Whether you have successfully raised your first round of funding or you’re thinking about doing so, the question of whether to pay yourself inevitably arises. The timing varies for different startups, different founders, and different business models, but it will happen eventually.
This guide will cover all the essentials required to make the decision on when, and how much, to start paying yourself. It’s an important decision but with a lot of considerations, here’s what we’ll cover:
- Your business needs
- Cash flow planning
- The real cost of salaries
- Claiming tax credits
- Fundraising stages
- Problems with high salaries
- Salaries and business value
- Other compensation
- Vesting schedules
- Investor opinions
- Reducing expectations
- Your life situation
- Co-founders with different situations
- Talking to your co-founder
If you’re short on time, jump straight to the summary at the bottom to get a list of steps to take that will help you answer this question.
Your Business Needs
Your first concern as a startup founder should be the health of the business. For many, it will be the first thing they think of in the morning and the last thing they think of before going to bed. When it comes to drawing a salary from your business, this needs to be a primary consideration. If you’re raising early rounds of funding, then your burn rate will be a significant factor in whether you can even afford to pay yourself a salary.
If you have bootstrapped up until this point, using your savings or loans to get the business up off the ground, then you’ll already be finely attuned to how much your business is costing to run, and you’ll have a better idea of what it will cost you to continue to run and grow. Therefore, the first thing you need to look at when determining if you can pay yourself a salary is the business cash flow.
Cash Flow Planning
Don’t have a cash flow document to look at? Don’t worry; they’re pretty straightforward: what is your revenue, what are your business expenses, how often do they occur, and when do they occur. This is typically broken down into sections (employee, capital, legal, accounting, office and miscellaneous), and then shown on a monthly timescale.
If you’ve been operating and generating revenue for more than six months, then you’ll probably have created something similar, but perhaps not realised it. This cash flow document can show you how much money there is available to pay you. To reiterate, this is not how much to pay yourself, but how much is available. In most circumstances, you won’t want to dry up the last of your cash on founder’s salaries.
If you’re raising money and thus, your company bank balance (cash) is going to increase, then you can reflect this in your cash flow (as well as expected business revenue growth). With this overarching view of your company’s financial health, you’ll have an easier time determining the viability of taking a salary.
If you don’t have the revenue or money in the bank to afford to pay yourself off the bat, then you’ll need to raise capital before you can start to take a salary. It is important to note that you should not be deciding to raise money solely in order to pay yourself (or co-founders) a salary. It can be a factor in determining how much to raise, but it should not be the primary consideration.
The decision about how much to pay yourself gets easier as time goes on, the first time you make the choice (most likely after your first round of funding), will be the hardest. Then as time goes on, and the business is more successful, your salary figure will be a negotiation with investors as to what they feel is fair compensation (more on this below).
Is there an amount of money that needs to be raised before you can afford yourself a salary? Seed Legals (a UK based startup focusing on automating the legal work for startups) completed a study, and their data and found that: “the decision to take a salary very much depends on the size of the round. For rounds of £150k or below, around half of founders secure a salary.” This was noted to increase to 73.1% when the funding round was higher than £150k. So, the more you raise, the more likely you will be able to draw yourself a salary from the business.
The lower the amount raised, however, the further the money has to go to grow your business. The less room there is in your cash flow for a founder’s salary.
The Real Cost of Salaries
If you’re looking to fundraise capital, you’ve probably considered how much you could pay yourself. You’ve calculated (using your new cash flow) that you can hire two employees and, considering the other business expenses that you’ve calculated, you have enough money to pay you and your fellow co-founder a salary.
This is where national insurance for both your employees and you may come as a shock. First-time founders, who have never hired anyone before, may be surprised to realise that while your personal take-home pay is taxable by national insurance, so is the company that is paying you. If you’re paying a web developer that you just hired £50,000 a year, then expect to pay £55,709 when you factor in employer’s national insurance. This is an 11% increase on what you would expect to pay. That number increases and decreases according to the salary. For example, if you decided to pay yourself £20,000 a year, then the company would have to fork out an extra £1,569 (7.8%). Resulting in an actual cost of £21,569 over the course of a year.
For most, this will be calculated in your cash flow already, but for those that weren’t aware, it is a factor that you should consider when deciding how much you’ll want to pay yourself. You can find more information and play around with some numbers here.
Claiming Tax Credits (For Technical/ Science Founders)
If you are a technical/scientific founder, then there are research and development (R&D) tax credits available that might be able to offset some of the cost of your salary, depending on what your company does and produces. For example, if you are developing a new business that uses machine learning to conduct financial analysis and make investment decisions for users through an app, then you would meet the criteria to claim some development costs back from the government. We’re not going to go into it all here, however, the requirements to meet the demands are relatively unrestrictive.
You need to demonstrate that you are:
- Seeking to create an advancement in science or technology.
- Overcoming a level of scientific or technological uncertainty to achieve this.
This doesn’t require that the technology or research is cutting edge (it is not referring to university-level research). “Uncertainty”, for example, might be developing a new web-based API for your business, and you’re unsure whether it will scale effectively.
If your startup is eligible, then you can look to claim back 33% of your R&D spending. However, as a founder, it is unlikely that you will be able to claim all of your salary back (you won’t be spending all of your time entirely devoted to the development so not of your work necessarily fall under the R&D credits parameters). That being said, if you’re a tech-based startup, there is a good chance that a lot of it will.
To explain this a little more simply: let us say that you are planning to pay yourself £30,000 a year, that will cost your company £32,949 with the obligatory national insurance contribution. Then you estimate that you spend 70% of your time developing things that would fall under the R&D criteria. That would mean that you could potentially claim £7,611.22 back from your salary. This would result in your effective cost to the company being £25,337.78 per year. This is a typical way to reduce the salary cost of technical founders and, later, technical employees. You can find out more about this tax credit from HMRC.
Problems with High Salaries
If you’ve stepped out from a job with a high salary compensation, perhaps you think that will continue at your startup. Regardless of how you come up with the final number you feel you should pay yourself; it is vitally important to consider the knock-on effects of high salaries. If you’re paying yourself a ‘market rate’ salary, then you’re going to have to pay your employees the market rate too, if not more. They won’t have the same level of potential equity upside that you do, and therefore, you’ll foster a level of resentment if this becomes public knowledge.
Here are some other problems with paying yourself a higher salary:
- Investor perception: you’re burning my money on your salary, why is it not focused on growth?
- Employee perception: why am I struggling to make ends meet, whilst they’re not, and do the founders really know what they are doing?
- Business growth: stagnated and not as quick due to reduced funds available.
- Team development: less money to make hires, and new hires are more expensive, resulting in fewer people in the company.
- Business value: removes money from the business, rather than re-investing, reducing the overall value.
Startups founders are often high achievers. Usually, this results in a pay cut from their previous job for new entrepreneurs. This might be hard to reconcile at first, resulting in dissatisfaction at the payslip you eventually receive every month. But it is important to remember that compensation in startups is not solely in salary, you have equity in the business, and are therefore creating value over time.
Salaries and Business Value
Just because your salary is not high to start doesn’t mean that you can’t increase it over time. If the business is doing well, then you should share in a level of that success. Let’s look at what effect business valuation has on founder salary.
Seed Legals concluded that for “every £100,000 increase in valuation, founder salary tends to increase by roughly £1300 per year”. If your business continues to grow and succeed, then your salary can follow.
At a £2,000,000 valuation, Seed Legals found that the average founders’ salary was £25,000, rising to £52,000 and £80,000 at £4,000,000 and £6,000,000 respectively. As your company grows, and the chances of success and stability increases, then founders can increase their salary compensation over that period. The growth of the business is clearly tied to the founder’s compensation.
As founders, you and your team will typically have different forms of compensation beyond a salary, most importantly, equity. The amount of money your equity will be worth, versus your wage, will be drastically different as your business grows. Consider, for example, Y Combinator, one of the most prominent incubators in the world; they invest $150,000 in every business they accept to their program at a post-money valuation of over $2.1M. This would result in two founders (without considering other factors) having an equity slice worth almost $1M each.
Founder’s equity stakes will all have a vesting schedule. The shares you have in the business are typically ‘locked’ away in some capacity until a specific period has passed. For example, if you’re on a four-year vesting schedule and you’ve just crossed into your third year at the company, you would have ‘unlocked’ just over 50% of your equity (in normal circumstances). A vesting schedule does not affect shareholder control, voting rights, director appointments. Instead, it is solely ‘locking’ away your (and your co-founders) ability to sell your equity, with certain amounts released over time.
Investors like vesting schedules (and you should too) because they lock founders into the business. They guarantee their focus as a lot of their compensation is tied to the success of the company. It also prevents founders from running away early on with large amounts of equity, making the business uninvestable for future rounds of funding.
A vesting cliff (as they are sometimes referred to) is a set period, during which a founder will get no equity if they leave a company before the end of that period — this is most likely going to be one year.
Vesting shares typically happens on a monthly, quarterly, or yearly basis. It is up to you and the investor to agree on how often the period is. You would generally find all this information in a term sheet that was presented by an investor.
Regarding the date at which shares start to vest, Seed Legals found that around “40% of the time, founders and investors agree that the fairest start date is prior to the funding round, selecting either the date the founder joined the company or the date that the company was incorporated”. This is good news for founders, as it might mean they get a jump start on their shares. However, Seed Legals also found “that the earlier the date from which shares start to vest, the longer the ‘vesting period’.” Investors opinions and demands on the matter vary, meaning there will be a level of negotiation required.
How does this affect compensation?
In summary, a vesting schedule may prevent you from selling your shares at a later date, as you might not have access to them all. Further, it will prevent you from having a larger stake, possibly any stake at all in the company you started if you leave before the period ends, meaning financial rewards based on the company’s future success without you being there will be capped.
In the grand scheme of things, however, a vesting schedule should not be of great concern. As a startup founder, you are typically in this for the long haul, and if the company is successful, you will most likely see out the vesting period. A vesting schedule is generally structured to discourage ‘bad behaviour’, and if you were in a position to have the company acquired, then you would not be penalised. You would receive the full proportion of the sale, as dictated by your (fully vested) equity share.
Unless you’ve had the right amount of luck and skill to have created a company that is revenue-generating and profitable from day one, and that company has never had to take outside investment, then you’ll be raising funding from investors. So how do they feel about startup founders’ salaries?
Christoph Janz, a partner at Point Nine Capital, early-stage investor and entrepreneur himself, doesn’t think “founders should get salaries that make them rich, but as soon as the company can afford it the founders should get enough so that they don’t have to be worried about how to make ends meet all the time.”
Peter Thiel, a founder of Pay Pal and Palantir, believes that “the CEO’s salary sets a cap for everyone else. If it is set at a high level, you end up burning a whole lot more money. It aligns his interest with the equity holders. But (beyond that), it goes to whether the mission of the company is to build something new or just collect paychecks.”
Sean Percival, an early-stage investor, who has invested in over 120 early-stage companies believes that in the early stages of a startup (pre-revenue and pre-beta) “the founder currently does not take a salary.” Then when they reach a later stage (launched and with revenue), they might pay themselves “themselves 240K NOK (£21,000) per year to cover basic needs like rent”.
While there is not a consensus amongst all investors, a large amount would agree that once a particular business stage has been reached, a salary is an acceptable thing to draw and that it should be high enough to cover necessary expenses and live modestly.
As we have already seen, this amount increases as the company succeeds and grows.
It is recommended that the discussion of salary expectations, requirements, and current financial situation happen early in the forming of a business to reduce the headache that will arise if the company is already rolling along and expectations have not been set.
When having the discussion, be open and honest with your co-founder(s) about your expectations and life situation. It is almost guaranteed that you will all have different ideas about what you would expect from a salary. Those of you that are more seasoned in the entrepreneurial life will be responsible for tempering the anticipations of those who are fresher faced. In all discussions, be open, be honest, take what is said at face value, and then take time to reflect on it and talk again. If you can survive difficult internal financial conversations with your co-founders, then you’ll be ready when you’re being grilled by potential investors later on.
We’ve listed three common disputes below:
- When they want more money and won’t take no for an answer: perhaps there are fundamental issues within the business, and they may not be the right co-founder. If they really won’t accept any less than what they are used to, or their request is genuinely unreasonable, then it is highly likely the startup life is not for them.
- When they believe they deserve more money than you or want a different compensation scheme: you should evaluate the possibility of a non-equal equity split where one person takes more equity, and the other takes a larger salary.
- When they’re not taking a salary and believe that you shouldn’t either: then it is down to you to make the argument for why you think you need a salary, and determine whether, at that stage in the business, they are correct. The earlier the stage of your business, the less likely you’ll be in a position to contemplate taking a salary. However, if you’ve just raised a Series A funding round, then there are significantly fewer arguments not to do so.
The final factor is you. When it comes to peoples’ needs and financial requirements — there is naturally a large variation. The two most significant factors are typically location and family. For example, if you live in London, you’re going to be paying significantly more than average to have a roof over your head. If you have a family, your circumstances may vary even more, and the salary required to stay ‘afloat’ maybe even higher.
In order to figure out how much you need to live on, you need to do two things. First, you need to find out what your average spend per month for the last six months was. Then, you need to annualise that monthly requirement which you can do using this reverse tax calculator.
If this number looks a little high, then you need to examine your fixed and variable costs to determine what the essentials are. Then make cuts as necessary. It is significantly easier said than done, when talking about reducing personal expenditure, however, the key thing to remember is that a lot of savings can be made by reducing costs not eliminating them. Cutting down rather than removing makes it easier to adapt to and doesn’t feel like such a loss.
To summarise, here are the steps to get a rough figure on what you should pay yourself:
- Create a cash flow for the business (including the future raises and revenue).
- Analyse the cash flow to determine expenses and burn rate. If there is not enough money, you will have to raise, or the business is not in the right stage.
- To determine how much to pay yourself, have an honest look at your personal expenses (fixed and variable). Find a balance between just enough to survive and relatively comfortable.
- Extrapolate that figure to a salary (not forgetting to add employer’s national insurance) and determine if any tax efficiencies can be applied (R&D credits).
- If your company valuation is less than £2,000,000 then the number, you’ll be looking to work to is around £25,000. If you don’t need that much, don’t take it. If your company has just raised seed funding, this number may be less due to their not being enough money in the business.
- As the company valuation and raises continue onwards, you can up your salary with respect to the current valuation and state of the cash flow in the business.
Originally published at https://www.seedrs.com.