I recently participated in an entrepreneurial rally where start-up business owners were each able to spend 25 minutes at four roundtables and ask questions of those of us with more established businesses. Sharing some of my relevant experience was a lot of fun. One interesting thread I noticed was that many of the start-ups had a business model that seemed to have been perfected in Silicon Valley: Build the volume of your business fast, even if it means giving the product away free, and figure out how to monetize it later. This brings up the natural question of how business owners are compensated.
Some Business Owners Go Big or Go Home
The business success stories we see on television tend to be the really big winners. Those who make it tend to build the business for the big payoff somewhere down the road (even if down the road only means age 26). In these cases, the model was “go big or go home.” There was no room for taking money out of the company along the way. Instead, the founders just plowed any money they could get, whether profits or venture capital, back into the business.
In this model, compensation for the business owner is predicated on a valuation at the end of the road, minus taxes. Hopefully, there’s enough money to allow said owner to retire, or at least to live well while they start another business. The success stories are cool but the reality is this formula may not work for many smaller companies. These businesses are not worth what the owners think they are and the money they’ll actually get when they sell won’t be enough to retire in comfort.
A Marathon, Not a Sprint, Better for Small Businesses
A different business model looks more like a marathon, where the owner is in a race where they have to be careful not to run too fast—or too slow. Owners who adopt this method try to compensate themselves for the labor they do (since that is what it would cost to replace them) and then take distributions from the company for ownership/risk taking, with the ultimate goal of selling the company. Before the company is sold, the ongoing income and ownership distributions create a safety net. (For related reading, see: Entrepreneurs Make Money: Why, How Where and When.)
As I mentioned above, too often owners get to the point of sale and determine they will not get enough to retire comfortably. The marathon method of compensation allows owners to save money slowly along the way so they are more financially secure at the end, which means they may not need a huge business sale to fund retirement. It might also open the door to sell the business to employees since the price will be flexible if the owner saves enough for retirement in advance and business sustainability is more important than the final selling price.
Choose Your Approach Wisely
There is nothing wrong with the “go big or go home” approach, but I believe this model is not appropriate for many businesses. Business owners have to decide which compensation method works for the business as well as their personal lives. Family usually plays a big role in that decision—I have found that the steadier the stream of money into the household, the less pressure on family life and the easier it is for a business owner to make the right decisions for the business. (For related reading, see: 5 Biggest Challenges Facing Your Small Business.)
Finally, we have all heard the adage of keeping business separate from personal life. When business compensation is intertwined with personal goals, problems can arise. Many business owners begin to use the business to provide compensation like car payments, trips, clothing, and other items that could be purchased personally. While some of these may be legitimate business expenses, it can also create murkiness when it comes to understanding the true value of the business. I still think it makes more sense to take money out of the business as compensation and then purchase those things separately whenever possible.
Business owner compensation is a topic that often is addressed incrementally, sometimes year by year. Yet having a well-thought-out structure for compensation will lead to less stress along the way and possibly a business that is worth more in the end. And when it comes to retirement planning, that is the best outcome you could ask for.
(For more from this author, see: How You Invest Now Can Affect Taxes in Retirement.)
The opinion of the author is subject to change without notice and must be considered in conjunction with relevant regulation, as well as subsequent changes in the marketplace. Any information from outside resources has been deemed to be reliable but has not necessarily been verified. Each individual has unique circumstances to which this information may or may not be relevant. Under no circumstances will this information constitute an offer to buy or sell and it does not indicate strategy suitability for any particular investor.