your business becomes real. Your Income Statement becomes meaningful. It reflects the true costs of your business. Plus, at a market rate, you can fund a lifestyle and a retirement that’s consistent with a person in the workforce who’s holding down a job like yours. Admittedly, you’ve got more on your plate as a business owner, but, if you stay on the happy path, you can get more out of your business as an owner than as an employee. Eventually.
OK, now I’m on a roll. Even after I paid myself a market rate, I still have money in the bank.
The next question is: How much money should I take out? It depends on a couple of factors. One, how much taxes will I have to pay? We can tell you that. And, two, how much money should I leave in the business to be safe? And I would say that’s two to three months of operating expenses. At least.
If you have receivables, there’s a real possibility that people won’t pay you for two months, but you still need to pay your employees, you still need to pay rent, and your suppliers. There are other weird disruptions, like pandemics.
They happen apparently.
Yes they do, and it’ll take time for the government to marshal a response to support you. So two to three months is a pretty conservative but also not an overwhelming amount of money to put aside as a margin of safety. Anything over and above that, we encourage you to take out.
You should either take it out as a dividend to yourself for your personal consumption or as a dividend to a holding company that you’ll use to invest in other businesses if you want to do that. But it should come out of the operating company. It shouldn’t just sit there. Unless you’re saving for a big expansion or something, then sure. But, if you have an operating company, and you’re at where you want to be as far as reinvestment in the business goes, which would be true for most businesses that have limited scope to expand, then these excess earnings should either go to your RRSP, to a TFSA, or to a holding company if you’re going to buy other businesses or pursue other ventures.
But it should come out. If equity is high enough to cover two to three months of operating expenses, then, by our simple rule, the excess of that should come out of the business.
Why is it so important to take this extra money out?
Because if it stays in the business, it gets wasted. It’s hard to resist spending it without a well thought out plan or reason for spending it. Money that sits around with no specific use finds uses. I’ll just hire more employees is usually the answer. That usually grows sales but shrinks earnings.
But, if my business is growing, don’t I have to be careful about starving something that has potential of the fuel it needs to grow?
Sure. Let’s say you have a really cool small restaurant that people like to spend a lot of money on. Sales are great. Earnings are healthy and stable. Then it’s probably a good idea to open another location.
Because you’ve found a formula that works. The Holy Grail.
If it’s not specific to your original location or situation. If you can take the idea anywhere. Then, yeah, you should have a separate bank account called Expansion, and your excess earnings should go there.
NOTE: You need to take a clear-eyed view of your financial statements before you push for growth. Without deep-pocketed investors, it’s risky to pursue growth before various margins are healthy. Don’t assume that growth or scale will fix earnings issues down the line. Or think you’ll be able to access capital to fill in those holes on your march to success. Or fund the expansion by taking less compensation for yourself.
This is a natural entrepreneur thing to do. We’re usually blessed/cursed with a strong (verging on blind) belief in the potential of our product or service. That’s where a careful check of the financials can help — a lot. The easiest products and services to believe in are those that make money and generate cash. It’ll be right there in the numbers. In my experience, a small business hasn’t found a formula that works if its financials are weak or if its financials are being supported by less than market wages being paid to owners who are working in the business. And, if the formula doesn’t work, it’s very risky to pour in more money to expand upon it.
OK, let’s review. My business will go through stages. At each stage, I’m relying on it for my personal compensation, first to pay my bills, then to support a lifestyle…
As long as the lifestyle is realistic given your occupation/role in the business.
… and then look after me when I want to be financially independent or I want to retire. I have the same financial concerns as anyone in the workforce, but I have to make it happen for myself.
Yeah, and the tax efficient ideal is the Warren Buffet example. There are never distributions. Berkshire Hathaway never pays a dividend, but it reinvests, it keeps the money so you don’t pay taxes on it as a shareholder, then it reinvests it profitably in other businesses. That’s the thing. Can you reinvest it profitably? There are very few businesses that have scalable potential, but that’s not to say you can’t buy other businesses if your original business is successful. You take the formula you used to make your first business a success to make another type of business a success.
So the idea of a holding company as well as an operating company comes in early.
I’d say under very specific scenarios. It comes in early if your retirement plan isn’t to invest in RRSP’s, it’s to invest in other businesses, that is, you plan to be a serial entrepreneur. Then it comes in early. It also comes in early if you’re making so much money that your RRSP and your TFSA can’t accommodate it. Then you could grow your investment portfolio in your holding company. Given a type of investment style, it could make sense.
After all that hard work and sacrifice, once my business has matured and it’s reliably making money, things look good, I have options.
As long as you’re able to still grow sales and maintain even a moderate profit margin, say 10%, as long as you’re able to grow revenue, you’re rich.
What’s next? The hard part’s done. Now, everything runs on routine, and it’s really enjoyable. But I’m also getting older. I’m not looking to retire, but I’m thinking about retirement.
You’ve worked hard and built up an asset, an asset that generates cash, an asset with value. If you still have a role in the business, you have to find ways to do whatever special thing you do or bring and turn it into a system. That way, someone else can take it over and run it. But, up to the point of selling, you’re living the dream. You’ve created something for yourself that more or less runs on its own and that pays you really well. You spend half the year traveling.
It’s all worth it now.
Yeah, and it’s worth the most to you. You shouldn’t be in such a rush to sell it, because you’ll invariably sell it at a discount compared to its value to you if you continued to own it. The buyer has to bid a discount, because there’s asymmetric information involved.
And their balance sheet will look different from yours because they’re going to use leverage, and they’re going to need to make the interest payments and eventually pay off those loans.Yeah. Things come up that take the decision out of your hands, it’s true, but I’ve seen successful owners leave their business way too early, in my opinion. Everyone wants to sell for some reason.
Maybe getting there takes a lot out of people.
Did I miss anything?I think it’s really straightforward. Step 1, pay yourself a market wage. Step 2, establish a margin of safety. Step 3, pay yourself distributions. As soon as you’re in Step 3, if you can maintain any type of revenue growth, you’re rich.
OK. That’s a wrap. Thanks, Kris.