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Looking to improve agency margins and profitability? Which key metrics are important to track? Are you paying yourself a salary? How much cash should you have in reserve? If you’re hoping to sell soon, you shouldn’t underestimate the importance of starting to pay yourself a salary. Potential buyers will pay attention to this and many other details you could start to work on right now. Today’s guest owns a CPA firm focused on helping agency owners scale by getting their finances in order and avoiding the biggest mistakes in agency finances.

Chris Hervochon runs Better Way CPA, a CPA firm that specializes in virtual CFO services for agencies. Over the past eight years, his company has provided services to marketing agencies and nonprofits all over the US. He provides some insight into the key metrics you should be measuring, why you should pay attention to your gross margin, and more.

In this interview, we’ll discuss:

• Avoid the biggest mistake in agency finances.
• How to increase your margins.
• Why you should pay yourself a salary.
• Key metrics to manage agency cash flow.

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Verblio: Today's episode of the Smart Agency Masterclass is sponsored by Verblio. Check out Verblio.com/smartagency and get 50% off your first month of content creation. Our team loves using Verblio because of the ease of their process and their large pool of crowd-sourced writers.

The Biggest Mistake in Agency Finances

The biggest and most common mistake Chris sees agency owners make with their finances has to do with cash management. Usually, they fail to understand how cash moves in and out of the agency. Also, how it’ll move into and out of the agency in the future. This is critical because it’s how you can really understand how to grow in the future.

As an owner, you must understand the way cash moves within the agency impacts clients, the work you do for them, and how you collect payments. This impact the people you pay to work for the agency. All of this helps you get a clearer vision of how you’re going to scale and bring in the next client.

Pay Attention to These Key Metrics

• Profitability. When it comes to profitability, you need to be over 15% or 20% to be good. 15% or less is when the alarm starts ringing and you need to pull some levers to figure out what’s going on.
• Net income. If you’re using some sort of accounting software and looking at P&L, net income is your bottom line.
• Gross margin. This varies wildly across agencies because every agency operates so differently. In this particular case, measure yourself against yourself and track that over time. Make sure you’re maintaining or increasing margins over time.
• Cash reserves. Every business should set aside cash reserves to fund growth. They help pay for unexpected costs that occur throughout the year, and they're often kept in your business account.
• Pipeline. Make sure to have a process to measure your pipeline. This bleeds into your forecast and indicates what roles you need to hire, when, as well as who you need to fire and when.

Why You Need to Pay Attention to Gross Margin

Gross margin is your revenue minus variable expenses (cost of sales). This is the percentage of revenue you can keep in order to pay fixed expenses and then pay yourself. In short, the costs you’re going to incur every time you generate a dollar.

If your margins are very low, it's hard to pay for fixed expenses needed to operate the agency and deliver your services. If you don’t have enough money to pay your team, for example, you might start making bad decisions, like cutting staff, expenses, and software. At that point, you don’t even have enough to pay yourself as agency owner, which is definitely a problem.

This is why you need to pay attention to margins and make sure you have enough money every time you generate a dollar of revenue to pay those expenses. In the end, having revenue is good, of course; however, there’s really no point to it if it won’t allow you to pay for your fixed expenses.

What Works for Agencies When it Comes to Increasing Margins?

According to Chris, pricing and how you price will always be the biggest lever you can pull to increase profits. This may be difficult in our current economic times. However, that’s your biggest opportunity to move the needle. How can you increase prices?

1. Build up value so you don’t face pushback from clients when it’s time to raise prices.
2. Have value conversations with your clients.
3. Ensure your sales and pricing functions are split.
4. Be open to flipping some internal capacity to external capacity and bringing in contractors. This can be beneficial and prove to be more cost-efficient than having a full-time employee.
5. Cut unnecessary software costs. Take a look at who’s using what software and get rid of what's not needed.

It's Important to Pay Yourself a Salary as an Agency Owner

Many agency owners don’t realize the importance of paying themselves a salary. They skip the salary to increase profitability. Paying yourself little to no salary just to be at 30% profitability is not an option if you want to sell one day. A prospective buyer will look at agency finances and see margins are good because you’re not paying yourself.

How much should you pay yourself? To determine the average salary of an agency owner in a given area, Chris’ team does a regional compensation study.

They take the owner’s functions in the agency and determine how proficient they are at these tasks. Next, they assign an hourly rate based on the bureau of labor’s existing data. Then add that up and have what the agency owner should pay themselves from payroll. The resulting salary is just low enough to save in taxes while also satisfying the IRS. The rest of the agency owner’s compensation is taken out as a draw or distribution. The amount of that draw depends on how much cash you can take out of the agency

Make sure you have an adequate cash reserve to get you through difficult times and invest in the agency. It’s a balancing act between what the agency owner should be making and planning for taxes.

Average salary for agency owners: For agencies around $1 million, most agency owners Chris has worked with have salaries ranging from $175,000 to $225,000 for an agency operating profitably. For agencies closer to $3 million, the agency owner’s salary doesn't necessarily increase much. It is roughly the same for tax purposes. The draw is where there's an increase and takes total compensation to around $500,000.

How to Project Your Agency’s Future Investments

Usually, investments in your agency’s future are in capacity. This means “people costs” such as equipment, bigger space, etc. The best way to calculate this is by putting together a capacity model and figuring out which roles you need to fill, the amount of work they’ll take on, and how much they’ll cost. Forecast that into the future and see what it does to your cash flow.

From a cash flow standpoint, look ahead to six months. Maybe the results of that tell you that in seven months-time you won’t be able to make payroll. However, knowing now gives you enough time to do course corrections.

How much should you have in cash reserve?

Typically, Chris wants his clients to have between 2-6 months of fixed expenses in cash reserve. Chris conducts a brief study of the clients' plans to spend and invest in order to assess and make a recommendation. Most agency owners land between 3 ½ to 4 ½ months cash reserves needed.

Do You Want to Transform Your Agency from a Liability to an Asset?

If you want to be around amazing agency owners that can see what you may not be able to see and help you grow your agency, go to Agency Mastery 360.  Our agency growth program helps you take a 360-degree view of your agency and gain mastery of the 3 pillar systems (attract, convert, scale) so you can create predictability, wealth, and freedom.