Are you tracking your agency’s gross margin? How about the EBITDA? KPIs are super important and something every agency owner should be aware of. But which KPIs you track depends on the priorities you set for the agency. Do you want to grow fast? Are you planning to sell soon? Having a clear vision and goals makes a difference when it comes to what you're measuring. Today’s guest shares the most important KPIs he believes all agencies should be keeping track of and what you can do if some of them dip below where they should be.

Jon Morris is the CEO of Ramsay Innovations, a company dedicated to helping agencies get greater insights out of their finances so they can grow at a faster rate. In his area of specialty, Jon is used to advising companies on ways to improve their finances and now shares some of that useful insight.

In this interview, we’ll discuss:

The most important KPIs for agencies.
What to spend on sales and marketing.
Revenue as a percentage of client base.
Dos and Don’ts of using a line of credit.

Sponsors and Resources

E2M Solutions: Today's episode of the Smart Agency Masterclass is sponsored by E2M Solutions, a web design and development agency that has provided white-label services for the past 10 years to agencies all over the world. Check out e2msolutions.com/smartagency and get 10% off for the first three months of service.

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How a Minority Investment Can Help Growth

Jon started working from his home in 2004 in an agency called Rise Interactive. Several years later, he took a minority investment and grew it into one of the largest independent digital agencies, managing about $250 million in media before he sold it.

When he took the minority investment, his agency’s fees were around $20 million. At the time, he wanted to invest more in sales and marketing. Their mission as an agency was to be the leader in leveraging data to help brands make smarter marketing decisions. However, the reality is that if you line up 50 agencies they would all say that they are data-driven. They had to answer why they were more data-driven than the rest.

$20 million in fees may seem like quite a lot. However, the cost of building technology and putting together a sizeable team is a major investment. Looking back, he knows taking the minority investment was the best move because back then he just didn’t have the capital for the technological investments.

When you build technology you need a fully dedicated team that eats, sleeps, and dreams the product. Every agency has a very standard leadership structure, with a client service team, a sales a marketing team, and operations and finance teams.

In their case, they added another pillar that was product development and strategy, which included:

UX developers
Engineers
Product developers
Development Operators
Quality Assurance

The Most Important KPIs for a Digital Agency

For Jon, the most important KPI for an agency is gross margin, which is different from adjusted gross income. The first thing you need to do to get to your gross margin is to know your revenue. He breaks revenue into two categories: gross revenue and net revenue.

Having worked with many agencies by now, Jon knows it’s not very easy getting these numbers. Often times it’s a matter of getting the data clean to figure out net revenue vs. gross revenue. A lot of agencies are very focused on payroll divided by revenue as a ratio. However, payroll generally includes everything from sales and marketing to operations.

What you want to do is get to your costs of service. To do that, you need to go through every single line item to determine whether or not it is dedicated to client work. If you have an employee that is dedicated to a client’s paid search campaign, then that’s going to be a cost of service. On the contrary, an employee dedicated to HR is not a cost of service.

On average, his clients are at a 40% gross margin when they start working with his agency and their goal is to get them to 50%.

Why Cost of Service is the Most Important KPI?

If you are selling something for $1 million and you get $500,000 in fees and $500,000 in gross margin, then you now have $500,000 to put back into your business or in your pocket.

However, if that same $1 million is costing you $800,000, you only have $200,000 to invest in your business.

Therefore, you can have two agencies doing the exact same thing both around $5 million in net revenue. In the end, one made a profit of $1.5 million and one lost a few hundred thousand dollars. The difference is their gross margin.

Percentage of Revenue Spent on Sales and Marketing

The next metric you should be focusing on is what percentage of net revenue you’re spending on sales and marketing. Again, divide your payroll to group sales and marketing people into "sales and marketing costs". In theory, if you spend on sales and marketing you have a better chance of growing than if you don't.

What you're willing to spend on sales and marketing directly impacts your growth:

Spend 0 and 5% of revenue on sales and marketing says you’re not that serious about growth.
If you’re between 5% to 10% spending, you’re where everyone else is in terms of the importance of growth.
Spending more than 10% means you’re very serious about growth.

Of course, it’s fine if your focus right now is not on growth. For instance, one of Jon’s clients is focused on increasing their revenue per employee and is interested in growing moderately. It will depend on your priorities. Some agency owners may just want to optimize their gross revenue to maintain their lifestyle business.

On the other hand, some of Jon’s clients don't spend anything on sales or marketing. To him, it was unbelievable that an agency could believe so little in marketing.

Where Should Your EBITDA Be?

The golden rule for agencies is to have 20% topline growth and 20% EBITDA. If you’re planning to sell to a holding company, they’ll expect you to have 20% EBITDA.

However, Jon has a different philosophy. If you can make a positive investment in your agency it’s okay for you to have a lower EBITDA.

If you hire a salesperson who brings in a client that ends up being a retained relationship, that’s fine, as long as you measure the percentages and outcome you’re looking to make. Keep in mind, if you want to build a big agency without outside capital, lowering your EBITDA target will give you more money to invest in the business.

Bottom line, your business is the best investment you can make.

How Much Cash Flow Should Your Agency Have?

Jon believes everyone should have two bank accounts at minimum, three if you manage media.

Operating Account: this is the one you’ll use to pay your employees, taxes, and bills. You should always have 1 month of payroll and 35% of your quarterly profits in this account. It should be enough to pay your bills at any given moment in time.
Savings Account: Here you should have your monthly overhead. Double the sum of all your expenses (like payroll, sales and marketing, traveling, and entertainment x 2). Rule of thumb for savings is two months and could be up to six months if 1-2 clients make up most of your revenue or if you are project-based.
Media Account: This is not your money. You have a fiduciary responsibility to make sure that money is completely separated and you’re not using it for anything other than the client ad spend.

Looking at Your Revenue in Terms of Percentage of Each Client

How much of your revenue do your top five clients represent? For instance, one of Jon’s clients has 123 clients, and the top 18 account for half their revenue. It's important to understand your agency's client concentration and strategize to reduce it.

Whenever Jon won a big account that became a large percentage of their evenue, he increased his sales and marketing to go win the next big account. He was really, understandably, scared of being dependent on any single customer.

Dos and Don’ts of Credit Lines

Jon and Jason agree if you have a positive 12-month trailing EBITDA, you should get a line of credit. However, you shouldn’t use it to use it fuel the growth of your business but rather for cash management purposes.

If you have a big account like Procter and Gamble – known to pay in a net 120 days – you may want to use a line of credit to make payroll. It may be an account you really want but you can’t negotiate better payment terms and that’s fine. Having a line of credit is important in those scenarios. Where you shouldn’t use it is to invest to grow your business.

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