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How Much Can I Really Make?

If you’re perpetuating the charade of the start-up, this might be the most boring article you read all week—because this is an article about profit. You can go live the high life while burning some investor’s hard-earned money, and think that profit is something you’ll worry about after you flame out. But if you are building a business that will support your family, and dependably provide for a great team of people, this might might be the most game-changing article you read all year. It’s an ode to the entreprenerd. Grab your calculator and let’s get funky. I’ve read a lot on the art of business—the passion, the focus, the team. Oddly enough, once I left behind the nuts-and-bolts articles on how to start a freelance business, the conversation online around the science of business vanished. Plenty on the art of the start-up, but what about the science behind managing and scaling the sustainable, profitable business? Maybe talking about pipeline analysis just isn’t sexy? And it isn’t, until you realize that the nuances of managing money often become the difference between “just getting by” and being able to buy a second home in Nicaragua so you can get away to surf (it hasn’t happened yet, but I’m angling hard). As our business grew, getting the answer to questions that used to be simple became more and more complex. How much can I really pay myself? When you have deposits, delinquent clients, vendors accruing, and want to be prepared for the future, how much money in that bank account is really yours? The adventure we undertook to get an answer continues to amaze me. When I was a solo freelancer, I looked in the bank account, moved 30% for taxes to a savings account (and eventually higher yield short term bonds), left about two months of estimated operating dollars, and the rest was mine to do with as I chose. After all, my business had virtually no expenses worth saving for besides my personal cost of living. As the company matured and I took on a business partner, figuring out our income was manageable enough using QuickBooks. I took the time to do basic bookkeeping, entering both income and expenses. I ran a Profit and Loss (P&L) statement, and as long as my entries were accurate, there was the answer: our available profit. Not a complete solution, but good enough. Until we really began to grow.

The Net 30 and Accruing-Costs Dilemma

Tracking the cost of salaried employees is easy. The challenge started when I partnered with Peter in 2006 to merge our agencies, and we chose to use only freelance contractors. Some worked hourly, others under fixed contracts. Around the 2nd of every month, we would receive a pile of invoices. I would enter them into QuickBooks, and within the next thirty days I would pay the bills. Fair enough—I just waited to pay Peter and I until we had paid everyone else. This worked until I realized that, come the 20th when I was writing checks, my team had been actively working for a few weeks, racking up billable hours. I had an accruing cost basis about which I had absolutely no transparency. A whole month would pass—plus the time it took me to review invoices and get them into QuickBooks—before I saw the total impact. In some of the worst cases, QuickBooks was forty-five days behind. At that point in our business, I could owe anywhere from fifteen- to sixty-thousand dollars, depending on the month. The swings were not subtle. Making financial decisions with data from more than a month prior, and a secret amount coming down the pike, was impossible.

Deposits and Late Payments, Oh My!

Figuring out expenses every month was a pickle, to put it mildly—and figuring out income became just tricky. “Awesome, we just put hundreds of thousands in the bank. We’re rich!” Except that deposit has to pay for things. A lot of that money is earmarked. And if the project was a fixed bid, often our income was predetermined—but our expenses might not have been. This meant that our actual profit was always a bit of a mystery. We had calculations, but were constantly uncertain about their accuracy, and needed to keep enough around to cover our commitments. Your clients always pay you on time, right? Ours do, too. Sometimes. The funny thing is that the biggest companies are the worst offenders. We’ve worked with a number of companies with three- and four-letter names who have been up to eight months late with near-six-figure amounts. No matter what our lovely clients are up to, we pay our contractors on time. We made the commitment to Net 30 and we honor it. When I look at the money listed in our accounts receivable (open invoices), there are times when it represents almost pure profit since all the expenses were paid for long in the past, and other times most of the income will go directly to paying future expenses. We realized that in order to get the answer we really wanted, we would need to start by getting better real time data. We simply couldn’t operate thirty to forty-five days behind; it didn’t give us the flexibility to react to potential challenges, or even to make informed financial decisions.

Marrying Finances and Project Management

We began to build systems. I imagine there are systems out there that might tackle these problems (though perhaps not intuitively or affordably). You might not need to build these yourself as we have, but hey, we’ve even open-sourced ours, so feel free to roll up your sleeves and join the party. We manage all our project on a modified version of an open-source Ruby on Rails system called Chili Projects, which we helped fork from Redmine in March 2011. Like Basecamp, Gyra and Active Collab, it had an amazing set of tools for coordinating work, but fell short when it came to the financial tools they offered. The first problem we decided to resolve was bringing visibility into accruing contractor costs. We needed contractors to clock their time regularly—from there, we could determine costs. This required a swift change in culture. Other agency owners often ask me how we get independent contractors to clock their time. The answer turned out to be easy: If you don’t clock your time, we won’t pay you. We then instituted a small upgrade called the “clock blocker” after we lost sixty thousand dollars due to a process error which only lets someone clock three days into the past. We then built a Rate plugin, which allowed us to track a contractors for a specific date range with overrides for specific projects. The result was fairly real time cost reporting. I could tell you what I was spending on any project over a specific time period over the life of the project, with the ability to drill down to specifics by person, type of activity, and more; a project manager’s dream. I honestly cannot figure out how we managed to make a decent profit and avoid disasters before having these reports. We then built an accounts payable plugin. This lets us assign hours entered to a specific invoice and mark it as paid. Now I could identify accruing costs that were as of yet unpaid. This plugin had an interesting—and unintended—consequence: An invoice needs to match the hours and costs in the system exactly, or we reject it. Last month, Susan rejected 9 invoices and required each contractor to review and update their invoices to ensure accuracy. When you consider that we can get anywhere between twenty and forty invoices in a month, having a third of them be inaccurate adds up. To date the biggest monthly-total deviation was an overcharge of nearly $9,000. Other months it has landed on significant undercharging. This process alone has paid for itself a hundred fold. We had another piece of the answer. We could see our Accrual Assets and Accrual Liabilities in QuickBooks, then calculate our Accruing Contractor Liabilities in our customized Chili reporting tools, add up all the losses, and determine our cash available. And for a while, we were satisfied—until the day came when we realized that we need to account for the commitments of our projects and for the future stability of the company.

The Magic 8 Ball: Planing For The Future

“Profit,” in the eyes of QuickBooks and our friends at IRS, is not necessarily a representation of the money an owner gets from a business. As an S-Corp, we get taxed on the difference between income and expenses. When we decided that we should save up a wad of cash for investments and reserves, and then held those funds across a tax cycle, the government took its cut. It didn’t care that none of the owners got any of it. To add another layer of obfuscation, we don’t get to deduct all of our expenses. Some meals and entertainment are deducted at fifty percent, while other things are assets and get depreciated (i.e. they’re expenses you can deduct over multiple years). We concluded that to get the answer we wanted, we would have to separate “cash flow and distribution to owners” from outright “profits”. When managing cash flow, I don’t care what the government says I earn; I care about the bottom-line cash I get in my wallet. To achieve that, we realized we’d need to build our own formulas and leave QuickBooks behind entirely. I know what you might be thinking: “This is guy is crazy. There must be a simpler and more obvious way to do this. Shane just likes to reinvent the wheel.” And you may be right—but to be fair, we sought out CFOs from some of the best agencies in the world and even from a couple of billion-dollar companies. We posed our challenge to them and then showed them our spreadsheets. We paid experts for further illumination. We couldnt shake the feeling that it just should not be this complicated. The answer we got consistently was praise for how much we “simplified” a complex problem—it turns out, folks, that our route was actually “the shortcut.” To get a legitimate understanding on the health of the business, and decide how much we could take out of the business, we would need to be able to project income and expenses, and carry the right amount in reserves.

Projecting Income

If knowing what we owed was the first piece of the puzzle, the second piece was getting a decent sense of what, exactly, we were going to make. You see, QuickBooks does an awesome job tracking what you’ve made, and what you’ve invoiced. And our updates to Chili brought expense data up to the current moment. But both tools did a poor job of representing the future costs of a contract, and don’t address the sales pipeline at all. To determine the value of our current contracts, we started filling out a spreadsheet on a monthly basis. I’m looking forward for the day this is more automated, but for now, we list all active contracts with two key details: their current non-billed value (the total value minus the invoices to date), and the likelihood that we would see the money:
Client Project Rem. Value Odds True Val. Manager
eBay Motors iPhone $27,000 90% $24,300 Shane
We then totaled the values to see the amount of money under contract that has not been taken into account on QuickBooks. We eventually then upped the ante by taking our sales pipeline into account. The process is identical to the row above. Project value times the likelihood of seeing the money equals the actual value. If you’re curious for more insight on this specific point, I wrote an article on eLance on this forecasting technique that might be of interest.

Projecting Costs

Projecting costs is actually fairly simple—until you need to be accurate. Typically, the first step is to separate your fixed costs from your variable costs. Figure out which expenses continue at the same amount no matter how much business you close. These are generally things like business licenses, rent and utilities, hardware, server fees, and insurance, for example. Every year we run a detailed P&L, extract the categorized expenses into a spreadsheet, and break them out as payroll costs, contractor costs, and operating costs. While we are able to break our operating costs carefully into fixed and variable costs, we found, during our first pass, that as a service company our variable costs were almost entirely composed of labor costs. It simply was not worth the additional clarity. We then take the operating cost, decide if we see any specific increases (factoring in things like inflation, technology changes, etc.), pad it a bit for safety, and then assign an average monthly value. In our case, we have about seventeen thousand dollars a month forecast as a fixed operating cost. Second is forecasting variable costs. In our case, due to our agency business model, we pretty much focus on labor expenses. Employees are simple: cost to business (the sum of salary, taxes, benefits, and reimbursements), plus any raises or bonuses we forecast. Contractors are a bit more challenging. After a lot of deliberation we decided use past patterns to gain insights. Using QuickBooks, we created reports to see what percentage of our gross project income was spent on contract labor. It fascinated us that between 2007 and 2014 the percentage had barely changed. We spend somewhere between thirty one and thirty seven percent of gross project revenue on our freelance team when a project is entirely freelancer-run. It has become lower over the last few years as we have become more efficient, and have paid more attention to the numbers in real time, optimizing for efficiency and profit. Our current setting tab lists 32.5 percent based upon the last twelve months. That number has changed in 2015, because we’ve added employees to the mix and are playing with a new baseline. We finally grab the value of our projected income from current contracts, apply the percentage, and do the same to the sales pipeline.


With a solid understanding of our current financial position—and a forecast we can rely on—we realized the final piece of the puzzle was planning for the unknown. What if bad things happen: a dry spell in the sales pipeline, or an injury of a key person, for example? What if good things happen, or some huge opportunity arises? Fortune favors the prepared, so we eventually broke out four situations we wanted to prepare for: operational responsibility, personal tragedy, opportunity, and taxes.

Operating Fund

We decided that the responsibility of the operating fund was to have enough cash on hand to settle our commitments. We don’t believe on making commitments we cannot uphold. We concluded that if things went to hell, that if we had two months of costs on hand, that would be enough to time to cover any typical shortfall. Considering that the bulk of our expenses were tied to income (i.e. we only pay contractors to work on projects for which we are being paid) we are not usually in a high-risk situation. I would imagine a product business would need to be more conservative. We keep two months of employee salary, fixed costs, and an average monthly contractor AP (determined quarterly) in this fund.

Rainy day Fund

When I started freelancing, I remember asking Quinn, my mentor, how he could be so chill about freelancing. The ups and downs were freaking me out. He laughed and told me that he has 6 months of living in a savings account. That was peace of mind. We eventually began to put money into a “rainy day fund” to give the owners the peace of mind to take some risks, and a safety blanked if the business ever fell apart. Its goal was to be sufficient for either rebooting the company, or supporting us long enough to find a new source of income. We keep two months of key employee salary, one month of owner salary (the owners have six months of savings personally), two and half months of fixed costs, and one additional average monthly contractor AP. I sleep well at night. How about you?

Investment Fund

We often struggle with how to use this fund and have vacillated in our approach over the year. At some points in our history, we treated this fund as a fourth partner and put a quarter of all profits into the investment fund. At other points in time, we require the projects be pitched, vetted, planned for, and then budgeted, at which point we begin to save for them. Currently we are using the intentional model, as we have a fairly clear vision into our key investments over the next year. Once a project is approved, a funding timeline is created and we begin to put regular deposits towards the fund to prepare.

Tax Fund

It’s the governments money, not ours. I may not always agree with this, but as a US-run business, I accept the reality. Every month I run a P&L, multiply the profit by thirty-five percent, and put that money into our tax fund. The amount is sufficient that I often look for secure higher-yielding vehicles that return the money come December 15th.

So How Much Can We Pay Ourselves?

Every couple of months, I run our finance spreadsheet. I fill out our cash position. I enter all of our current liabilities. I update any changed core costs. We work as a team to update the finances on all current contracts and on all of the projections in the sales pipeline. Then, I top off all of the funds according to their proper thresholds. Everything that remains after that is gravy! All surplus cash gets moved into the surplus fund for distribution to owners.

Go Sell or Go Surf

In trying to answer how much we could pay ourselves, we created a forward-looking six-month projection of the health of our business. We know how much base the owners want to make. We know how much it would cost to keep the business alive. We had a firm grasp on our actual and sales pipelines. We can now actually answer that typical conversational question: “How’s business?” By knowing how much money was forecast to flow out, and how much would flow in over time, we built a very simple dashboard. We set the time horizon, and then it measures our projections against our goals. It returns “GO SELL” or “GO SURF”. It’s a huge relief knowing how you are doing six months out and having time to address any income challenges. It also gives us the foundation to know if I can afford to go buy the house I want to buy in Nicaragua.

How Much Can I Really Make?

A guided tour of the inner financial workings of an agency’s bottom line.