Are You Calculating Your Agency’s Profits Correctly?

Sei-Wook (00:04.283) On today's episode, we'll dive into agency profitability, specifically, what do we mean when we look for agencies doing at least 15% EBITDA and how owner salaries might impact this calculation? Peter Kang (00:17.134) All right, Sei-Wook. So oftentimes when we look at agencies and people talk about their profitability, it's really unclear how they're calculating it. And it's not quite apples to apples. One of the things we'll dig into today is how we calculate a normalized profitability. And this starts first with understanding a couple of terms, the first being SDE, or seller's discretionary earnings, and EBITDA. EBITDA is a term that gets thrown around a lot, but what it really means is earnings before interest, taxes, depreciation, and amortization. I think it would be worth digging into each of those and then walking folks through how we look at SDE versus EBITDA. Sei-Wook (01:11.946) Yeah, I think it's a very important distinction because we talk to a lot of agency owners who might be saying, oh, my agency is doing great, it has great margins. But it's not always clear what they mean — whether they're talking about their profit after paying themselves a market salary, whether they're excluding their comp, whether that's inflating their numbers. So yeah, it's important to understand the difference between SDE and EBITDA. Peter Kang (01:37.613) Yeah, and when we're talking about numbers, I think it's always helpful to have clear illustrations because we can throw out percentages and high-level numbers, but I've always found it helpful — I'm sure you as well — to see some concrete examples. For our audience, we've put together a few things on a spreadsheet. So hopefully if you're a fan of spreadsheets, this is going to be fun. If you're not, we try to make it as simple as possible so that we can walk you through what we're thinking about. Sei-Wook (02:08.697) All right. Yeah, let's dig in. So this is a sample P&L, a very basic P&L, looking at a business doing $1 million in revenue, $500,000 in COGS, yielding a gross profit of $500,000. Peter Kang (02:34.701) And just to stop you there — COGS, when we look at an agency business, what are we typically thinking of when it's COGS and gross profits? Sei-Wook (02:41.305) Yep, so COGS — cost of goods sold — in this case would be the cost of the team that delivers the work for clients. Depending on the company, that could be a majority of the team members you have. So salaries, contractors, employees or contractors all included in this number. Things that could be excluded from this: any administrative team members, sales team members, marketing team members that don't directly work on the delivery of client work. Peter Kang (03:19.617) Yeah, and the calculation of gross profit is also a debatable point. I think a lot of people interpret it in different ways and there's a whole episode to be done on that. But just for our purposes here, we'll say basically revenue minus delivery cost equals gross profit. Sei-Wook (03:38.873) Mm-hmm. Yeah. All right. So below that we have SG&A expenses — general expenses across the business, everything else. So marketing expenses, software expenses, any office expenses, travel expenses, et cetera. The assumption here is $100,000. Owner salary here at $150,000 to get to an EBIT number of $250,000. In this instance, when we're looking at SDE, you're adding back the owner salary again to get to a final SDE number. So here it's $400,000, which is a 40% margin for this business. Peter Kang (04:22.828) Yeah, and one of the scenarios you might see is sometimes an owner doesn't pay themselves a salary — a fixed amount going out every two weeks or every month — but they're just taking distributions throughout the year on profit. So they might not even have this owner salary number on their books, and instead they're just taking what they can out of the SDE number. Sei-Wook (04:48.856) Yeah, so effectively the SDE would encapsulate all the owner distributions that would come out of the business. Peter Kang (04:55.436) Yeah, and one thing I just want to remind folks is that just because your SDE is $400K doesn't mean you're pocketing $400K, because there is something to be paid to Uncle Sam — and wherever you pay your taxes if you're not in the US. So yeah, that could take a big chunk out of this SDE number. Sei-Wook (05:20.248) Definitely. And it's not all distributed. You can obviously leave cash in the business to retain for future periods. Peter Kang (05:29.236) Correct. Okay. Sei-Wook (05:30.455) All right. And then when we look at EBITDA — on the right we have a few scenarios to run through. Same assumptions for revenue, COGS, gross profit, and SG&A. But here we might see an owner salary of $65,000, getting to an EBITDA of $335,000. In this instance, the owner salary might be considered a little low for a business like this. So this may inflate an EBITDA percentage to 33.5%. Or, scrolling through a few scenarios, an owner salary of $250,000, which might be considered high for a business of this size, which might depress the EBITDA to 15%. Or maybe a right number here might be $150,000, which gets to 25%. So you can see — comparing this version over here to the one on the left with the same salary — the difference in margin between 40% and 25%. Very different numbers when just floating a profit margin number. So it's really important to understand whether it's EBITDA or SDE being referenced. Peter Kang (06:57.763) Yeah, so in case you're just listening to the audio version of this: the "too low" scenario is if an owner marks their base salary as $65,000, they're going to show an EBITDA of 33.5%, which is a high number — and that's kind of underestimating what somebody in their place might be making. We'll get back to that point in a second. Then the "too high" scenario: if the owner salary is too high, the EBITDA gets depressed. A $250K salary might lead to 15% EBITDA. And then in the third scenario, if you peg owner salary at $150K, your EBITDA might be at 25%. So going back — how should we think about owner salary? I think this is really at the crux of the matter: what does that really mean, and how does this tie to how we think about EBITDA at Barrel Holdings when we evaluate agencies? Sei-Wook (08:11.001) Yeah. We have a number of agencies and we really want to look at them on an apples-to-apples comparison when looking at a metric like EBITDA. So there is a bit of normalization. Typically in a company of this size, the owner is involved in the day-to-day operations of the business and contributing in a meaningful way — whether it's the delivery of the work, sales development, managing a team. So we're really thinking about what is the replacement cost of that person and making sure that's accurately reflected in the EBITDA. Depending on the size of the business, the salary could range. So that's something we definitely want included in an EBITDA calculation, especially to understand: if that role were to be replaced, how much would we pay to have that person in that seat? Peter Kang (09:11.889) Yeah, so just to bring this home — if we start with that first example where somebody was paying themselves $65,000, their owner salary on the P&L is $65,000. Let's say we would go in there and model it out to be like, hey, we should probably add another $90,000 to this so that it normalizes at a $150K owner salary. That would bring down the EBITDA from effectively 33.5% to 25%. And then on the high-salary version, if we thought, hey, we actually think we could replace what the owner is doing with a leader making $150K base salary, then we might adjust it and add back another $100K to the EBITDA, which would bump it up from 15% to 25%. So I think that's something to keep in mind — just because somebody says, hey, my agency is doing 40% profit, you don't always get the full picture and you have to dig a little bit deeper in terms of, hey, are they talking about SDE? Are they properly accounting for what the replacement costs might be? This is also a matter of opinion, because some might argue you shouldn't pay an owner salary or a replacement salary below $200K, and some might feel like $100K is perfectly fine as a replacement salary. So I think here it really comes down to where you land on what you think the appropriate owner salary is for that scale of agency. Sei-Wook (11:01.748) Yeah, and when we say we're looking for agencies that do at least 15% EBITDA, this is how we're looking at it. We will do the adjustments to get to our adjusted number if we do see those ranges where owner salary might be low, high, or it's being added back entirely to the calculation. Peter Kang (11:23.814) Yep. And in this example, obviously, it's a very small agency doing a million. But I think the swings are pretty big — someone's owner salary of $150K to $250K can really swing the EBITDA quite a bit. But one of the things to note is that as the revenue scales up, it's quite a different story. Sei-Wook (11:51.989) Yeah, so here's a scenario where all the numbers are essentially 10x: revenue is $10 million, COGS are $5 million, gross profit is $5 million, SG&A bumped up a bit for a business of this size to $2 million, and here owner salary of $300,000 to get to an SDE of $3 million, or in our calculation here, an EBITDA of $2.7 million. And here the percentages get a lot closer — 30% SDE versus 27% EBITDA. So at scale, the variance gets much, much closer, where the owner salary is a much smaller component of the overall profitability of the business. Peter Kang (12:40.872) Yeah, and you can argue that in many cases, when a business is super small like we mentioned, the owner could be super involved. So their replacement cost becomes, 99% of the time, an absolute necessity to factor in. But when an agency has scaled up, it's very possible they have a very built-out infrastructure with a leadership team and maybe they're out of the day-to-day completely. So in some instances, owner salary could be zero as well. And in that instance, the seller's discretionary earnings could basically be equal to EBITDA. Sei-Wook (13:22.86) Yeah, that's true. I think it's important to understand the business, the structure, and the role of the owner in that business — whether it's critical or very much not critical to the day-to-day operations. And that's where we can make the adjustments as needed. But really, it's understanding what the owner's role is, what it would cost to replace that person, and that would give us a normalized view on profitability of the business. Peter Kang (13:51.995) Yeah, very good. Just to wrap this up — for anyone thinking about how they talk about profitability at their agency, a good exercise is to think about your own role as an owner and what you might have to pay to replace yourself. Sei-Wook, you and I did that when we were running Barrel. We always pegged a number. So just play with that and try to see, hey, instead of SDE, what does EBITDA look like if I were to replace myself, and what is that appropriate salary? That's a number to peg, at least when you have a discussion with us — that's the number we're looking for. All right, until next time, thanks for joining us and have a good one. Sei-Wook (14:43.745) Thanks.