The Right Way to Not Pay Yourself
Today I received an email asking me to clarify what I wrote last month in Why sweat equity often stinks. The person quoted the sentence in italics below and asked “what does that mean, exactly?” I’m including the whole point because the context helps:
Founders work for less than fair value and record the difference between actual pay and fair value as owed to founders, a liability on the balance sheet. This has the advantage of recording real expenses into the financials, so I like it. But founders asking for outside investment should expect to capitalize that and swallow the liability. You can’t use founders’ labor to justify the valuation ask, and then turn around and get it paid too. You know: cakes and eating?
So here’s a true story, an actual case, one I know very well because it was my money and my sweat equity. While I was bootstrapping Palo Alto Software I couldn’t afford to pay myself what I was worth. But I didn’t pretend I wasn’t an expense. I practiced what I preach by recording the market value of my work, month by month, as an expense called unpaid Tim salary. And I balanced every month’s entry into expenses (a debit) with a corresponding entry to liabilities (a credit).
(By the way, important warning: I didn’t report my unpaid compensation as an expense for tax purposes. You can’t deduct compensation to yourself unless it’s paid; and when it’s paid, you have to pay payroll taxes. This is not trivial.)
(Oh, and a disclaimer: I’m neither attorney nor CPA. I don’t give tax advice, accounting advice, or legal advice. I’m just telling you a true story.)
As time went by, I accumulated an interest-free liability that was a serious amount of money, more than six figures, as debt owed to me. And that still on the books years later when I brought in venture capital money.
When that turned up in due diligence, my investors said:
Tim, that’s not going to fly. If we’re investing, you have to swallow that. Capitalize it. Take it off the books.
And so we did. The money owed to me became another version of sweat equity. It was in the valuation we negotiated with the investors. It disappeared. It was never paid.
Would I do that — keep track of unpaid salaries — again? Yes. Would I recommend you do it? Yes. It gives a better picture of real expenses, break-even, and so forth. It might be useful for some future close-in negotiation with partners, people close to you, perhaps divorce court or inheritance tax. But investors won’t want to pay it back.
That’s what I meant. I hope that clears that up.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.