Here’s the best way to pay yourself as a startup founder

Photo credit: 2041497.

“How much should I pay in salary to us founders?” This is a common question I get when an aspiring startup founder drops me a message on Facebook.

It’s understandable, to be honest. Many founders still have their day jobs while some just left theirs to start their companies. It’s a bit of a challenge to shift from having a stable cash flow to exploring a totally uncharted path.

While I do believe the work that founders do for their businesses should be appropriately compensated for, taking salary as compensation might not really be the wisest thing to do. Five out of six startup founders that I spoke with over the past year paid out salaries that were more than what was justifiable for founders.

Founders’ salary

In a while, I’ll be discussing the income tax consideration as applicable in the Philippines (which is applicable as well in most parts of the world), but for now, let’s talk about your salary first.

In a sole proprietorship, you establish the business as if it is your extension. In this case, you don’t pay your own salary. Similarly, the income (usually measured in terms of cash) of the business is then treated as your own disposable income (in a way, salary).

The concept doesn’t really change when you go for incorporation, where you still own the business except that you share it with somebody else. But determining your fair share will be a challenge. Ultimately, the net income of the corporation (again, for most startups, this is ideally equal to cash, except for some adjustments to receivables and payables) should be split between the founders—yes, through dividends!

So, where’s salary in the picture? There are two views that you need to consider: payment for work and payment for investment. Payment for work done for the business is through salary, while payment for investment into the business is through dividends.

Delaying gratification

Being an entrepreneur requires a bit more discipline than what is expected from employees.

Startup founders still need to make ends meet, and the salary (I prefer to call it allowance to the extent that the salary is not fixed) they receive should ideally just satisfy that purpose. However, most founders try to emulate the salaries they enjoyed in their day jobs.

This practice is not only risky on your startup’s liquidity planning but also highly inefficient in distributing the company’s profit. It might even make the business go in a continual loss position. At this point, then, paying yourself off fully in salaries is one of the worst things you can do.

Income tax perspective

A corporation is taxed after deduction of expenses, and this is massive.

Compensation earnings by individual are taxed based on the gross salaries less exemptions allowed by local tax codes. The difference between exemptions and expenses is major!

While I am not fully aware of tax exemptions in countries other than the Philippines, let me just put this in the Philippine context (which could make sense for other countries as well).

Benefits of using dividends

Conclusion