A Deep Dive into Agency Working Capital

Sei-Wook Kim (00:04.106) On today's episode, we're going to nerd out on one of the least talked about, but most important financial topics for agency owners: working capital. Most agency founders focus on revenue growth, profit margins, and utilization. But the thing that often determines whether your agency feels financially strong or constantly stressed is working capital. Peter Kang (00:19.77) All right, so working capital. Hopefully our listeners' eyes or ears don't glaze over, but we have a lot of interesting and very relevant things to talk about with this topic. But let's first set the stage. What is working capital, and especially for an agency, what does working capital mean? Sei-Wook Kim (00:49.922) To put it simply, working capital is the timing gap between when you pay your team and when your clients pay you. If you boil that down, some of the biggest drivers for an agency are your payroll or your team costs, accounts receivable — so how quickly or how much clients owe you — and then the concept of deferred revenue, how much work you need to deliver into the future. Those are some of the key points to talk about for working capital. But oftentimes this translates to the amount of cash a business needs to keep on hand. Peter Kang (01:35.754) Got it. And just for folks who are still trying to grasp this concept, why is there a gap at all? Why is there a gap between when you pay your expenses and when clients might be paying? Sei-Wook Kim (01:53.164) In a typical agency, employees are paid every two weeks. Contractors may be slightly different, but generally speaking, every two weeks. But then clients — you might agree to payment terms: net 30, net 60, in some cases net 90. The work that you are delivering and paying your team for, you may be paid well later, it could be months later from when you incur that expense. Peter Kang (02:22.245) Right. And when it comes to working capital, this comes up a lot in our acquisition conversations, because as we're in the process of acquiring an agency and it gets to the conversation around working capital, we actually get to see the variation — some agencies have really high working capital needs, and some have very low working capital needs. Maybe you could explain what that means for folks. Sei-Wook Kim (02:52.833) High working capital needs usually correlates to long client payment terms where you have to keep incurring expenses before actually getting paid. Let's say all your clients pay you net 90, so in three months, but you're still paying your team every two weeks — you essentially have to have enough cash on hand to cover all of your expenses for three months before actually getting paid by a client. That timing difference is what really creates that pressure on an agency. Peter Kang (03:25.901) Yeah, and there are cases we come across agencies that have very low working capital needs. What are the characteristics of such agencies? Sei-Wook Kim (03:34.508) In some agencies, you're paid upfront. You bill before the work happens, and clients could be paying upfront as well. So you have cash on hand to pay your team at all times. That concept is called negative working capital — basically a very low need to keep cash on hand. Peter Kang (04:06.313) All right, just so we get it clear — if you have high working capital needs, that is bad. But if you have negative working capital needs, that is essentially good. Okay. So how does this tie to balance sheets? There's the P&L, which a lot of agency founders are really looking at to manage a business — how much revenue comes in, the expenses, and the profit at the end of the day. But working capital has a lot to do with the balance sheet. Maybe we could explain what that means and why it's important. Sei-Wook Kim (04:15.564) Yeah, confusing, but that's right. Sei-Wook Kim (04:45.612) You could look at two agencies that have identical P&Ls — identical revenue, identical profit — but it could be very different from a balance sheet perspective. One may have, let's call it $300,000 just sitting in cash in the business, versus another agency might have $300,000 that's owed to them in their receivables. Very different stability when you have cash on hand versus cash owed to you. And then you have the liability of having to pay your team on an ongoing basis. From a P&L standpoint they look identical, so the balance sheet is something you've got to look closely at. Peter Kang (05:27.48) Yeah, and this is something we also look at during acquisitions, right? An agency might have an amazing trailing 12-month P&L where it's like, wow, profits are super high. But then you take a look at the balance sheet and it's like, where's all the money? They might have a really fat accounts receivable, and basically some clients are super late in paying, the payment terms are terrible. This is always why we look at balance sheets just as much as the P&L. Sei-Wook Kim (06:08.725) Yeah, for sure. Peter Kang (06:10.632) Okay, let's talk about billing structure. In the case of agency A, which has $300K in cash, and agency B, which has $300K in receivables — part of that is the billing structure. We talked about payment terms, but let's talk about why this matters so much for agencies. Sei-Wook Kim (06:32.831) One of the biggest levers for working capital is when you invoice clients and when they pay you. In a typical agency, you do the work during a month, you invoice at the end of the month, and you get paid 30 days later — that's a pretty typical way of looking at it. If you think about the actual terms: you work in January, you invoice at the end of January, you may not get the cash until March. There's a huge gap between when the work happens and when you get paid for it. On the flip side, if you think about agencies who bill at the start of the month, and in some cases are paid upon receipt, then you have all the cash upfront. Let's say you invoice January 1st for all the work to happen in January and you get paid January 1st — even net 15, a pretty short window, and you're sitting on the cash before the expenses go out. It's the idea of: are you financing the client's work, or is the client financing your operations? Who's actually holding the liability there? Peter Kang (07:50.791) Yeah, and definitely across our agencies we've seen some variations of this. Those that have been able to collect payments upfront typically tend to have much stronger cash positions. One of the things we should talk about is a common scenario that happens a lot with agencies, especially as they move upstream. As an agency, a typical growth journey is you work with smaller clients, you work with startups, and there's less red tape in the sense that you tell them it's upfront or net 15 and they're going to be okay with that. But as you move upstream and start dealing with more enterprise clients, especially ones with structured procurement processes, you start to get net 45, net 60, and even net 90. I've heard net 120, which is bonkers. The implications for an agency moving upstream could be pretty drastic, and these are bigger amounts as well. Maybe you could just illustrate what that could mean for an agency and why it's so perilous for them to be in that situation. Sei-Wook Kim (09:23.594) If you think about an enterprise client that pays you $150,000 a month and you have net 90 payment terms, which is very common, you could go for three months and have $450,000 sitting in receivables. You've incurred all the expense, you've paid your team every two weeks, and you haven't seen a dollar from that client. That's a clear example of why agencies need to have a large cash reserve to get through that period of time, or in some cases a line of credit they can tap to get through it. Peter Kang (10:09.446) Yeah, so even if they've accumulated $450K of receivables — even if they're doing it at 50% margin — that's still $200,000 plus that they've incurred in expenses before they see even a dollar. Is that what we're saying? Sei-Wook Kim (10:26.343) Yeah, exactly. You're not going to incur the full expense of that receivable, hopefully. But whatever you need to pay your team, you have to float that until you get paid from the client. Peter Kang (10:43.395) Yeah, so it's a double-edged sword. As you move upstream you're like, great, once I have big clients with deep pockets everything's going to be great. But there are these things to navigate. Speaking of navigating it, there are some ways to mitigate this, and we've had some experience to share on how we navigated clients with onerous payment terms. Sei-Wook Kim (11:05.767) It really depends on your relationship with the client and that particular procurement team. Oftentimes these larger companies are budgeting annually — they're really setting aside the funds. So you could potentially accommodate a unique request where you say, hey, let's invoice upfront for the next three to six months, maybe even a year of invoices, knowing that the payment cycles are going to be really long. In some cases you can get more cash upfront to try to get ahead of this curve where you're always delayed by 90 days. It doesn't work in all cases, but we've had that go successfully in a few scenarios, and that helped really smooth the working capital needs. Peter Kang (11:55.822) Yeah, and it goes to show that you can develop really good relationships with the procurement team, and they can actually help you navigate this as well. So it's always important to make friends. Sei-Wook Kim (12:09.819) Yeah, definitely. Peter Kang (12:11.723) Awesome. Let's talk a little about the method through which payment is collected, because this too can impact timing, and the way you set this up could give you an advantage or disadvantage. Sei-Wook Kim (12:33.224) In most cases, agencies issue an invoice and rely on clients sending a check or an ACH payment, or some other client-initiated payment through an invoicing platform. If they're late, they're late. If they don't get to your invoice — the check's in the mail, we've heard it — payments come in late and you have very little control at that point. You could have a lot just sitting there in receivables. But in other agencies we've seen systems like an ACH pull, where you keep their bank account information stored in your systems so you can actually auto-charge them at the intervals. Credit card auto-pay works well too — you initiate the payment from them. We've seen even a scenario where agencies offer a discount to do one of these methods. It's like, we'll give you a 1% discount if we can do an ACH, so clients might be incentivized to use that as a way to discount the services. But from the agency's perspective, if you have that predictability, if you know you can get paid faster, it's a small amount to pay for that service. Peter Kang (14:13.7) Yeah, which is interesting because if you're used to not having to deal with working capital challenges, you might be like, no way, I'm not going to give up 3%, that's quite a bit. But once you've had some close calls — oh my goodness, you barely made payroll because the check came super late — 3% might actually feel like a small price to pay for that certainty. Every agency is going to have their own take on whether it's worth it or not. Sei-Wook Kim (14:47.803) Yeah, and the other thing is, depending on your specific agency and the number of clients and invoices you deal with, if you're in the hundreds of invoices a month, it becomes onerous to chase down specific payments. The time it takes your finance team, or whoever is doing that, your account managers — to actually get the payments — that's easily more than 3% of what somebody is paying you. Peter Kang (15:12.804) How to present. Right, yeah, definitely. Okay, we talked about the billing structure, we talked about payment methods. Let's talk about how agencies should think about this from an accounting perspective and understanding the numbers, because we're talking about movements of cash with working capital. It's important to look at the accounting in a certain way. Maybe we could dive into what we're talking about there. Sei-Wook Kim (15:46.266) This is really about how agency owners can look at profitability through an accurate lens. There's accrual accounting and cash accounting. In cash accounting, you're recognizing revenue as you receive the cash. So any large prepayment — let's say a client pays you a year in advance — it could look like, wow, we had a really good month, and it can make the business look a lot more profitable than it actually is. But you still need to deliver on the work. The next month could be really unprofitable because you're incurring all the costs but not getting the revenue. It really distorts your view of your finances. Under accrual accounting, that payment would show up as deferred revenue on your balance sheet, and you're only recognizing that revenue as the work is being delivered. That year deposit the client made, you'll spread it over the next 12 months. It really smooths out what that looks like. Peter Kang (16:52.405) Just to make sure we tie this together: from a cash accounting standpoint, it could go two ways. One way is what you talked about — you get prepaid for a lot of work and you end up being like, we're so profitable this month because all this money came in. On the flip side, you could have signed a lot of projects, you're doing a lot of work, but the payment hasn't come in yet, and then you might be like, oh my God, we were so unprofitable. You have a distorted view, even though under accrual accounting you would have had a very profitable month if it all lined up — you recognize the revenue, you've signed the contract, it's just a matter of collecting on it. The danger here is you can have a very false sense of your financial situation and make poor decisions with what you do with that cash. Maybe we could talk about some ways this could go all wrong. Sei-Wook Kim (17:58.201) If you think about an agency that distributes some kind of profit share or bonuses based on performance — let's say you do that on a monthly basis, quarterly basis, every six months — and you're basing your distribution calculations on your cash-based financials, you could end up distributing way more money than you should. You'll leave your agency cash-trapped and have that shortfall in working capital. Cash-based accounting is a dangerous place to be. Peter Kang (18:41.139) Oh my goodness, just thinking out loud — Q1, a client prepays for nine months of work or whatever, you have this huge balance, and then you're like, all right, time for Q1 distributions, we were so profitable. You pay out a big chunk of that to yourself. And then all of a sudden you still have six months more of work to do, and that's where things can get — I mean, hopefully very few people listening have done that, but that's quite scary. So accrual helps you get a much more accurate picture. Sei-Wook Kim (19:12.697) Yeah, but even with accrual, you could also be in a cash situation where from an accrual standpoint you've recognized revenue, but the client hasn't paid you. From an accrual standpoint it looked like we're profitable and we have money to distribute — but if clients are late, in some cases you could be late for a month, two months. You definitely have to take a look at how much is in your accounts receivable before making those distributions. Peter Kang (19:45.692) Right. That's a situation we've come across a few times ourselves — it's like, hey, we had a very profitable quarter, time to make the distributions, but this client is late. Where's the money? How would you advise agencies? It's not like there's one answer — you have to be pretty smart about looking at the bigger picture and looking at multiple sources, right? Sei-Wook Kim (20:13.569) It's structural, right? As much as you can, receive money before the work is being done, really mind how quickly you're being paid by clients, make sure you're monitoring the accounts receivables, and be realistic — if clients aren't going to pay, quickly write that off and have a realistic picture of your financials. Peter Kang (20:34.686) Got it. All right, let's talk about some concrete examples. We have a couple of scenarios to talk about. Go ahead, take the first one. Sei-Wook Kim (20:41.796) Okay, so this scenario is called the prepaid service trap. This is for agencies that sell a large bundle of work that's prepaid. Some examples: you sell a bundle of hours — we're going to sell you 100 hours and you can use them whenever. Or it could be more deliverable-based, not time-based: we'll sell you 100 blog posts or 10 videos, but we'll deliver at a later time, and you buy it upfront. In many cases these are open-ended work arrangements — whenever you need to use it, you'll use it, but you've paid for it upfront. In that scenario the agency collects a lot of cash, but all of that is an obligation you need to deliver on. It ends up being a red flag. When we look at agencies like this in a potential acquisition, if we see there's a ton of obligations that need to be delivered on and we don't know when it's going to happen, that's an immediate red flag for us. Peter Kang (21:55.975) So this counts under deferred revenue then? Okay. And the way around this obviously is you can't have open-ended timelines, and this is a hard-earned lesson for a lot of folks. You have to operate with some kind of cap. For some of our agencies we might sell 25-hour or 100-hour packs for web development, but it's like, to be used within one quarter — there's a three-month expiration on it. That way there's some resource planning that can be done. One of the scariest things is having thousands of hours of work you haven't delivered on and you don't know when they're coming. That's when it gets a bit dicey for your agency. Sei-Wook Kim (22:49.622) Yeah. When all of those credits come due and everyone's asking to use their credits at the same time, suddenly the agency has to deliver a ton of work. From a team perspective, you may need to bring on more team members or contractors in a very specific time period to deliver on those contracts that were pre-sold. Peter Kang (23:20.499) Yeah, to illustrate it clearly: you get paid a bunch of money and you're like, hey, we're good, we're financially strong. And then your team is coasting with low utilization because there's not much demand, the clients aren't needing you to do a lot of this stuff right now. But then all of a sudden that could pick up, and it could exceed the capacity you have, which forces you to spend extra dollars to bring on excess capacity — which, of course, kills the margins. That's a crappy place to be, but it's giving me some flashbacks. Okay, the other scenario we've come across is something we call the agency Ponzi scheme. This is related to the deferred revenue challenge, but a lot of this starts almost like a downward spiral because the agency is unable to do the work profitably. One way agencies fall into this trap is: you're doing a web project, it gets extended, the timelines go way beyond scope, it's maybe a fixed fee, and then all of a sudden they still need to pay their employees but they've run out of money. So they have to find a way to fund that by selling another project to a different client, collecting a big chunk upfront, using that to pay the expenses for this other project. Now all you've done is kick the can down the road — you have to keep selling new projects to keep the music going. The moment you can't find a new client to fund your current operations, the music stops. This is a Ponzi scheme situation. It's not about fraud — it's a fragility aspect. You're operating your agency on a knife's edge, because the moment you can't bring on that new client to pay for what you're doing now, everything falls apart. Sei-Wook Kim (25:45.311) Yeah, and if you don't have a handle on your financials and you're looking at things on a cash basis, it may seem like things are okay. The cash comes in, you're paying your team, you get another deposit, and the cash looks good. From a working capital standpoint you've solved that immediate challenge, but you're literally not looking at the deferred revenue and the liabilities of what you need to deliver into the future. Peter Kang (26:15.41) Yeah, bonkers. All right, we've talked about all these nightmare scenarios. For an agency, what does a healthy working capital model look like? Sei-Wook Kim (26:30.718) The first is billing monthly in advance — a regular cadence, bill before the work is being done. Clients being on some kind of automatic payment, ACH or credit cards. If you do have enterprise clients that pay on longer terms, 60 to 90 days, being realistic and making sure that if it's a big portion of your client base, you manage the cash that will come. Really managing accounts receivables — making sure you don't have any aging receivables over 30 days, definitely not 60 or 90 days late. Making sure clients are paying on time and having the discipline internally to keep checking in on a weekly basis on that. And then — Peter Kang (27:24.872) Yeah, stopping work if clients continue to be late, right? Sei-Wook Kim (27:28.992) Yeah, stopping work — because that's another dangerous spot. If you continue working and then the client defaults on all your payments for six months, that's a tough spot to be in. And then the last thing: for all prepaid work, if you get big deposits, be really disciplined with how you handle that cash and don't distribute it all. Peter Kang (27:51.246) Yeah. And what's the impact on the balance sheet for a healthy agency? Sei-Wook Kim (27:56.436) You should have strong cash reserves in the business. Your inflows should be very predictable. And your delivery on your work should be very manageable — no lumpiness to the expectations. Peter Kang (28:11.965) So liability-wise, the obligations — the deferred revenue part on the balance sheet — is much, much smaller, right? Okay, awesome. We've talked quite a bit about this topic and hopefully there's enough value here that folks have made it this far. We've hopefully also helped you think about some of the ways you can improve working capital. Going back to those two agencies — same revenue, same margins, but you can still have drastically different situations financially. That's what working capital is really all about: how can you ultimately turn the revenue into usable cash? Because at the end of the day, businesses live and die by how much cash they have. If you take away anything, think about converting your revenue to cash — that's what working capital is all about, and you want to shrink that gap to as little as possible. With that, thank you for joining us, and until next time, have a good one. Sei-Wook Kim (29:25.758) Thanks.