Agency Profit Deep Dive: Gross Margin, Sales & Marketing, and EBITDA

Sei-Wook (00:04.886) On today's episode, we're doing a deep dive on agency profit. We're going to unpack gross margin, EBITDA, and why so many agency founders misunderstand what healthy numbers actually look like. We'll explain why gross margin is the starting point for everything, how it creates optionality in your business, and why a very high EBITDA margin is not always a sign of strength. Peter Kang (00:26.89) All right, Sei-Wook. Today we're going to be talking about a lot of agency finance stuff. Not the most exciting topic for agency owners, but this is something that you and I love to talk about with great enthusiasm, so we're going to try to bring the energy here. Before we talk about some of the importance of these things, we should first define the terms so everyone is aligned on what we're talking about, because obviously we've seen through all the different interactions that some of these terms are interpreted differently. So for today's purposes, let's lay out what these definitions mean and how we're using them. Sei-Wook (01:06.51) The first thing we're going to be talking about quite a bit is gross margin. We'll also use gross profit. Let's start with the difference between those two. Gross margin is the percentage. Gross profit is the actual dollars. So let's go into the definition of what we mean by gross profit. When we define that from an agency perspective, it's the revenue that an agency receives or recognizes minus the cost of delivery. Delivery costs in an agency are typically labor — client-producing labor. Think about the full-time team members on your team that actually work towards delivering for your clients, and freelancers that you might bring on for that client work as well. It's all about: what is that billable work that everyone is delivering against? Peter Kang (02:05.433) Okay. Let me just interject there. Let's take an agency doing a million bucks in revenue. They tally up all their costs at the end of the year and they're like, all right, we spent $400,000 delivering the work to clients. What is gross margin? What is gross profit? Sei-Wook (02:32.494) So that would be a million minus 400, so $600,000 as gross profit and 60% as gross margin as a percentage. One big thing is this is an aggregate number. Oftentimes we might hear, "we have really high margins on our projects." What we're talking about here is not an engagement-based margin. This isn't project margin, this isn't specific to one engagement. This is an aggregate view of all of your revenue and all of your costs to deliver against that revenue. Peter Kang (03:13.026) Yeah, and usually we're looking at a 12-month period when we're typically talking about this. Sei-Wook (03:15.906) Yep. To go a little bit deeper there — you can scope things and really execute single engagements at a very high margin. Let's say you do one engagement with a client and you're like, wow, we killed it, we had a 70% margin on that. But overall, your gross margin as a company can be low if you have low utilization — if a lot of your team is sitting idle that you're still paying for, or if other engagements your team works on have a very low or potentially negative margin. So this is really focused on the aggregate view of all of the engagements and all the costs at a company. Peter Kang (03:57.117) Cool. All right. Next one — I'll take this one. EBITDA. Earnings before interest, taxes, depreciation, and amortization. The reason we use this number is that it's accepted across different financial communities as the cleanest way to measure operating performance in businesses and agencies. Because oftentimes they are valued at a multiple of EBITDA, that's why it becomes an important number to track. This is basically the revenue minus the cost of delivery, and then we also subtract sales and marketing costs and G&A — general and administrative costs — and then it's what's left there. This is the key thing: interest on a loan that you have to pay doesn't count here. You might have taxes to pay on the profits. There might be some depreciation you're taking or a loan balance you're paying down — that doesn't count here either. So this is all stuff that comes above that, and that's why EBITDA is an important number that really focuses on operational efficiency. Sei-Wook (05:11.758) Yeah, an important distinction here is it's different than net income, which might be referenced as well. Net income includes all the things you just mentioned. And oftentimes the things that really fluctuate are taxes — depending on where you're located, your region, geography, and how you approach tax planning — and then any extraordinary ownership distributions that could really fluctuate your net income number. So EBITDA is a nice normalized way to look at the health of a business. Peter Kang (05:49.898) Okay, great. So let's dive in. Let's talk first, going back to gross profit — why is gross profit the starting point? Sei-Wook (06:00.31) Yeah, gross profit really indicates the health of the agency in terms of: are you disciplined in how you're delivering for your clients, and do you have the right mix of expenses relative to the work that you're delivering? Gross profit is really the funding source for the rest of the business. When you look at everything else that you may want to invest in — sales, marketing, building additional infrastructure through processes or R&D — and when you think about the volatility in your business, the highs and lows throughout the course of a time period, a high gross margin gives you the ability to withstand all of that. Peter Kang (06:56.277) Yeah, definitely. Taking that high gross profit slash margin percentage as a health signal — we talk about this a lot amongst ourselves with our agencies across Barrel Holdings. It's really a reflection of strong pricing, because if you're charging a high amount, you're going to have that cushion to play with. And then obviously the efficiency in your delivery — your processes, how effective and talented your team is at the delivery aspect. And then there's the discipline around scoping: are you making sure the process and the ways in which you deliver the work give you a clear margin on top? And then there's the project management discipline around managing against unanticipated things that pop up. Those are all important. The other thing that's really underrated but definitely huge — and this is something we talked about in episode four around specialization — is clear positioning, because that really sends a signal that what you guys do is differentiated. A higher price should be paid, and at the same time, because you're experts in what you do, you can do it more efficiently. Sei-Wook (08:39.758) Yeah. A couple other points on getting to a high gross margin: you could have really high utilization across your team where people are spending a majority of their time on billable work, so there's not a lot of idle time. Or you could have a cost structure where you have very low-cost resources relative to the amount of revenue you're receiving, so that margin spread in itself could get you to a high gross margin without necessarily needing very high utilization. So those two aren't hard and fast rules. Peter Kang (08:59.481) Yeah, the levers for high margins for sure. And on the flip side, low gross margins — how do they show up as warnings? Sei-Wook (09:09.964) Oftentimes this starts with everything you described — it could be underpricing. You might give a discount on the work to win it, so work is underpriced from the beginning. Throughout the course of delivery, there could be scope creep where what you agreed to balloons over time and you're not charging more for it. Or there could be issues with delivery — a lot of rework or delays on an engagement. And on a macro level, going back to the points we talked about before, poor utilization or overstaffing where you just have way too many team members for the amount of work that you have. And ultimately, if from a positioning or scoping or pricing standpoint you end up competing a lot on price to win work, that results in giving those discounts and underpricing. Gross margin has a lot of different factors that can contribute to it, but pricing is a really big one. Peter Kang (10:18.726) Yeah, okay. So let's talk about why it's so important for agencies to start by anchoring their gross margin goals really high. I think many times we've been guilty of this — we hadn't even thought about it, and gross margin considerations came after the fact, like at the end of the year you're like, our margins are crappy, and you think about it in hindsight. But in order to really do it the right way — and we talk about this with our agencies these days — you have to aim for a very high gross margin in the business. This could start at the engagement level, but ultimately you want that to bubble up to the aggregate. So why is this so important, and what's the number you should be aiming for? Sei-Wook (11:13.614) Yeah, what is high? Maybe we'll start there. Across Barrel Holdings, what we typically see is anywhere from about 40 to 60% gross margin, depending on the company and what exactly they're delivering. The reason we encourage a high number there is it really helps create optionality — without the gross margin, you don't have the money to invest in different areas. You can't invest in growth. We've been there throughout the years where when you're really squeezed at that level, you just end up making poor decisions later on. Peter Kang (12:00.746) Yeah, and obviously AI is a big point of discussion these days and the leverage you can get through that. If you really lean into it and believe that AI can compress delivery time on tasks and automate certain aspects of delivery, and if you're able to hold the price, margins should expand. But just in general, why is it important for agencies to aim beyond that 40 to 60% range? We obviously want to see it higher than 40%. Why is it that software-like margins, which could be 70 to 90%, are something we should really aim for? And what are some things that could actually get an agency there? Sei-Wook (12:54.058) Yeah, we're always aiming higher. If you bubble it up even further — when you're scoping an engagement, it should be even higher than your target because you're about to have some loss in utilization, there's going to be some rework, there are the realities of the business. If you shoot for 80%, you might land at 60%. So in general, you should always shoot a little bit higher to give yourself some buffer for all those things. And then it's really about how do you get there — it starts with specialization and really having a differentiator that allows you to have some pricing power, where people will pay you for your expertise in a specific area and your experience there. Over time, as you get more and more specialized and have that expertise, internally you might have more productized services that are repeatable and aren't exactly tied to the amount of time it takes to deliver the work — more about the results. You might even develop more IP to help you do that work internally faster. Again, you're not selling the time you're spending on something; it's more about the results or the products. All of those factors really help you get to that 70 to 90% gross margin that you typically see in software. Peter Kang (14:26.745) Yeah, the beauty of it is — for so long, agencies' growth was linearly tied to headcount. The moment you could decouple headcount and revenue is when gross margins can achieve the high levels we're talking about. Just to make the math concrete for everyone, what does a gross margin increase look like in absolute dollar terms? Sei-Wook (14:56.302) Yeah, let's say you have an agency that does $2 million in revenue and you're at 45% gross margin. And let's say you want to increase to 55% gross margin. That 10% increase in gross margin gives you an additional $200,000 of capacity that you can then deploy across a variety of different areas. Peter Kang (15:20.147) Yeah, that 10% — that could be raising prices a little bit, tightening scope, making some processes a little bit tighter. But then unlocking $200K that could be salary for a salesperson or a marketing person. You start to see the possibilities of the margin impact on your business. Sei-Wook (15:41.528) Yeah, for sure. Maybe that's a good segue into thinking about — you have gross margin, we talk about it creating optionality — how can you allocate that capital in the best way possible? Peter Kang (15:59.714) Yeah, and this is where most agency leaders, once again, don't think about it in a proactive way. They look at it in hindsight and go, okay, we did this — maybe we should do what we did last year. That reactive thinking. But if you put on a capital allocator hat — by that, we're talking about how do you best deploy dollars that will then yield more dollars in the future — you can start to think about some of these things differently. Let's say you achieve 50% margin. On a million dollars, you have all of a sudden 500K leftover to deploy in various ways. Obviously you're going to keep some for profit and all that, but you still have some room. And there's going to be some kind of baseline cost for some of these things, and beyond that it's: how aggressive do you want to be? How much do you want to allocate? And what do you expect as an investment? So maybe we can just dive into specifics. One of the first things we can talk about is the sales and marketing piece, which is something that we really obsess about across our agencies. Sei-Wook (17:20.864) Yeah, that's probably one of the biggest buckets beyond gross margin — we'll bucket it all in SG&A. Thinking about how do you allocate funds against sales and marketing: if you look historically, there's going to be a baseline sales and marketing cost that any business has. There's definitely going to be some inbound leads that you need to process, or activities around expanding the accounts you already have, or even baseline things like you have a website, so you have to update your website. There are costs you're going to incur. But beyond that, you can set a baseline, look at your historical sales and marketing budget, and ask what additional budget you can allocate to sales and marketing and use it as an experiment: all right, we're going to increase our budget by X amount and do these additional experiments — we're going to hire a salesperson, we're going to go to these events, we're going to put more effort into advertising or newsletters. And really be explicit about the outcomes you want from it. You're going to spend $100,000 — we want to yield $200,000 or $300,000 or more in new business. And these are just general numbers. You can do the math to say: if you get an additional $200,000 in revenue and your gross margin is 50%, then you spent $100,000 to get there — that may not be enough. So you may need to shoot higher so that your sales and marketing costs pay for themselves. But the overarching thing here is: measure it and see if the investment you're making in additional sales and marketing will yield the results you need. Peter Kang (19:16.294) Yeah, definitely. Seeing this as a continuous series of growth experiments — you're basically giving yourself room to experiment and find the things that work. Sometimes you're going to hit some really good experiments that yield fruit quickly. Other times it might be a slower burn over a longer period of time. I think it is important not to be so obsessive about the immediate input-output of the results, but to think about it as long-term investments. Because so many biz dev or sales roles or marketing roles in agencies are on a really short leash. You give somebody three to six months to pay for themselves, and most of the time they're going to be set up to fail — and first of all, they probably don't even have the right systems to support them, which is a whole other topic. But at that point, you go, look, I spent a lot of money and haven't got any results, I got to cut them. Whereas actually you probably should have thought about it as a longer time horizon, maybe 18 months or even a couple of years, and seen it compound over that time. But once again, none of this is possible without gross profit, because if you don't have that, all of a sudden you just don't have enough dollars to play with. Sei-Wook (20:39.66) Yeah, definitely. Maybe it'd be helpful to just go into what falls under sales and marketing expenses, because we've seen a lot of different interpretations of this. What we're talking about is any of the labor — any specifically biz dev or sales people in the organization whose sole focus is that, and anyone on a marketing team — their salaries and costs would definitely fall under that. Any hard costs for marketing: if you're running ads and have ad spend, that's marketing; if you're spending money for events or sponsorships, let's say a booth at a trade show, all those things would be hard costs. You also might be experimenting with different software tools and platforms, even your CRM and outbound marketing tools — all of that falls under there. But the piece that's often missing and takes some time to think about is how much of your team's time — your founder, CEO, or leadership team — is spent on sales and marketing. Because that could be a pretty significant percentage depending on the maturity of the business and what everyone does. Peter Kang (22:00.334) Yeah, I mean realistically, you could argue the founder's baseline salary should, if that's what they're doing, just be under sales and marketing, and that would really increase the sales and marketing expense. But a lot of times that's not quite where you find it. And yeah, that gives a bigger picture, but even with that said, when we see an income statement and the sales and marketing costs is only the founder's costs, that is also flagged as under-invested. Sei-Wook (22:40.142) Yeah. And this is where time tracking helps — not all agencies do time tracking, but that's one area where it can show you, for all these different team members, that, let's say, a designer actually spends 20% of their time doing case studies, assets for the website, other marketing channels. That is a hard cost you could allocate towards sales and marketing. And the same thing with a leadership team — let's say your creative director or CTO actually spends a lot of time closing deals and working on proposals. Time tracking can give you some good insights into where their time is going. Peter Kang (23:21.557) Yeah, absolutely. Okay, so that's sales and marketing. Now let's also talk about G&A — general and administrative expense. How do we think about this, not just as overhead, but as a strategic investment? Sei-Wook (23:36.578) Yeah. Maybe let's start by defining what's included here. A lot of the administrative expenses at an agency — finance team members, finance software, HR, talent acquisition people, legal expenses or accounting expenses — whether it's contractors, vendors, or employees, that would all be captured there. We would also see any leadership or management team members that aren't specifically dedicated to delivery of work or sales and marketing; their expense would be allocated here. Any general software the team needs to do their work, any hosting or anything related to infrastructure at the agency. Office rent is a big one — depending on the agency, that could be a pretty sizable investment. And what we've seen more for agencies that have gone remote and no longer have an office, team retreats or offsites can be a pretty significant expense that replaces the office rent expense. Peter Kang (24:53.538) Yeah. And to that point, for every one of these things, you can also think about it not just as a necessary fixed cost, but as a strategic investment. Even to your point about team retreats and offsites — there are benefits to that: increasing a sense of belonging for the team, playing a role in retaining your employees. And when it comes to other intentional investments you can make: going back to having great gross profit and margins to play with, maybe there's internal R&D you can do to improve processes or other aspects of your delivery. Maybe there's new investment in systems, tools, or even custom apps to increase leverage. And on the talent side, if you think about it strategically, you might invest in having a better ATS — applicant tracking system — or better recruiters or talent acquisition support, to make sure you can build out a bench of freelancers or stay ahead of hiring so you're not desperately seeking people when you get too busy. All of these things don't have to be seen as a necessary evil. They can be seen as: how do we make our agency better? Sei-Wook (26:25.486) Yeah, that's the important point. It's not just overhead that's going to be the same every single time. You have the ability to look at all these expenses and see if they're strategic and helping in the direction you want to go with the agency. And if you have excess margin to play with, how do you allocate it most intentionally? Peter Kang (26:52.108) Yeah. All right. We've talked about gross margin slash profit. We've talked about sales and marketing. We've talked about general and administrative expenses. Now we come to: how do we get to EBITDA? You basically take the revenue, subtract the expenses — the gross profit — and then take away the sales and marketing and the G&A from it. So let's talk about EBITDA and what is good EBITDA. That's something we get asked a lot — hey, what's the EBITDA we should be aiming for, what's an acceptable EBITDA? Let's dive in. Sei-Wook (27:32.078) Yeah. There's a bunch of nuance here, but as a benchmark across the Barrel Holdings agencies, the average is around 25% for EBITDA. We've seen agencies that are lower and agencies that are higher. It's also really relative to revenue — if you have more revenue and you're a larger agency doing, let's say, 10 plus million in revenue, you could have a smaller EBITDA percentage, but the absolute dollar of that EBITDA could be large. Or if you're a smaller agency, you need a higher EBITDA because the absolute dollars are so small. It really has to do with the relationship between the gross margin and the EBITDA as well. You can't look at EBITDA in a silo — is it good or not. Peter Kang (28:29.43) Yeah. Going back to the margin and profit side of things — there's EBITDA as a percentage and then there's EBITDA as an absolute number. I think there is a line at which — and we generally say 15% is the line you want to draw, you definitely want to be north of that — but there are some caveats to that which we'll get into. And yeah, the scale and the absolute dollar amounts matter. Sei-Wook (29:04.942) Right. Cool. So let's talk about when a high EBITDA can be a red flag. When we think about high, we're thinking 35% plus. The first thing that calls out to us when EBITDAs are that high is it could mean they're under-investing in sales and marketing and other areas that could support their future growth. Peter Kang (29:32.656) Yeah, this reminds me — every week we're reviewing agency P&Ls that come in for M&A, and just looking at a few of them over the last week even, there are a lot of agencies reporting 50, 60 percent EBITDA. As a snapshot, it looks like a flashy number — they're doing four million in revenue and two plus million in EBITDA, wow, very profitable agency. But then you take a step back, look at their growth over the last three years, and you realize they're pretty flat or declining on the top line. That just goes to show: they built something profitable, but they did not invest in any growth. Sei-Wook (30:26.577) Yeah. And to that point — to look at how much they spent on growth — in some cases a high EBITDA could be okay. If they have a really high gross margin, let's say 70 to 80%, and they still invested 20 to 30% of that for SG&A, and their EBITDA ends up north of 35%, maybe that scenario is okay. It's not a lack of investment. But on the flip side, let's say you have 40% gross margin and 35% EBITDA and you've only spent 5% on all of SG&A — that signals a flag of underinvestment. Peter Kang (31:09.998) Yeah. And usually that rings very true because some of these agencies we've seen with flat growth that are reporting 60% EBITDA — their gross margin is probably right around there as well, like around 58% gross margin. Sei-Wook (31:28.824) Yeah. So if we think about what the flag actually looks like — what we look at — there might be an under-investment in biz dev, dedicated resources or processes around that. So it might be very founder-led business development and marketing, minimal marketing investment at all, with not a lot of activities to get awareness. From that, it could be very founder-driven relationships, so all the leads coming in are just from the founder's personal network. There isn't a lot of system built out for growth. The pipeline just isn't that strong — it could be very sporadic, leads coming in from referrals and relationships. You'll see not a lot of organic leads coming in because there's not a lot of awareness of the agency. There are just a lot of gaps where, if you don't invest there, you could temporarily have a high EBITDA number, but it is a warning sign for us. Peter Kang (32:45.062) Yeah. And look, these businesses exist. We should highlight — we do have a high-EBITDA agency in our portfolio where the gross margin and EBITDA delta is very tight, like a 3% spread. It's a great business in the sense that it generates stable cash flows year in year out. They pay a lot of attention to retention, and they're very good at keeping those clients and growing with those clients. But in terms of growth, it's been relatively flat versus some of our other agencies that have invested in growth. We're no strangers to seeing this pattern play out close to home as well. Okay, so actually — one of the things in our many conversations with agency leaders is this statement, especially when you look at their P&L and profits are, let's say, sub-10%, even break even, or in some cases even negative: the thing we often hear is, "oh, that was a year that we invested in growth." And we're here to point out that nine out of ten times it's a myth — this "we reinvested in growth." Let's dive into why that might be. Sei-Wook (34:19.112) Yeah. When we see that or hear that, we always look at the gross margin, because the gross margin should tell the story. Usually what we see is gross margins have slipped. If your gross margin is low and your SG&A is a fixed expense or you're spending the same amount, that's easily how you can get to a low EBITDA number. If you dig into why gross margins slipped, it's all the things we talked about — maybe their pricing power went down and they've been less disciplined, so they're discounting and trying to win work at lower budgets without really changing how they're doing scoping or staffing. It's just not well managed. And there's not a lot of room — when your gross margins are low, when you have low utilization, there's not a lot of room to fund growth. So any growth that they did invest in is taking them from a low gross margin to close to breakeven or negative as a business. Peter Kang (35:22.561) Yeah. Let's illustrate for folks — because we get asked this so much — what is the right profile? What's the disciplined, healthy profile for an agency in terms of percentages down the margin stack? Maybe just go through the rule of thumb and then obviously, depending on situation, you modify here and there. Let's share this because it's something we get asked multiple times every week. Sei-Wook (35:52.046) Yeah. 50 plus percent as a gross margin target. 15 to 20% for sales and marketing. 5 to 10% for other G&A expenses. To land at around 20 to 30% EBITDA. That's a comfortable, healthy mix for the business. Peter Kang (36:16.172) Yeah. And this gets a little bit tougher when you're smaller. At a million dollars in revenue, you'll probably have higher gross margins. And you could argue the founder is wearing many hats — they're getting paid to do the work, so they're in the cost of delivery, but they're also wearing the sales and marketing hat. So you're getting some degree of discount there. It's really when you get to two, three, four, five million plus that these numbers are what you want to hew closely to, and obviously try to do better on the gross margin side. Okay. So I think that's it. We covered a lot of ground here. What are your takeaways? Sei-Wook (37:11.33) Yeah. Hopefully this message came across: gross margin, and high gross margin, creates freedom and optionality in your business. From there, you can make very intentional allocation decisions. You can decide how that money is spent. Where we usually find under-investment is sales and marketing — really think about how you can be intentional, how you can measure the results, and be clear about what the outcomes are, with a reasonable time horizon for measurement. Take a look at G&A and use it strategically. Don't just think of it as overhead that has to happen — be deliberate about where your money is going there. And finally, margin is important. If you have revenue growth without margin integrity, it's really just erosion. There's something wrong with the system that you need to fix, because you could have high revenue growth, declining gross margin, fixed SG&A, and your EBITDA could be declining even though your revenue is growing. Really focus on gross margin. Peter Kang (38:38.573) Yeah, that's it. Hopefully we've beaten this over your heads enough times today. Mind your gross margins, and until next time, thanks for listening. Sei-Wook (38:51.406) Thanks.