Your 3 Sources of Reward
As a business owner/manager of a small or medium size business, there are 3 sources of financial reward that you should pay attention to, if you want to maximise your income and wealth. They are; your salary, your profit and the capital value of the business. In my experience, few business owners pay enough attention to deliberately achieving specific targets in each of the three rewards. Most business owners focus on their “drawings,” or the cash they can safely withdraw from the business. Few actually pay attention to achieving a targeted capital value for their business, which is what they could expect to receive if they sold the business. Very few business owners even think far enough ahead to have a strategy for how they will exit the business and what they would like to receive from the sale of the business when they do make their exit. In this article I want to elaborate on the importance of your focus on each of these 3 sources of reward and how to maximise your results in each area.
SALARY
How much do you pay yourself?
If you are like many business owners, you may pay yourself out of what is left over after all the expenses have been paid and all your employees have been paid. Often, what is left is barely enough to get by, or worse. I have seen many cases where the business owner is the lowest paid person in the organisation. This method of rewarding yourself for your efforts in the business, though common, is very undermining and comes from a misplaced attitude about the business – that the business is all important and that it is your role to support the business. This attitude comes from a survival mentality and pushes business owners into a position where the business and their own families operate on a mere survival level of reward, if that. Often, in this situation, the elements of salary and profit are confused and all rolled into one. The concept of salary may only be considered as a tax minimisation strategy rather than as a proactive reward strategy. When you only take out of the business what is left over at the end of all the expenses, you are making the business your master. You are working for your business where you should actually be making your business work for you.
There are only two valid reasons for a business to exist:
- To create and deliver something of value to its customers, and
- To create and deliver valuable rewards to its stakeholders, particularly its creator.
If one of those reasons is missing, there is no valid reason for a business to remain in business.
If that is your attitude going into business, you will create strategies that generate value for the business stakeholders, including yourself. You will be in control and you will insist the business works for you. You will determine the rewards you want from the business and do what it takes to ensure the business delivers those rewards. You will clearly understand your two distinct roles in the development of the business and you will determine the appropriate level of reward that flows from those two roles – that of one, manager/employee and two, owner/investor. This process is even more important when the business has more than one owner working in the business.
Let’s look at the first area of reward for the working business owner, the salary. Most business owners are usually also the business manager or have a management position. Occasionally, with several business owners, there may be one of the owners working as the Managing Director or CEO, with the other owners occupying positions such as sales manager, operations manager and so on. Sometimes however, there may be some owners or shareholders who work in a position with no managerial responsibilities. The appropriate reward strategy in each of these cases is to pay the owner/shareholder a salary relevant to the work role they occupy. For example, the CEO should be paid a salary equivalent to what would have to be paid to employ someone to work in that same role. The sales manager should be paid the equivalent salary to what anyone working as a sales manager in the same industry would be paid. The owner who works as a toolmaker should be paid a toolmaker’s salary for that work. This ensures that the business operates on a competitive level with other businesses in the same industry. If you pay yourself less than you would have to pay someone else to work in the same role, you are robbing yourself for the sake of the business. If you are paying yourself less than you would pay a professional manager because you cannot perform well enough to make the business capable of paying you the appropriate salary, you should sack yourself from that position and employ a professional manager who can make the business perform at the appropriate level, because at least then, you may derive some reward from the other two reward areas.
I once worked on a consulting project for a business that had 7 owners who all worked in the business. But this business had the opposite problem. The owners worked in various roles, from CEO, to designers, to toolmakers on the shop floor. There were other employees as well. Here, every owner was paid exactly the same salary despite the position they worked in. The toolmaker owners were paid a CEO equivalent salary, working alongside other toolmakers who were paid a normal toolmaker salary. This business was struggling to be competitive, which should come as no great surprise.
For competitive and strategic reasons, an employee/owner should be paid a salary equivalent to what the role they occupy is worth on the commercial labour market. For motivational reasons, the owner should also be paid first, before other expenses are paid and the business should be expected to perform at the appropriate level to ensure all expenses and salaries can be paid when they are due. In my experience, it seems that people usually get what they expect. If you expect your business to perform well enough to pay you the salary you deserve from the work you do, you usually will do the things that are necessary to ensure your business performs to expectations. If you are willing to settle for whatever is left over, your low expectations mean you will probably do what it takes to survive, but not have enough left over to really pay you what you deserve. So, be sure to set your salary level to the equivalent to what you would have to pay someone else to do your job and make sure you pay yourself first, before other expenses.
PROFIT
True profit is what is left after all expenses and owner salaries are paid. This is the true measure of performance of the business and your target should be to achieve a profit that is higher than what you would achieve if you invested the equivalent of the funds you have invested in your business in another investment vehicle. For example, you could earn 8% interest on a short term money market account at the bank in a safe and secure investment. Or you may earn a 20% return on a share portfolio that is a more risky investment. Reward is always measured against risk when it comes to investing. In your business you have funds invested. They are probably in the form of assets you use to produce your income, eg machinery, plant and equipment, computers, office furniture, motor vehicles and so on. You may also have some value in intellectual property, which is your proprietary way of conducting business, and some value in goodwill, which is usually the value of having a loyal customer base, people who could be expected to keep doing business with you for some time.
The value of all your assets, minus the total of all your liabilities (what you owe to others) equals the investment of funds in your business. Your target profit should represent the return on investment you want in relation to the risk of employing those funds in your business. Because the risk of running a business is usually higher than putting your money into the bank, or even investing in shares on the stockmarket, your target return on investment should be higher than the returns you would get from those safer investments. Most professional business owners would target at least 25 to 30% return on investment and some target much more as a reasonable return compared to the risk.
In reality, if you can’t achieve this level of return on your funds invested in your business, you would be better off selling off your assets, paying out your liabilities and investing the remainder in a safer investment. You may need to get your accountant to help you determine the level of profit you should be targeting, if you don’t know the value of the investment you have in your business. Your financial statements, particularly your statement of financial position, will give you some idea of the value of your investment (or your equity) in your business. However, financial statements usually use historical cost figures and don’t necessarily reflect current values of assets that you have.
Your assets should be valued at what you could sell them for, rather than their book valuation. When you know the true value of your equity in the business, you can reasonably set a target for the profit (or return on investment) you should achieve. Again, when you expect your business to achieve the desired level of profit, you tend to do what is necessary to achieve your goals. Most businesses that don’t achieve the required profit returns are businesses where the owners have not established clear targets in the first place, but are trying to do the best they can. The trouble with trying to do the best you can is that there is no clear definition of what “best” means, so you can never know when you are achieving it, or do something about it if you are not. When you have a clear target, you can make adjustments to your performance when you are off track.
CAPITAL VALUE
The last area of reward is usually the most neglected, even though it has the potential to be the most rewarding. The capital value of your business is the amount of money you would expect to receive if you sold the business. There are a number of ways a business can be valued, depending on certain criteria. One way to value the business is to determine the value of the net assets minus liabilities, similar to determining your investment in the business as above. However, often this method does not capture the true value of the business, which is really related to the earning power the business has, in terms of the expected revenue stream that the business should earn in the future. A valuation is determined by estimating the net present value of future earnings. In many cases, future earnings can be predicted by looking at the profits the business has achieved in the past. This is another reason for ensuring you can show a level of profit that would attract an investor, as distinct from your salary, as we showed above.
Probably the most frequent method used to determine the value of a business is to use a multiple of past annual profit to determine the net present value. The multiple used is reflective of the level of risk associated with the business earning potential. Frequently, the multiple used is 4, which means that you could sell the business for 4 times its annual profit. If the risk was higher, you may only receive 3 times the annual profit, particular if it has to be averaged out over a few years of fluctuating profit levels. The main factors to consider here are that you can prepare your business for sale on the most advantageous terms by maximising its profit levels over the years before you sell it, and you can reduce the risk in the business performance to ensure you can sell at the highest multiplier rate.
One of the major risk factors that comes about in small and medium size businesses is the risk of what happens to the business when the owner is no longer there. Many businesses are highly dependent on the owner. The risk for a purchaser is that the business is the owner and that the business may not perform well without the old owner. The best way to overcome this risk is to ensure the business is set up with proper management systems and documented operating systems which double as an operations manual for any new owner. These systems ensure the business can be sold for maximum value, because they clearly demonstrate that the business operates systematically through well defined procedures and is not totally dependent on the skill and passion of the owner to achieve results. Your plan to exit the business therefore should include establishing documented operations manuals and management systems, so that you can achieve the maximum value for your business when you decide to sell it. Another advantage of doing this is that, because of the systems, the business runs profitably by itself. Therefore, you have a choice of whether to sell it for the capital value, or to keep it while it continues to earn you a level of profit that enables you to live off the income and enjoy the freedom and lifestyle you deserve from having created such a successful enterprise.
CONCLUSION
Don’t operate like most business owners who just survive and look forward to the day they can escape from their business with their heads just above water. You have the opportunity to create your own financial rewards through your business. There is no reason you cannot follow this tried and true process to maximise your rewards in each of the three areas; your salary, your profits and your capital value. It is up to you to plan what you want to achieve and how you will achieve it.