While overly simplified, the Sankey diagram is a help way to visualize the flow money in a business. In an agency context, it's a clear way to see how revenues are eaten up by costs and how many dollars end up making it into the owner's pocket.

Below are 3 scenarios of a $5 million/year agency business. This makes some very broad generalizations around cost structure and taxes (45% on profit paid by the agency) to help show a simpler picture.

Also, agencies define & categorize costs in very different ways. In our example, cost of sales is the labor cost in delivery and gross profit is what you have after deducting that labor cost from revenue.

One more disclaimer: these Sankey diagrams are a snapshot of an agency's finances, basically a colorful P&L column. This doesn't show the agency's ability to retain clients, its momentum, or the quality of its team. These are all factors that would be considered in determining the agency's health. However, for the purposes of this post, you can assume that the Sankey diagram reflects performance as a lagging indicator. Something must be right/wrong for the agency to post these types of numbers.

Scenario 1: 30% EBITDA, Healthy

Right off the bat, an agency that can generate 50% in gross profit sets itself up nicely. Most of an agency's costs is in labor costs required to deliver the work, so if that ratio is kept in check without sacrificing the ability to deliver, the business model can work nicely.

This agency is able to generate $1.5 million in EBITDA (30%), which is very healthy. We typically target 20%+ for our Barrel Holdings agencies. An agency that can consistently post 30% EBITDA each year while growing topline revenue will become very attractive to potential buyers. What's more, the business will be throwing off some serious cash.

Our tax illustration is very rudimentary. You can explore all kinds of sophisticated tax schemes to bring your effective tax rate down from the 45% we have here, but if you make money, expect some amount to make their way to Uncle Sam.

With a post-tax earning (net income) of $825k, there are many options. As an owner, you can pull that out of the business as a profit distribution or you can decide to leave some cash in the business for a rainy day. This is where capital allocation becomes a good problem to have. Related: Keys to Reinvesting Agency Profits

Scenario 2: 15% EBITDA, Okay

In this scenario, the profit is halved vs. Scenario 1. The main driver is in the labor costs. Gross profit is at 40%, which is not terrible. The other driver is the increase in general and admin (G&A) cost. This could be things like office space, back office resources, IT, etc.

I remember in the pre-COVID days, we used to buy lunch every single day for our entire team at our Manhattan office. We thought it was a great perk but the costs added up and there was a lot of waste as many team members preferred to go and choose their own lunch options in the neighborhood. We eventually phased the program out and it bumped annual EBITDA by at least $60k.

If you're preparing your agency for a sale, you could make the argument that many expenses could be "added back" to make your EBITDA look better. For example, if we were selling our agency back in the day, we could've added back the $60k expense and made our EBITDA look better, making the argument that lunch was just a nice perk that wasn't necessary for a buyer to continue. But a buyer could make the case that perhaps lunch was an important recruitment, retention, or productivity benefit and there's not enough data showing how the business would fare without the lunch program. The same goes for things like professional development, training, etc. We've seen many agency sellers trying to add all those back to beef up the EBITDA and some are just too much of a stretch. Better to be disciplined with costs and run a tight ship.

An agency in this scenario has a couple of options: A) tighten the belt a bit to improve margins (reduce headcount, cut back on contractor expenses, and tamp down on G&A costs) or B) improve revenue while keeping costs the same.

Option B will require tightening up the sales & marketing approach as well as other activities like better pricing and growing existing client accounts. If done right, a modest 10% revenue increase can quickly boost EBITDA.

Option A is often a less pleasant approach but in many cases, it's actually what's required to get the agency back in track. There may be underperformers or toxic employees in the business holding the agency back from being more effective and efficient. We've personally experienced situations where going through Option A was the only way to give ourselves at Option B.

Scenario 3: 0% EBITDA, Help

The Sankey diagram isn't made to depict negative dollar amounts, so 0% was the lowest we could go, but there are plenty of agencies that are operating at breakeven or worse.

Similar to the Okay scenario above, the issue with Scenario 3 starts with an upside down cost structure: too much headcount for the revenue. A 25% gross profit makes things really tight.

This type of scenario usually doesn't happen overnight. Most likely, the agency was doing more in revenue–let's say $6 million–with the same cost structure. They had a respectable 16-17% EBITDA. But then something happened. They lost a couple of big clients, they completed a few big engagements and didn't have replacements, or they went on a very long dry spell. They kept the cost basis the same but their revenue was suddenly much lower.

In such cases, some agencies will let gross profit get down to even lower amounts while cutting back heavily on sales & marketing. They often do this in service of retaining the team and avoiding any reductions in force, but such decisions often lead to a slow death spiral: the lack of sales & marketing activities means less deal flow and not enough resources to properly close opportunities, which then means even lower revenue. 10 times out of 10, the agency owner will wish they had made the tough headcount reduction decisions much earlier.

An agency might have cash in the bank from previous years that helps them weather a zero or negative EBITDA year. And they might be able to recover and come back strong the following year while retaining their full team. But oftentimes, the timetable for recovery tends to stretch out longer than anticipated, which then puts pressure to increase revenue or cut costs.

Moral of the story: be sensitive to changing conditions and act quickly. Rather than give it half a year or even a full quarter, start thinking about making moves 1 or 2 months into a decline.

I'll leave you with this excerpt from a book that's been a good resource for working through tough situations, Corporate Turnaround Artistry by Jeff Sands:

A typical first call with a business owner starts with them telling us how they have a $100 million business, but when they send the financials, the current run rate on revenues is about $70 million.

“Well, it was $100 million a few years ago and that’s where we need to be” is the explanation we usually hear. The entrepreneur is slowing tapping his feet waiting for the business to recover to $100 million.

In those situations, I usually see a $50 million business that makes a lot more sense; it is protected with high margins, real expertise and loyal customers. Although I want to quickly shrink to sustainable profits and a business with great core strength, the owner struggles to give up the big number that sounded so great but never really worked for them. “You went from $100 million to $70 million. What about $100 million (other than your dreams) sounds sustainable to you?”