What Entrepreneurs Don’t Know about Paying Themselves (but Should)
As a young entrepreneur in my twenties, I took great pride in the fact that I never once missed making payroll (even if that meant funding the business with my credit cards and not paying myself). Though my first company Jasmine Multimedia beat the odds and was successful, looking back on the experience decades later the pressure was too intense and actually counterproductive to my startup’s growth. Founders are by definition optimists who believe that their vision for the future will translate into financial rewards. But what many fail to realize is that even the best of ideas have to wait for market forces to catch-up. Get ahead of demand and the burn rate can quickly outstrip one’s financial resources. Startups shouldn’t fail because the founder couldn’t last financially, but all too often this is the leading cause of failure.
While just out of high school, Bill Gates and Paul Allen had a brilliant idea of improving traffic by using computers to measure traffic flow. The young geniuses were decades ahead of the market and Traf-o-Data went bust. If the guys that created Microsoft can get it wrong, so can you. To give your brainchild the best hope of survival, here are three simple rules to follow when the discussion of founder pay arises.
If your startup is far enough evolved to be raising capital, then it must also be able to pay the founder’s salary. This is important for two very distinct reasons. First, many startup entrepreneurs make the mistake of not paying themselves and then calculating their burn rate on a falsely deflated number. If your work is crucial to the company’s success, then that cost must be figured into the organization’s overhead. Otherwise you make the mistake of believing your profit margin is significantly higher than it actually is or worse yet, believing that the business will be profitable when it scales (without the proper level of staffing). Modeling out any business for the long-term must include all of the actual, costs needed to sustain the operation. I recommend calculating your budgets on the actual amount it would cost investors to replace you (even if you are working for a fraction of the actual competitive salary).
The second reason to pay yourself is to allow you to focus one hundred percent of your energy on the business. If you are worried about keeping your lights on or your car being repossessed as I was, you are not going to be thinking clearly and making the right long-term strategic decisions for your fledgling company. Short-term thinking to make ends meet leads too many entrepreneurs to undercharge for services, forego royalties in exchange for lump sum cash advances or commit the techie cardinal sin of not paying for patent filings. When I look back on my costliest mistakes as a first-time entrepreneur, most would have been avoided had I spent the money on proper legal and accounting advice.
Now that you have decided to pay yourself, don’t expect to get rich from it either. There is a big difference between not paying yourself and your fair-market value to an established corporation. No investor should be paying you what you could earn at a regular job. You are getting more than cash compensation with your startup. You are getting to pursue your dream, test your mettle, have creative autonomy and retain a sizable portion of equity. Your lifestyle should be frugal and as bootstrapped as your startup. Remember, as an entrepreneur you have to be willing to live a few years of your life like most people won’t in order to live the rest of your life in a manner that most people can’t.
As a rule of thumb, most seed stage founders going through the Y Combinator accelerator program for example pay themselves around $50,000 a year. When revenues grow enough to pay many of your top employees six figures, then it is appropriate to increase your salary as well.
Most people are surprised to learn that startup CEO/Founders are usually not the highest paid people in their companies. I reserve that honor for top engineers and salespeople. Founders’ wealth comes from the delayed gratification of holding onto as much equity as possible. In the case of the Y Combinator founders behind Dropbox and Airbnb, waiting was worth over $6 billion. You can’t build a great company working for free, but you can build a great company by giving yourself enough time to succeed.
This column originally ran in the Wall Street Journal January 26, 2015