Is there an accountant in the house? Getting real about agency financials with Jenn McCabe

Speaker 1:

Are you tired of feeling like the lonely lighthouse keeper as you run your agency? Welcome to the Agency Management Institute Community, where you’ll learn how to grow and scale your business, attract and retain the best talents, make more money, and keep more of what you make. The Build a Better Agency Podcast is now on our third year of sharing insights, and how small to mid-sized agencies survive and thrive in today’s market. Bringing his 25 plus years of experience as both an agency owner and agency consultant, please welcome your host, Drew McLellan.

Drew McLellan:

Hey, everybody. Drew McLellan here with another episode of Build a Better Agency. One of the pain points for many of the agencies that I talk to revolves around accounting and financials. The truth is that it is a rare agency owner who is actually somebody who comes out of the financial world.

Every once in a while, I will bump into an agency owner who loves spreadsheets and understands the inner workings of P&L statements and all of that, but for the most part, most of us came up through the agency world, and avoided accounting and Math courses in college as we made our way to our profession and, certainly, in our daily professional lives for at least a while didn’t have to worry about that. Now as owners and leaders of an agency, obviously, the financial health of the agencies becomes critical.

I’ve been talking to several agency owners lately who have literally said to me, “I have no idea where we are financially. There’s something wrong with our books. I don’t know how to read this. I’m not sure where the money is going.” How many times have you thought or heard someone say, “I owe a bunch of taxes, but I have no money. I can’t figure out how that works”?

So, I think the whole idea of understanding how the money works and how to have better accounting documents, how to have better financial documents that allow you to not only see where you’re at today, but look down the road and see where you’re going to be in the next 30-60 days is really critical.

So, my guest today is well-poised to chat with us about that and to talk about how agencies can stay ahead of themselves financially and make better decisions with better data.

So, Jenn McCabe started her career working at Ogilvy inside their accounting department, and then quickly leaped out and started her own, basically, an outsourced accounting and HR company. Then recently, she merged her company with a larger firm called Armanino, and what they do is, again, they’re an outsourced HR and finance company, and they work primarily with agencies, trying to help them have great dashboards and some simple financial documents that allow the agency owner to make good decisions.

So, I met Jenn a while ago, and we had a really great conversation around how to help agencies wrap their hands around the financial aspects of their business and, really, what are some of the key elements and indicators that agencies really need to be watching on a weekly, monthly, quarterly basis to make sure that they are tracking what they need to track.

So, one of the things I want to do with this episode, we also put together a list of what I think of as are the Key Performance Indicators or KPIs that many agencies should consider putting into their dashboard, and I’m going to make sure that that AMI document is at the end of the show notes, and I know that Jenn is going to have some things for us to add there as well. So, with that, I want to just jump right in to the conversation and let’s talk money.

All right. So, without further ado, Jenn, welcome to the podcast.

Jenn McCabe:

Hi, Drew.

Drew McLellan:

Hey. So, I know that I just told everybody all about you, but I suspect I didn’t tell them all about you. So, how is it that you came to be doing the kind of work you’re doing helping agencies with this whole finance thing?

Jenn McCabe:

Well, I started a long time, a long time ago, I won’t say how long ago, but I started at Ogilvy and Mather. Back when I was at Ogilvy and Mather, they were building what they called Ogilvy Orchestration, which meant they were grabbing and buying public relations companies, and direct response companies, and television production and radio companies. I was working at the big agency, and they had a training program back then that allowed me to work in every department of that big agency, and I went back and forth to New York a lot. I helped them put in the first nationwide computer system. It actually connected all of the offices, so Atlanta and New York. We’re talking to each other.

So, I got to be on the very front of agency technology, and I got to learn about the little companies that a big agency was pulling in, and it turned out that the little pieces were more fun. They were nimble and they reacted quickly to market, and the big agency was a lumbering giant, and I became a corporate dropout as I watched what the big agency was doing, and I got addicted to their little companies and to working with the guys they put in charge of these little production pieces that were 20 people or I would go onsite to a production in Canada.

I just got really passionate about the industry because I learned a ton about all the pieces of it and also about the little businesses that are all connected in peripheral to advertising. So, I started my company when all my friends started dropping out of the big agency and starting their own production companies and their own little agencies. As they became corporate dropouts, they just started coming to me, and I accidentally became, I like to say I’m like Algor. I like to say I invented outsourcing.

Drew McLellan:

There you go. With no doubt, just as much accuracy.

Jenn McCabe:

Yeah, I’m sure.

Drew McLellan:

Yeah. So, today, if somebody’s going to hire you, Jenn, they hire you to do what, if an agency hires you?

Jenn McCabe:

Usually, I get a call from a small agency person and by small, most of them have less than 25 people when they call me, but almost always less than 50. Every once in a while, they have, right now, we have somebody with 700 employees, but, generally, they’re small. They call because they’re realizing they need real accounting and they need someone to help them figure out if they’re making money. They call because they’re scared and they don’t know if they’re doing it right. A lot of times, they have also dropped out of a big agency. So, they know that they need information. They don’t even know because all my friends are creative people. They don’t even know what to ask for. They do know they wish they could talk about their company’s finances at a dinner party.

Drew McLellan:

Okay. All right, or at least lie about their company finances at a dinner party.

Jenn McCabe:

Exactly.

Drew McLellan:

Right?

Jenn McCabe:

Right. They want to be able to tell their bros that they’re making money or not making money. A lot of times, people call me and say, “I don’t have a lot of money in the bank, but I owe taxes.” That doesn’t make sense to me or, “I got to hire someone because I’m working my teeth off, but I don’t think I can afford it,” and the answer is usually, “Well, we need to look at your numbers,” and they say, “What?”

Drew McLellan:

Yeah, “What numbers should I look at?”

Jenn McCabe:

Yes, “What?”

Drew McLellan:

Right. So, let’s take that scenario. Somebody says, “I need to hire somebody,” or “I have to pay taxes,” because they’re really the same question, right? “I need to hire someone but I don’t have the money,” or “I have to pay taxes and I have no money in the bank.” How is that possible? What do you go in and look at?

Jenn McCabe:

The first thing I see, the two mistakes I see over and over are they’re doing cash accounting. That means that they’re recording expenses when they write the check, and they’re recording income when it gets deposited into the bank. That sounds perfectly logical to anyone who hasn’t taken an accounting class. So, I have to explain to them that there’s a reason that in Corporate America accrual accounting is actually legally required because accrual accounting ac tells people how they’re doing. Most people run their business out of their checkbook, money in and money out.

In our business, if you’ve done a good job of billing upfront, so say you’ve billed 50% upfront or even 100% if you’re really cruising, unfortunately, all the money that you pay out hits two months later, and it really messes people up. This jerkiness of cash makes them not know where they are. That’s the number one mistake.

The number two mistake is they have underestimated the importance of having accounting instead of bookkeeping. It’s my mission to make bookkeeping illegal, at least unlicensed bookkeeping. There are a lot of well-meaning people out there who are very organized and very meticulous. Sometimes it’s this person’s family member who’s keeping track of everything for them, and it’s cost effective in the short run and very expensive in the long run to have unprofessional accounting.

Drew McLellan:

So, define for me the difference between accounting and bookkeeping.

Jenn McCabe:

Bookkeeping is paying the bills, depositing the checks, typing up invoices to clients, and just letting it hit the bank, and really taking care of the bank account. The bank account is just one-

Drew McLellan:

Right. It’s really taking care of accounts receivable and accounts payable.

Jenn McCabe:

Yeah. By the way, I see in a lot of startups they’re not even really doing that because when you say accounts receivable and accounts payable, you’re assuming that the people listening to us understand that to have a payable account, it means that you have to book all the bills that are going to be paid, not just when you write the check, but, one, as it comes in the door and you put it in the pile of, “Oops, I got to pay that next week,” you book it, so that you have a report.

I always teach people that the accounts payable report is a to-do list of all the bills that you have to pay, and an accounts receivable report is a list of all the people who owe you money. Most startups have a folder or maybe a Google Doc. The new folder is a Google Doc with all the people who owe them money in a list that’s not in their accounting software.

Drew McLellan:

Okay. I’m really hoping most of my listeners have gone above that. So, when you and I talked on the phone before we got to know each other, one of the conversations that I think we bonded over was this whole idea of in any accounting software, assuming that you are logging in things into accounting software, where do you put contract labor? So, today, so many agencies either are virtual agency and they have no W-2 employees or many agencies-

Jenn McCabe:

Oh, oh, you just gave me a rash.

Drew McLellan:

Hang on, or most of them have a high bred, where they have some W-2 employees, again, whether they’re a brick and mortar or virtual, and then they also use contractors for skills or deliverables that maybe they don’t do often enough to need full-time employees. So, I know you are in California. So, we’re going to put that aside for a second.

So, for the other states, that’s still a feasible option, but what I want to talk about is not whether or not you should use contractors. What I want to talk about is how you record that expense so that your financial metrics line up? So, we had an interesting conversation about, is it a cost of goods or does it drop down below the adjusted gross income line? Do you want to talk about that a little bit?

Jenn McCabe:

Yes. Again, we’re talking about startups and smaller agencies.

Drew McLellan:

Well, but keep in mind, most of my agencies who are listening have been around for 20 years. So, they’re not startups, right? So, how are you-

Jenn McCabe:

Okay. So, they’re what size would you say?

Drew McLellan:

It could be anywhere from 10 people to 500 people, but the point is they’ve been around for a while. So, they have been behaving in a certain way for a while, and a lot of them are in some accounting software. Nonetheless, they wrestle with this idea of, “Well, I’m paying this contract person to do-”

Jenn McCabe:

“Where do I put them?”

Drew McLellan:

“Where do I put them?” Right.

Jenn McCabe:

“Where do I count my money or don’t?” So, I think that even in my big agencies, it’s best to keep the financial statements simple. So, I fight the fight to keep the profit and loss statement or the income statement one page long so that when I’m talking to my owners, it’s one page. If it’s more than that, they see squirrels out the window and don’t pay attention. That’s part one.

To keep it simple, part two, when yo hire cost that is specific to a job that we’re doing and we are gig to gig in this industry-

Drew McLellan:

Right. So, we’re hiring web developers, let’s say.

Jenn McCabe:

Yeah, and if it’s a web developer that is for just a gig and it’s on the SOW to the client, I go ahead and put that above the line. It’s what I call a direct expense, and it’s only for that gig, and it’s also the most important term that I want to get across everybody to get is variable versus fixed.

Drew McLellan:

Absolutely.

Jenn McCabe:

So, what people get all caught up in their underpants over is direct and indirect cost. If they hire Jenn McCabe and she’s going to work on a gig, sometimes it’s direct and sometimes it’s indirect. I think that that just complicates thing and it’s just much better to say, “I’m going to put all of my fixed expenses below the line in my operating expenses. So, if I have Jenn McCabe over and over and over, and she works some of the time on direct gigs and jobs and sometimes not, but I’m going to have to pay her no matter what month after month after month like a lot of my salaried people.”

I like to put that in the operating expenses because it’s fixed. Even I don’t have any work, I’m going to have to pay those costs. So, what you end up with is above the line as in above gross profit or above income as well. I like to have on the top, billing minus cost of sales. Billing is what you send to your clients. Cost of sales are all of those cost that are really specific to that gig that are on the estimate to the client, and what you’re left with is what we call income in the industry a lot of times, income after pass through expenses.

Drew McLellan:

Yeah. So, in AMI vernacular, that’s adjusted gross income. So, you have your gross revenue minus your cost of goods, and then we have adjusted gross income, and out of the adjusted, and what adjusted gross income should cover is your W-2 folks and their benefits, your overhead expenses and, hopefully, there’s money left over for profit and taxes and all of that sort of thing, right?

Jenn McCabe:

Yeah. So, when you look at your profit and loss statement, you can almost exclude everything above that gross income that your gross adjusted income. Anything above that is just going through the washing machine.

Drew McLellan:

Right. Yeah. You’re being a bank, right?

Jenn McCabe:

Yup. Absolutely. It’s really because we call ourselves agencies. There’s a legal reason for that word. It means that you are the agent for your client and you are just paying their bills. So, that to me doesn’t apply to my staff. Their my staff. They’re not agent expenses. So, I put everything below the line that is fixed, isn’t variable, and it helps me identify for an owner what I call the run rate. So, every month, that should be a pretty fixed amount.

Drew McLellan:

So, define a run rate for people who are not familiar with that term.

Jenn McCabe:

A run rate is how much do I have to spend to keep the lights on? Even if I don’t get a nickel of work, what am I absolutely committed to? That’s a really important number for a business owner to know. That’s the number at the cocktail.

Drew McLellan:

Let me just make sure I’m tracking with you. So, what you’re really talking about is that’s my monthly nut. I have to pay my people, I have to pay my rent, and my overhead expenses. That’s the amount of money that I need to have without any profitability, whatsoever, just to keep my business open.

Jenn McCabe:

Yeah, and depending on the philosophy of the agency that I’m working with, sometimes the owners like to have their guaranteed payroll in that monthly nut, and sometimes they don’t. Sometimes they say, “Okay. What’s my run rate without me in it, and what’s my run rate with me in it?” Sometimes they want their taxes included or not, but it’s the cocktail party number. It’s when you’re hanging out at the cocktail picnic, you want to say to someone, “Yeah, it costs me $100,000 a month just to keep the lights on.”

It’s important in goal setting because then agency owners and all of their people that they put on a goal plan know what they have to go out and get every month. Now, if-

Drew McLellan:

Right, which, by the way, is why I think it’s, and I’m curious about your opinion about this, but I think, too, for the owner to exclude their own salary means that, really, they’re running their business inefficiently, which means that they are not actually running their business the way it should be run because nobody is doing this for free, right?

Jenn McCabe:

I agree.

Drew McLellan:

So, what it allows them is it allows them to be a little fat in the staff side or on the overhead side as opposed to running their business well, and I find that most owners who do that are doing it so they don’t have to make the difficult decisions that they should make about cutting staff or cutting expenses or something else.

Jenn McCabe:

Agreed. Interestingly, because I also do mergers and acquisitions work a lot, so I help agencies start and take them all the way through exit. Now that I’m getting along in my years, I’m starting to help people buy themselves back from the big networks, which is really fun work.

Drew McLellan:

Interesting.

Jenn McCabe:

Yeah. It’s very interesting. I’m working with some people now who are buying themselves back from one of the big networks. It’s my second time around. In my career, that wasn’t how it went. So, I’d always build agencies and sell them. What has happened lately is people get referred to me because they wanted to drop their agency to one of the big networks. They will come to me with the financial statement where the owner has been excluded or paid too little and they’ve had financial advisers or maybe investors who wanted to see a bottom line margin.

They have done all sorts of things to hit that margin because they were told that that would help their multiple, which is flat out wrong because when you do evaluation, of course, you have to go in and do what we call a minus back when you haven’t paid the owner enough. What I don’t like-

Drew McLellan:

You have to normalize the books, right?

Jenn McCabe:

Absolutely. So, I also have to compare a lot of agencies to each other and people ask me to benchmark a lot. They say, “How does my agency look compared to my nextdoor neighbor’s agency? What’s my margin?” I can’t benchmark an agency that isn’t paying its owners because it’s nonsensical.

Drew McLellan:

Right. It’s not real life and it’s not sustainable. Nobody can work for free forever. If you have that much money, you don’t own an agency anymore, you’re doing something else.

Jenn McCabe:

That’s right. Yeah. It doesn’t make any sense. I really try to fight with people to make sure that they’re paying themselves something that’s fair and square.

Drew McLellan:

Yeah. What is your recommendation in terms of doing that in the mix of W-2 and dividend income? Do you have a formula that you like to follow with your agency owners of how much they pay themselves in each of those two buckets?

Jenn McCabe:

Well, I’m a recovering tax person, so the reason I’m recovering is that I like to be able to operate on a continuum of risk as I say instead of by the book. So, when you an S corp, which is what I had until I merged my company with Armanino, so I practice what I preach. You pay yourself a salary and it’s a tax, this first part of my answer is a tax answer. You pay yourself the minimum acceptable salary because then you have a lot more in dividends. Dividends are taxed at a lower rate than your wages are. We have to weigh that because you might want your wages to be high because of your retirement contribution, for example.

Then there’s this other thing for the valuation and for the internal revenue service. You need to pay yourself a reasonable wage. I like to make sure that people know reasonable is for their geographic area, their years of experience, other similar agencies. So, even if they do make an aggressive tax move, they at least know that in a valuation, here’s how it’s likely to be adjusted.

Drew McLellan:

Right. We do an annual salary and benefits survey. One of the ways we break it out is salaries by agency size and by job review so owners can see not only what their peers are paying themselves and, by the way, then they have documentation from a third party if they ever did have to defend that. Also, they can also see from their employees’ point of view, “Oh, okay. I’m in the ballpark,” or “I’m not in the ballpark,” whatever, but you’re right. Geography and size of agency matters in that number.

Jenn McCabe:

Absolutely, and having a proper survey. You just talked about something that’s important. In our industry with turnover going crazy, it really hurts agencies when they lose people sometimes. I mean, it might help in the creative department for all I know because maybe you don’t want institutional thinking, right? In other parts of the company, institutional knowledge is being lost by turnover.

I really believe in having a proper survey that isn’t online on Glassdoor because a lot of people are having conversations where somebody comes and says, “Hey, look what I found online. My salary is low.” So, what we do in our HR team, which rolls into our CFO advisory team and our accounting team, the HR team salary band based on years of experience and performance and an owner can say, say that you develop a 5% pool of money, you need to allocate that money according to performance, tenure, and what’s right. So, that survey is critically important, I think, to doing a proper review of your entire staff and staying on budget.

Drew McLellan:

Yeah. So, I’m curious. We were talking about run rate. So, how do you help agencies, A, internalize what that is, and then what do you ask them to watch for? How much cash do you recommend they have that’s liquid and accessible to them as a cushion against the run rate?

Jenn McCabe:

Okay. There’s a couple Key Performance Indicators as we call them, KPI. So, when we design software for an agency, we like to have dashboards. Run rate is on the dashboard. We want to know. Networking capital is a term or I call it cash and cash equivalents for owners because I want them to understand that it’s not just about cash. It’s about cash equivalents. Really, the smart, mature answer for you, Drew, is that people should have three months of cash and cash equivalents. I would love to tell you that it should be a year, and it probably should be. That’s not realistic in the advertising agency and production world, where we’re all gig-to-gig, and there are not very many long-term contracts anymore. Every agency I see has maybe one or two long-term retainer deals.

So, it’s got to be three months. Networking capital or cash and cash equivalent snapshots or something that I have my team sent out to companies every time they cut checks, that is, cash in the bank plus your account receivable, what people owe you and are going to pay you in the next 30 to 60 days minus payables, which is what you got to pay out in the next 30 to 60 days, which means you add in payroll because it’s not in payables. What’s left is this cash and cash equivalents number. It’s a very simple number to look and find, and that should cover two to three months and that’s a nice conservative way to look at it because it assumes business is going to stop today. No bizdev, it’s my safe way to operate.

Drew McLellan:

One of the things that we recommend our owners, and I’m curious about your take on it is, is my rule of thumb is I want you to have two months in the business. I want you to have another two months personally in something liquid that if you need to lend it, but get it out of the business because, otherwise, you misspend it. Put it in your personal name, put in the money market account, put it somewhere liquid that if you need to lend it back into the agency you can because I find and I’m curious if you find this, too. So, times are a little slow, clients cutting back. I really know that I’m one person heavy, but I got a bunch of money in the bank account. So, I’m not going to cut that person lose because agency owners are the most cynically optimistic human beings I’ve ever met in my entire life, right?

On the one hand, they’re cynical as heck, but on the other hand, they know that right around the corner is the big client. So, they’re going to keep that person and I’m not a big advocate of just being a hatch it shop, but sometimes you know you’re overstaffed, and there’s nothing down the road that says you should keep the body that you’re keeping.

So, I find that they keep them too long when they have too much money inside the agency, but when they keep it lean, two months’ worth in the agency, and then if I still want to keep Bob on the payroll, I, Drew, have to write a personal check out of my money market account back to the agency to keep Bob’s job. All of a sudden, I make a very different decision.

Jenn McCabe:

Right. I like to have people have a revolving line of credit.

Drew McLellan:

Yeah, I’m up for that, too.

Jenn McCabe:

So, I’m with you. So, when I say not cash but networking capital, and I say two to three months, I’m saying the same thing, and I don’t like people to get fat in that bank account because what I see is when they have an accounting staff that isn’t future-focused, accounting is not finance. Finance is future-focused, right? A controller is accounting and a CFO is finance. If you don’t have that forward-looking person, they can also get complacent. That’s what you’re talking about.

So, I like it to be a line of credit because then what happens is it’s on the balance sheet and the accounting professionals in your organization are also looking at that LLC, which has to revolve and get paid back. So, it does make you lean and mean, that discipline.

The other KPI that I think about just because it’s super easy is that your fixed payroll, your salaries should be 50% of that gross income number that you’re talking about.

Drew McLellan:

Yeah, that adjusted gross income, yeah.

Jenn McCabe:

Then you can add on benefits on top of that, but it’s a real easy thumb rule for an owner. A lot of clients are creative guys, and they don’t like numbers. So, I try to make it really easy. Salaries should be half what your fees are, man. The other reason to keep that fee number very identifiable that you and I were talking about earlier in a lot of states is that when you have to pay a business license like New York, California, a lot of places, Chicago where we have agencies, they want that on your gross revenue. If you’re an agency, you can pay on that gross income number instead. That’s a sometimes not known fact. There’s a lot of reasons for that number to be identifiable and clean.

Drew McLellan:

Yeah, yeah. So, at AMI we teach 55/25/20. So, your loaded salary should be 55% of your adjusted gross income. Your overhead should be no more than 25%, which should in theory leave you 20% profitability. What I say to owners is as long as your salary and overhead combined stay at that 80%, if you are in a second tier market so you can keep your overhead at 17% and you have a lot of developers or expensive people, your salaries might be a little higher, but the key is, you’re right, it’s around that 50%-55%.

Jenn McCabe:

Yeah. I completely and totally agree, but when you and I were talking earlier about moving salaries all over your P&L, it’s really hard. That is not to say that I disagree with tracking job-by-job or gig-by-gig profitability.

Drew McLellan:

Absolutely. Absolutely. Yeah.

Jenn McCabe:

That’s why accounting software is so important. You should be able to do both. You should be able to have your project managers and your producers know their gig profitability without mocking up your P&L. That’s critical, absolutely critical.

You also mentioned the whole issue of freelance in our industry, which is beyond the tax piece. That’s the piece a lot of people make a mistake on. They even have cartoons about it in Ad Age about suddenly, they’ve got a bunch of freelancers running around and an agency owner says, “But I thought they were an employee,” and it’s what they call, oh, my God, permalancer. That word gives me chills. It means you’ve got a problem. If you have a permalancer, you have some kind of a problem, period. There’s something wrong with that word.

I always tell people that freelancer is the F word. We have to, in our industry, control the use of freelancers. What I see CFOs doing, some of them decide, “I’m only using freelancers for new biz pitches,” and then other ones say, “I’m never letting a freelancer work on a new biz pitch because then-”

Drew McLellan:

Right. The clients hate it.

Jenn McCabe:

Yeah. Exactly. So, it depends. At least those two vine philosophies with some limitation on the use of them. Then what’s happening in 30 of the 50 states now is that they’re using what’s called the ABC Test, which basically says you can’t really ever have a contractor unless they have a true business. That’s the easiest way.

Out here, I’ve found out recently that [Shayette 00:31:51] is not letting anyone come in and freelance even if they have a federal ID number. If they are performing services of a copywriter, art director, anything that is usual for that business, they’re excluding them. So, that’s making things a little easier to control for us accounting people. It’s not as easy to hire people, right?

Drew McLellan:

Yeah. I think the challenges for a lot of agencies, especially smaller ones is they don’t need any of those people full-time. So, I think they have to figure out how to use contract labor or how to outsource to another company some of the things that they only do episodically. Again, I think they have to just be aware of how the IRS would decide if somebody is actually an employee versus, “Okay. That’s somebody you’re subcontracting out to,” just like you would a video production company or somebody else that really has been part of our agency forever.

You started on Ogilvy, I started at YNR. We had every department under the sun there, but if you’re an agency of 10, you don’t have a video production department. You don’t have a web dev department. So, you’ve got to go find those people when you need them. So, you have to smart about it, right?

Jenn McCabe:

Yes. Well, I mean, you have to be smart. You have to make sure you have insurance. You have to have work comp on them if they don’t have their own. If there are photography people, that’s a big warning sign. I’ve had a couple agencies get in trouble where somebody’s production equipment got stolen, and it turned out that they were not a proper business. They didn’t have proper insurance, and they, unfortunately, rented the photography equipment from someone. The buck always stops at the agency. So, there’s a good reason to make sure the person that you’re working with is truly an established business owner and what’s becoming habitual in New York and California, in particular, is these offer letters that say, “You’re going to work for us and you’re going to be on our payroll, and we’re going to pay you. When the gig is over, the gig is over. So, you’re a temporary, full-time employee.”

The letter, it’s like a gig memo and it says, “This is what you’re going to do.” Out here in the land of entertainment, there’s a lot of production companies that routinely now run all their payroll through these production payroll services. We used to remember have off the card and on the card, and if they were off the card, you pay them all like a freelancer. Those days are gone. They’re completely gone.

So, we have to be very careful with the way that we staff our jobs now and our agencies. Freelancers are not the way to go. The IRS is actually the easy hurdle. It’s the states that are broke and the infrastructure budget that’s pushing these people to go after all the local little shops.

Drew McLellan:

Yeah, to do audits and all of that.

Jenn McCabe:

Yeah. They catch you. The first thing they do is they catch you through a 1099 audit when someone files for unemployment, who got a 1099 from you or, unfortunately, disability. I’ve had a couple of nightmares where an ad agency hires a production company, who hires a casting company, who hires a guy to roller blade for a bank commercial. This is one of my early experiences that really scared me straight. The guy roller blading fell and broke his arm in Venice. He was working for the casting agent that gave him a 1099. The casting agency was paid, and they were real a business, by the production company, which was a real business, which was paid by the agency.

This guy filed a work comp claim and a disability claim and the agency paid the bill because they were too embarrassed to tell their client. The governing authorities and the insurers were saying, “Well, let’s go to your client, the bank. They’ve got money,” but the agency, of course, was like, “Are you kidding me? How embarrassing. No.” So, there’s a million reasons for this whole employment stuff.

Drew McLellan:

It gets complicated. That’s for sure. Hey, earlier, you mentioned that you’re helping folks with the whole M&A thing, and I want to dig in to that, but first, let’s take a quick break and then I want to talk about what is this small agency that hopes to be purchased someday. How do they need to polish themselves up from a financial point of view? So, let’s talk about that when we come right back.

Thanks for checking out this week’s episode of Build a Better Agency. I want to interrupt very quickly and just remind you that one of the services that AMI offers is our coaching packages. It comes in a couple of different options. So, you can do a remote coaching package where we would communicate with you over the phone or over a Zoom call or we also do onsite consulting, where we would actually come to your agency and work with you for a day or a period of days to solve a specific problem typically that you’ve pre-identified and we’ve talked about on the phone.

So, if you’re interested in either of those, you might go over to the AMI website and under the consulting tab, you will find more information about both our remote coaching and our onsite consulting. Let’s get back to the episode.

All right. We are back with Jenn McCabe and we’re talking all things finance and money and IRS and all that stuff that you guys love to talk about so much. So, before the break, I had said to you that you had mentioned in passing that you’re doing a lot of M&A work with smaller agencies. A lot of my listeners are 50 employees or less, and they aspire to sell their agency someday, sometimes for a plugged nickel they would be glad to sell it, but on the good days, they’d like to sell it for more than a plugged nickel. So, what kind of things do they need to be thinking about from the finance side of their world to ready themselves, to make them an attractive acquisition target?

Jenn McCabe:

Okay. Boy, there’s so many things that go through my head when people bring this to me. So, I often get this from the get-go. They come to me in the first year of formation and say, “We are building this to sell it.” So, that is often a strategy. It is rare now to see someone who wants to pass it on to their child or leave their name on the door forever. Although the guys that I’m working with who are buying themselves back, both of them want to put the agency in some trust for their children now. Interesting. So, pendulum has swung.

I always say to them, “Okay. Look. Look on the horizon. Let’s make a goal right now. Is it going to be three years? Is it going to be five years? Is it going to be seven years?” The way that we determine that is I make sure they sit down with their own personal wealth advisors first because I want them to know their number. It’s really interesting when you have an agency that’s owned 80/20 because the guy with the 80% is going to hit his number a lot sooner than the 20% owner.

So, then what I do is I make sure the operating agreement legally allows for drag along, tag along, all these discussions of who gets to decide when we’re selling, who gets to hit their number first. Now, when you do that and you say that someone decides their number is 12 million, let’s say 20 million because it’s such an easier number for my math. If their number is 20 million, that means that their piece of the agency has to be worth at least four million. Call it. Okay?

So, I stick in everybody’s heads a multiple that has been holding still for many years. Agency multiples are somewhere between three and 10. That’s a horrible, big, huge swing. 10 is extremely rare and that’s what’s happening in recent years because as investment bankers say, the market is frothy. It’s a disgusting word, but 10 is silly, but it’s pretty normal for somebody to be able to aim for six. Five or six is a multiple on an agency-

Drew McLellan:

Just for the listeners’ point of view, a multiple of what?

Jenn McCabe:

A multiple is an agency world on the bottom line, what we call EBITDA, which means how much money you’re making before amortization and depreciation, which most people don’t give a rip about, and before tax. So, it’s that bottom line number. Of course, on a accrual basis, Drew, which we should maybe talk about, but that number on the bottom line, if you’re making $5 million a year and you multiply that by five to be safe, your agency is probably worth 25 million. It could be worth 30 million, right?

Drew McLellan:

So, is it even reasonable to have this conversation if what’s dropping down the bottom line is 300,000?

Jenn McCabe:

In some case, it is, and it depends on how old the agency owner is, how desperate to get out, and I actually have an agency. They just did a deal with one of the big networks, and their bottom line was $400,000. The reason they did it was they wanted access to that big agency’s bizdev pipeline. They got a 10x multiple, and they get that multiple every year going forward. So, over time, it’s an interesting deal, they’re going to lose control of their agency gradually over the next five years to this big network, and they have an incentive to build that bottom line and they’ve locked in that 10x multiple over five years.

So, even though their bottom line is very small, they’re going to get the benefit of it over time. If they don’t, they give up ownership of their agency faster. It’s a scary deal, actually. It’s quite scary, but I think a 10x multiple is really silly and it’s for smaller deals. A 3x multiple I’ve seen on agencies that have a terrible client concentration problem, and this is a common problem in small agencies. They have one-

Drew McLellan:

The gorilla, the gorilla.

Jenn McCabe:

Oh, yeah. So, I tell people, “Look. You should aim for 15% to 20% on the bottom line to get that six multiple. You can get a six or seven if your bottom line is 20%. You can get five or six if your bottom line is 15%, but that is all contingent upon you having diversified client mix, and that means one client should not take up more than 25%.” Does that sound right to you?

Drew McLellan:

Yeah. That’s the same number I preach. Yup. In fact, I say you got to have more money in the bank. There’s all kinds of rules. If you have a gorilla that’s more than 25%, your risk factor is so much worse.

Jenn McCabe:

Yeah, and it brings your multiple down. The other thing that really discounts a company is when they don’t have a solid team that’s going to stay. So, I try to help people with plans to lock in key performers, so that when the agency changes, the buyer is going to have to do something nice for people who usually you’re near and dear with. So, you want to have them locked in in a very positive way that helps them cement an employment agreement with the buyer, and a lucrative one, and also tells the buyer, “Don’t worry. Everybody is not leaving rubber in the driveway when we consummate this deal.”

So, I think those are important pieces. So, as an agency is building the first three to five years, I say, “Okay. Let’s work on your team. Let’s nurture and develop the culture of your company and your team,” because make no bones about it. When you make your deal, the culture goes.

Drew McLellan:

Right, because you’re leaving.

Jenn McCabe:

Yeah, sometimes. I do not see that happening very often, though, Drew.

Drew McLellan:

So, you see them selling and then staying as an employee.

Jenn McCabe:

They get locked in.

Drew McLellan:

For how long?

Jenn McCabe:

Well, at least three years. My favorite deals are only three years, but it’s much more common to have an owner have to stay for five years, and that can be excruciating.

Drew McLellan:

Well, I was just with a bunch of agency owners this week and I said, “Okay. No offense, but I’m pretty sure you weren’t awesome employees before. You owned the place, and now imagine.” Basically, it’s like having a baby and then watching someone else raise your baby and you don’t get to vote, right?

Jenn McCabe:

You know what? I, as you know, merged my own outsourcing firm last year with a big consulting firm that I love and I love everything about it, except that I’m not the boss. Yet, I did the deal because I was so tired of being the boss.

Drew McLellan:

Isn’t that ironic?

Jenn McCabe:

Yeah, and I see things and I go, “Oh, God! I don’t like that. Well, I’m going to have to live with it.” Now, that’s what happens, and you work for someone who, depending on the face of your career. So, say that an agency owner sells out when they’re young. Here’s what I see happening in those cases. They get in a big rush to sell. Maybe they even have a short earn out or they quit. They make their number in the first half and they go, “Forget it. I don’t want my earn out. I made enough. I’m out.” They leave. They are prohibited from doing business in the trade in which they are educated and qualified. When they’re young, that sucks because they really want to do something with themselves. If they’re older, they can’t wait to get done.

Drew McLellan:

Honestly, though, until they’re done. So, I see a lot of it being handed down from generations. A lot of times, the departing generation, the older, the founder of the agency, whatever, they have a hard time getting out. They have a hard time letting go. So, much of their identity is tied up in being an agency owner, and if they don’t have something super exciting and that they’re really passionate about to move to, a lot of times, they wrap their arms around that agency and they don’t really want to let go.

Jenn McCabe:

Yeah. They start hugging, and then it’s awkward, and when it is successive generational stuff, it’s terrible because the younger generation has to say, “You know what? Mom, Dad, you need to stop coming to the office. You’re actually getting in the way.”

Drew McLellan:

Right, and who wants to have that conversation with their parents, right?

Jenn McCabe:

Yeah. I’ve only seen that twice. Family business is tough no matter how you slice it. I usually see my family agency running themselves and they end up going winding down in a graceful way or the older generation is super disappointed that the younger generation has absolutely zero interest in working that hard.

Drew McLellan:

Right, which is pretty much what my daughter said to me. I said, “You could go to school for this.” She was like, “I don’t want to work hard as you do.” I said, “Okay.”

Jenn McCabe:

Yeah. I had several employees tell me they loved working for me, they wanted to stay with me working for me forever, but they never wanted to be me.

Drew McLellan:

So, let’s go there. So, for a lot of agencies that are listening, they’re small enough that the big networks, they’re not probably going to buy them. So, their thought is that they can do an internal purchase, that their employees might buy the agency. How does the multiplier and all of that change when you’re talking about it? So, let’s say I’ve got an amazing leadership team, and two or three of them on the leadership team really could run the agency. In fact, day in and day out, they do run the agency without a ton of my involvement every single day or I think I can groom them to that. What am I looking at for a deal like that?

Jenn McCabe:

Well, it complicates the deal. The easy answer is say that you’re in the middle of transferring ownership to two stars. The worst possible thing is that they each have 50/50 voting and they disagree. So, you never want to have 50/50 ever. So, if you transfer to two people, my recommendation is always keep 2%. Then you have to decide in your operating agreement how decisions are going to be made.

I preach to people, and this is a skipped step a lot. Go get a really solid operating agreement that says what you’re going to do when you fight and what you’re going to do when you break up because, usually, a business is not till death do you part. It’s not like a marriage that you swear to God you’re going to be together forever and, yet, it’s harder to get out of than a marriage. Divorce is easier than breaking up a business. That’s the truth. It’s horrible and very expensive compared to a divorce.

So, in that case, you’re basically deciding how you are going to break up with your company. You’re either going to give it to two people or not. If you try to switch directions and Omnicom comes knocking on your door and you go, “Oops,” psyched, “I don’t want to give it to those two guys. I want to sell it.” If your operating agreement says you can change direction, great. It better also have an employee agreement for them or a buyout of their contract clause where they get a lot of money. So, if you’re trying to hedge your bet by doing succession planning with an existing strong team and also leave the door open to a buyer-

Drew McLellan:

Yeah, and I’m thinking the existing team is buying it, not that you’re giving it to them, that they are going to buy you out.

Jenn McCabe:

That’s what I call an MBO, and I see a lot of those, a management buyout. That works if you have eager beavers and super hard workers, and it’s becoming less common.

Drew McLellan:

How come?

Jenn McCabe:

There are less people willing to buy out their bosses. Where I see it happening is not in succession plan, okay? So, there’s a difference. Succession plan is me old lady Jenn. I want to give it to a couple of kids who work here, who kick ass and they’re awesome. They may or may not want that. I’m finding more and more that employees do not want that. The average tenure at a job, if they love their job now in this United States of America, is four years. Okay? So, why would anyone who’s young and eager want to work somewhere forever in this current culture. This culture we have is destroying that, okay?

So, instead, what I see are MBOs when there are three partners or four and one of them dies, see that now? That’s the most common MBO, ironically, or there’s four owners or three owners, and they decide they don’t really like Joe in the next office and they want to buy him out. That’s the common scenario.

Drew McLellan:

Interesting.

Jenn McCabe:

So, it’s not that common for one person to say, “I want out. Please buy me out,” because I’m quitting. Why would I garner any money? If I say to you, Drew, “You know what, man? I’m not into it anymore,” why would you pay me? You know I’m going to leave. I want to go, right?

Drew McLellan:

Well, in theory, they’re buying the client list, they’re buying the relationships, they’re buying the employees, they’re buying the equity of the firm. They might be buying whatever’s in the bank. They might be buying the name, right?

Jenn McCabe:

You’re in the very last rare category, though, where you assume. Say you and I are in business and I’m not quitting. You actually are pushing me out and you want to own everything, the client list and everything. That’s where I get the most money.

Drew McLellan:

I’m the employee.

Jenn McCabe:

Yeah, and you say to me, “I really want you to get out of the way, man. This is my thing. I’ve been running it.” That’s when I’m going to get the most money when I’m reluctantly leaving the building because you’re going to have to pay me to leave, but if I want to quit-

Drew McLellan:

Right. So, at that point, I’m an employee who sees the fruit of owning it, but I’m doing all the work, so I want to recruit as well. I want the juice for the squeeze, basically.

Jenn McCabe:

Right. Those deals when they work, they’re very rare, like I said, because, usually, one person is like, “I’m sick of it.” You don’t really have to pay me very much money if I’m sick of it, right? If I’m the old guy who’s hanging on to the doorknob and being shoved, then you’re going to pay me money. Those deals can be very long tenure payouts in those cases because the new generation says, “I’m going to make this make more money. There’s no money in the business until you get out of the way. I’m going to use your salary to pay you off over time,” and that’s how it works.

Drew McLellan:

Right, a long earn out.

Jenn McCabe:

Yeah, and not a big multiple in those cases, definitely, because the return on investment, the ROIs they talk about in these big deals, what they’re doing is they’re coming in and they’re going, “Okay. We’re going to use WPP or Saatchi or Omnicom’s back office. We’re going to strip out all that overhead. We’re going to have your payables processed in India,” and that’s how they get their money back. In a deal we’re talking about that’s a friendly family deal, none of that’s going to happen. There’s not a huge ROI. So, there’s a smaller multiple, longer earn out, and not a big change and big shake up in the business.

The other one, the MBOs that I see are buyouts of a partner who died, in which case the operating agreement helps and makes it great or there’s nothing in the operating agreement for the death of a partner and it’s grim. It’s interesting. It’s happened to me twice in the last year.

Drew McLellan:

Yeah. You know what? You need to have all of those things squared away. It is very much like a marriage. You need to do the prenup while you’re on your honeymoon, not when you’re fighting, right?

Jenn McCabe:

Yes, and I don’t like people to go into business where they have 50/50 as I said.

Drew McLellan:

Yeah. I’m not a fan of that either. Somebody has to be in control.

Jenn McCabe:

You need to have a breakup and fight provision. You’re right. People who are in the honeymoon phase are all excited about starting a business, and I’m the buzzkill that comes in and says, “Okay, but here’s the deal. You guys are going to hate each other periodically, and you’re going to go home and bitch at your spouses about each other. So, we got to figure it out ahead of time.” When you fight about it legally later, it’s usually quite expensive.

Drew McLellan:

Right. Absolutely.

Jenn McCabe:

We’re back to the back office discussion, which is don’t try to cheat and save money on legal or proper accounting advice. By accounting advice, I don’t mean tax. Tax is easy. It’s filling out forms.

Drew McLellan:

Yeah. It’s the planning and the strategy around it that takes finesse, right?

Jenn McCabe:

Yes. Exactly. You need to have a plan of attack. We’re in a creative industry, so there’s a lot of people out there going, “If I build it, they will come.” I have a sign on my wall when you walk in my office here that says, “A goal without a plan is just a wish.” So, the legal part of the goal is setting up the structure for decision making in a business. The accounting part of it is a plan, and by a plan I mean, “Okay. Where are we going? What are our goals?” Whether it’s to sell or not.