How do you decide what salary to pay employees or partners when you first profit?
Suppose there is a situation like this:
There are 3 people in a startup, the CEO, a partner, and an investor (very small angel). The investor does no work but has 7.5% equity and 7.5% net profit sharing already. The CEO is willing to give the partner 10% equity as well. So now the CEO has 82.5% equity left.
They starting making $10k in net profit on month 1, and then $15k month 2, and $25k month 3. Now that the startup is profitable, the partner wants to be paid a salary to compensate him for his time. He wants profit sharing in addition to his equity stake, but the CEO wants to give a salary based compensation.
My question is, how do you decide how much the CEO should pay himself and his coworkers in a startup business? Like for example, if I went to be a programmer out of college at some corporation I could get paid $65k in entry level salary per year, but those are standard rates. The partner wants an increasing share, so if we are making $500k a year he wants $100k salary, and if we are making $5 million a year he wants a $500k salary..
I'm a little confused how to fairly pay off the other people in the startup, especially since I do most of the work and I am least expendable.
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What type of business structure do you have (LLC? S-Corp? C-Corp?), and where are you located? – rbwhitaker 11 years ago
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Wyoming LLC operating from MI – Goose 11 years ago
1 Answer
What the partner wants is slightly unreasonable - only equity should allow for profit participation, but not salary. You should first establish a salary based on these factors:
1. Contribution to the business - hours and level of skill
2. Market value
3. How valuable the person is to the company (easy or hard to replace?)
4. What your company can actually afford to pay
If your partner was contributing while not compensated fairly in the past, he/she should have been given or promised equity in the business. Sounds like you (CEO) is willing to give some of your equity to partner - a reasonable move. Whatever equity you give to partner, don't give it all without a vesting schedule. Typically, equity vests over 4 years, but sounds like there was some sacrifice by the partner already so you could have his equity vest over 3 or even 2 years. The partner should participate in a profit through equity only, and CEO should be protected through a vesting schedule.
P.S. Read up on getting paid salary versus owner profit distribution if you are an S corp - there are tax implications. TLDR: as an owner you are better off getting money through profit than salary because of payroll taxes (13%), but salary can not be too low or IRS will come after you.
TLDR: Don't mix equity and profit with salary, they are different compensation methods.
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Thank you for the insightful answer, so are you saying I should only give out equity? We aren't a public company and probably won't be anytime soon, what happens to all the profits we make? I imagine others will want some. – Goose 11 years ago
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No, I was saying you need to use both salary and profit for compensation, but understand how the 2 are different. Only those who have equity (own part of the company) should be compensated RELATIVE to profit made, which doesn't exclude the need for a baseline salary. Other people that work for you can be employees but don't have to be - they can be freelancers getting paid based on hours, but not on your payroll (please read up more on this to keep from trouble with IRS). Those who are paid a fair market salary, don't need to know about company's profit and you as owner don't have to disclose. – Webbie 11 years ago
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Remember, startup founders/owners use equity instead of salary because they either don't have the money for salary or need it more to cover other growth related expenses. Whoever you are referring to as "partner" should have equity in the company if they worked for you for less than their worth and contributed to company's success. How much equity he/she gets should have been discussed before, but is up to you now. – Webbie 11 years ago
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Last comment, promise. If you never promised equity to the partner, and it hasn't been that long (less than a year) since they started working with you, you could simply catch up on their compensation by paying him/her based on hours they spent at a market rate. But, if they are partially a reason for your company's success, equity is more fair. – Webbie 11 years ago
