Introduction:

In the small owner-managed business environment, the question of compensation is a recurring theme that often leaves entrepreneurs pondering the best compensation strategy. Clients frequently approach us with questions like, “How should I pay myself?” or “How should I compensate my employees?” While a conventional response might consider the tax aspects of dividends versus wages, a deeper exploration reveals that compensation strategies should be aligned with the unique dynamics of three distinct domains: the employee domain, the investor domain, and the entrepreneur domain.

The Employee Domain:

From an employee’s perspective (whether the owner or an arm’s length employee), compensation should be aligned with annual effort and performance. Salaries, wages, bonuses, and management fees are the most appropriate currency for recognizing and rewarding these contributions. This alignment helps avoid resentment among team members and business partners, especially when working hours and results vary.

The Investor Domain:

From an investor’s perspective, compensation should be aligned with the duration, priority, and risk associated with the investment. Investors should be rewarded for their long-term commitment and risk through interest (for debt instruments) or dividends (for equity instruments). The investor’s compensation is distinct from the employee’s, emphasizing returns on long-term capital and risk rather than annual effort and performance. Addressing differences in investment amounts ensures fairness and minimizes potential resentments between business partners.

The Entrepreneur Domain:

From the entrepreneur’s perspective, compensation should be aligned to the long-term enterprise value created by the entrepreneur. Once employees and investors have been appropriately rewarded, any surplus value should accrue to the entrepreneur. This is usually reflected in annual dividends to the entrepreneur from surplus retained earnings and/or in the terminal value of the business at the time of sale or wind up.

 

A thoughtful alignment within the employee, investor, and entrepreneur domains is key. Understanding the distinct purposes and meanings behind various forms of compensation ensures fairness, minimizes conflicts, and ultimately contributes to the sustained success of the business. As you navigate the landscape of compensation, remember that each domain plays a crucial role in a well-structured and thriving business.

The ideal scenario involves a business generating value across all three domains and being able to compensate accordingly. However, challenges may arise, leading to the crucial question: What if you can’t pay yourself or your employees? In such cases, it’s essential to evaluate the health of the business. A struggling business may indicate the need for strategic adjustments, while a conscious decision to reinvest time without immediate compensation could align with long-term entrepreneurial goals.

 

Written by: Doug Johnstone, CPA, CA

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