Agency owners actually make money in two different ways, even though they often treat it as a single income stream.
Owners bring their own time and expertise to work for the business. Whether it is client service, business development, or administration, there is plenty to do and it consumes a lot of time.
At the same time, owners take a risk by being an entrepreneur and get rewarded for that risk in the form of profits from their businesses.
Commingling compensation and profits
Most agency owners don’t clearly delineate between the two income streams, in part because it is simpler and in part because they may not have a formal salary as an employee for tax purposes.
All of the income and expenses go in and out of the same bank account and the owner just withdraws whatever money is left over.
In some cases, that may be a set amount each month, but more often than not it is simply a question of “how much can I safely withdraw right now?”
The problem with this approach is that it makes it very difficult for the agency owner to properly assess the performance of the business.
Tax accounting and business accounting are not the same
It is important to understand that how you account for your compensation for business purposes may not be the same as how you allocate it for tax reasons.
Your accountant will provide you with the best advice on how to take money from your business to legally minimize your tax liability, but that isn’t the same as understanding the agency’s financial health.
To make better decisions about pricing, staffing, and strategy, you need to know how much money you are taking out for the work that you are doing and how much is attributable to the risk that you are taking as an entrepreneur.
Why separate compensation and profit numbers matter
I often talk with agency owners who brag about really large profit percentages for their businesses. They will tell me that they have heard that 20% is a really good number, but that their profits are actually more like 40-50% (or more!).
In almost every case, that percentage ignores any compensation expense for the owner’s time.
Even worse is when I hear an agency owner say that a client is “pure profit” because they don’t have to pay an employee or contractor to do the work.
Unfortunately, these same owners are often the ones who feel the most stuck because they are working too many hours and can’t take time off. They are willing to push through that unease, though, because they feel like they are making good money.
Because they are commingling compensation and profits, they are putting themselves in a position where it is difficult to hire someone else to do the work that they are doing and give themselves a break (as well as the opportunity to grow the business more effectively).
Commingling makes selling the agency more difficult
Selling your agency isn’t easy, despite what many owners may want to believe. Agencies do get sold, but often for much less (and with more strings attached) than you might think.
If you treat all of your compensation from the business as “profits,” then you are setting yourself up for disappointment in this process because sales prices are often talked about in terms of “multiples of profit.”
For example, a typical agency might sell for 4-6 times the annual profit number.
If you are not paying yourself a fair salary, however, that number will need to be deducted from what you think of as your profit number.
For example, an agency owner might say “my profit last year was $250,000 so I should be able to sell for between $1 and $1.5 million.”
However, a buyer is going to look at that $250,000 and say, “but you are paying yourself from that amount and I need to hire someone to do the work that you’re doing which will cost me at least $150,000.”
So in a best case scenario, the potential acquirer has now reduced your profit number to $100,000 (or less) which means your sale price would be $400,000 to $600,000 – or less than half of what you were thinking it might be.
Be honest with yourself about compensation
In the United States, almost every agency owner should be paying themselves at least $100,000 per year for the work that they are doing for the business.
Most should be paying themselves considerably more than that.
Yes, you can take a discount because you have the perceived flexibility that comes from being your own boss, but don’t overstate that benefit to yourself.
Setting a fair compensation figure is a longer discussion and has many facets, but the important thing here is to acknowledge that your time is worth something and you ought to be paid fairly for it (even though you are both employer and employee).
How you pay yourself isn’t important as long as you do it consistently
You don’t need to pay yourself as a payroll employee, but you should take a fixed amount from the business every month to pay yourself for your time.
That steady flow of cash helps you personally, but it also provides a dose of financial discipline to the business.
Then you can look at your numbers every quarter or annually and pay yourself a dividend from the profits above and beyond that salary.
If you are not doing both consistently, then you need to look at how the business is operating.
Separating compensation and profits helps you to grow
If you want to grow your business, you need to pay yourself fairly so that you know how to price correctly and you put yourself in a position where you can eventually pay someone else to take on some of the work that you are currently doing.
When you hire up to transfer your responsibilities it becomes a net positive to the business because now you can spend your time on something that presumably has higher value to the agency.
But that only works if you were paying yourself fairly to begin with.
Looking at your profits independently of your compensation for your time also helps you to better assess the growth of the business and make decisions about where to invest and what clients to target.
Agency owners serve two distinct roles as employee and entrepreneur, and they should be compensated for both.
Understanding the difference between compensation and profits will help you to build an agency that you actually enjoy owning.