How much cash in the bank makes sense for an agency business?
Some agency owners I’ve talked to say enough cash to cover at least 3 months’ of expenses. I’ve also talked to ones that have enough to cover a year’s worth of expenses. Some serious amounts.
I like having cash in the bank. Especially in a higher interest rate environment, having cash is a good place to be and provides a sense of security. If things go wrong, say, you have to settle on a lawsuit that liability insurance only covers partially or a client goes belly up without having paid their invoices, it’s smart to have cash on hand to ensure the business can overcome these setbacks.
But what’s enough or too much? How should we be thinking about cash reserves?
I like to limit the amount of cash that gets earmarked as “emergency” funds. This is the rainy day cash that we may dip into if unexpected costs show up. At most, 3 months’ worth of expenses is what we target. And even here, we might limit the coverage of expenses to really be some core fixed costs (e.g. key software licenses, accounting, insurance, etc.) and the payroll of our salaried employees. We’d exclude variable contractor costs and also any owner comp. Depending on the month, this might be as low as 60-70% of an average months’ outflows.
Some agency owners might believe that having a large rainy day fund is a conservative move, but I’d argue that it’s actually a greater risk. A large cash balance can lull an agency owner into making less disciplined choices, like tolerating decreasing margins or even negative cash flow months when business slows down. “We’ve got buffer to turn things around,” is a line of thinking that a large cash reserve tends to encourage.
Sometimes, things work out and the business can get back to its winning ways. However, when things don’t get better and a prolonged period of business contraction happens, the large emergency fund can continue to delay critical actions like cutting costs and reducing headcount.
I believe that by having a limited amount of emergency funds, you’ll be forced into making difficult decisions much sooner, which usually leads to better business outcomes. Every agency owner has different comfort levels around this, so some may agree with me and others not so much.
From our experience with Barrel, we’ve been in situations where we let a cash cushion give us a false sense of hope (e.g. “we’ll eventually win those big deals that’ll come through soon so let’s wait it out…”) and act with less urgency when things slowed down with new business or certain projects went off the rails and had crazy cost overruns. By failing to make changes sooner, we logged negative cash flow months and quickly burned up our cash reserves, finding ourselves on the brink of insolvency on a few occasions. Thankfully we found ways to bounce back, but those were painful and hard learned lessons.
Pay Yourself More
A simple way to manage cash is to just dividend out excess cash beyond a set emergency amount. There will be some tax implications, but sometimes it’s good to take money out of the business and put it towards something else. Maybe you buy some real estate, invest in equities, beef up your own personal emergency cash reserves, or write some angel checks. This is the beauty of agency businesses – if you run a profitable, cash flowing business, you can pay yourself well. There’s no rule that says you have to underpay yourself if you’re looking for an eventual home run exit. You can still reward yourself along the way.
You can also reward your employees. Maybe the leadership team gets a bonus, maybe you have a profit share program. Instead of having excess cash stored somewhere that might get misused one day, you can use it to build some goodwill.
Funding Agency Growth
If we’re looking to “reinvest” in the agency business, I like to separate out reinvestment cash from emergency cash. Reinvestment cash should be thought of as an investment – an infusion of capital with an expectation of return. I’ve made comments to peers about “reinvesting for growth” in the past, but upon closer examination, I was actually just seeing an increase in expenses without the necessary growth in profits – the classic growth challenge of margins being eroded as the work volume increases, processes break down, and inefficiencies creep up around the business.
Another way I’ve confused “funding for growth” is incurring expenses ahead of revenue, like hiring a team or creating a department before we had the volume of work to generate a profit. If done right, it should be possible to fund this growth with the revenues flowing from client work. Perhaps you might subsidize some work in the early days as the new team/offering gains traction (via fee discounts or some free work), but this amount should really be negligible and not enough to require a sizable cash investment.
In general, I like to avoid funding growth by infusing cash into an existing agency business. I find it hard to track ROI. This is why our Barrel Holdings model has been helpful. We’ve launched separate businesses with their own P&Ls. We can see clearly, for those that have needed some upfront capital to get things going, what kind of ROI we’ve gotten for the investment.
I’ve heard of instances where some agencies will spin out a new services offering as a separate entity, seed it with some capital, and then if it does well, merge it back with the original agency. It’s a pretty good way to stay disciplined about how the cash gets spent, because I can imagine cases where funding growth / reinvesting into the business can be a cover for running a loose ship.
Start a New Business
Similar to funding agency growth, you can earmark excess cash beyond emergency fund as investment capital to start a new agency venture. This is what we’ve done with Barrel Holdings as I mentioned above. It doesn’t have to be a ton of cash, either. It can be enough to get things going (incorporation, some early software and labor costs, etc.) and if the business starts generating cash, you don’t have to fund it anymore.
Buy Another Business
This is where we’re looking to go with Barrel Holdings and why it’s important for us to build up our cash position. We want the flexibility to acquire other agencies. Maybe they can be merged with Barrel or they can become standalone agencies in our portfolio. We’re not in a rush, but having a growing cash reserve will allow us to make a move when the right deal comes along.
The cash amounts here could be well in excess of 12 months of expenses to run our agencies, but we’re making a conscious decision to wall off these funds for acquisition purposes vs. emergency funds. I can’t see a situation where we’d dip into our acquisition fund because we’ve exhausted our emergency funds. If that ever happens, then we’ve most likely made some horrible decisions and probably deserve to lose a lot of money.
Agency Capital Allocation
The things I’ve mentioned above are really just basic capital allocation options that are available to businesses with cash to deploy. Astute capital allocators are those who can take excess cash flows and deploy them in ways that get them the best returns. This could be in the form of M&A, share buybacks, investment in new ventures, reinvestment in the business/funding internal growth, paying down debt, or paying out dividends. There are many options and creative ways to allocate capital effectively. Those who do it really well typically have a high conviction strategy (e.g. using cash flows to roll up similar agencies) that’s executed with discipline.
Through this lens, the question of how much cash reserves an agency should have really comes down to another question: what is your capital allocation strategy? How do you want to deploy excess capital and to what ends? Personal wealth enrichment & diversification away from the core business via dividends? Acquiring and growing topline for a larger multiple exit? Launching multiple cash flowing businesses that compound into a bigger cash machine? There are lots of ways you can go about this game.
But one option that I’d be careful to avoid: having a big number sitting idly in a bank account serving as a security blanket ready to shield me from having to make hard and prudent business decisions.