Financial Management of A Marketing Firm (Second Edition) by David C. Baker

Nashville, 2022
courageous thought leadership insight
RockBench Publishing Corp.

Nashville, TN, USA
www.rockbench.com
Copyright ©2010 and 2022, David C. Baker

All rights reserved
Printed in the United States of America
First edition, 2010

Second edition, 2022
Published simultaneously in electronic format
Library of Congress Control Number: 2010913358
ISBN-13: 978-1-60544-075-0
2 3 4 5 6 7 8 9
For all the bookkeepers, accountants, controllers, and
CFOs who have been saying all these things for years
With no one listening until a high-priced consultant

comes in from a long ways away and says the same things
TAB LE O F C O N TENT S
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
1) Your Compensation & Ownership Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2) Financial Statements Part 1: Definitions & Reporting. . . . . . . . . . . . . . . . . 14
3) Financial Statements Part 2: Interpreting. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
4) Benchmarking Your Financial Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5) Funding Growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
6) Projecting Your Firm’s Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
7) Collections. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
8) Making the Decision to Own or Lease Your Facility . . . . . . . . . . . . . . . . . . . 88
9) Systems & Utilization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
10) Principles for Pricing Work. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
11) Handling Costs of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128
12) Compensating New Business Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
13) Open Book Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
14) Employee Incentives & Rewards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
15) Policies for Employee Paid Time Off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
16) Managing a Downturn. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196
17) Formalizing Client Relationships. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
18) Constructing Appropriate Retainer Relationships. . . . . . . . . . . . . . . . . . . 242
19) The Role of Legal in Your Agency’s Financial Wellness . . . . . . . . . . . . 255
20) Preventing Financial Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
21) Transition Options for Principals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Sample Balance Sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

Sample Income Statement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
Utilization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
About the Author. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 298
Credits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
P R E FAC E
One of the courses I was forced to

take when working toward an MBA
was one on financial management.
It was a night course, taught by a
graduate assistant whose English
skills made it clear that his native
language was something else.
I remember getting hung up on
the vocabulary, first. As I’d ponder the meaning of a word I’d just then
learned, he would prattle on and on, using the word in various con-
texts to get through his prepared notes. With each subsequent use of
the word, I’d sink deeper and deeper into the quicksand of ignorance …
and sometimes panic.
All of it left a really sour taste in my mouth about all things
financial. So much so that I never really bothered to fully understand
the financials of the agency I owned for six years. It seemed out of
reach, first, and then there didn’t seem to be a context for it, second.
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M vi

P R EFACE
By that I mean that it was one thing to understand the concept of,
for example, the assets and liabilities on a balance sheet. But it was
something else altogether to understand what sort of ratios should
be exemplified by a balance sheet. I just didn’t know much.
When I started this consulting practice, I had to force myself to
understand the financial component of management—after all, prin-
cipals the world over would be looking to me for guidance, and so no
matter what I felt about financial
information, I simply had to under-
stand it. Beyond that, I had to teach
it in a way that principals could
understand, if they wanted to.
Better yet, I needed to explain
it in such a way that they would
want to conquer their fear of
financials and want to begin
seeing their business through
a financial lens.
That gave birth to this
manual, and I want to thank
each of my clients for their
very astute questions over the
years. This manual is entirely reactive in nature, only in the sense
that I’m reacting to what you want to know. The writing of this has
taken nearly ten years of fits and starts, but I’m happy with how it’s
come together.
I hope that you’ll find good, plain help in here and conquer your
own fears.
If I can learn financials, you certainly can too.
—2010
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M vi i

P R EFACE
A further note, 12 years later for the second edition: I had no idea
how popular this manual would be. The countless copies sold and the
related sold out seminars are a powerful statement of how badly you
want to understand your firm’s performance. The IP has been used by a
half dozen purveyors of software dedicated to this field, too, and so I’m
very proud of all our combined efforts to understand this field we love.
I am leaving the original title that refers to marketing firms, but
understand that this is really for creatives, advertisers, software
engineering firms, and digital firms, too.
Thank you for being on this journey with me.
—2022
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M vi i i

INTRODUCTION
Money isn’t everything.

It isn’t nothing, either.
You should be in business primarily for
two purposes. The first is to make money,
and the second is to have an impact via
effective work. That second purpose fol-
lows the first almost immediately, and in
fact I would argue that they are inextricably
tied together. Without having an impact,
making money on its own is hollow. And without making money,
impact is compromised simply because clients won’t listen and
because you won’t have the requisite time to get deeply enough into
any given situation to understand it and make a difference.
So this manual is about money, and I make no apology for that.
The reason many firms don’t make money is because they don’t
understand it and because they don’t have a strong enough positioning
to enforce the principles of money that they do understand. Instead,
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M ix

I ntro d u ctio n
they muddle along with a low utilization (see chapter 9) because of their
own unique blend of under-pricing and over-servicing. If you would like
to understand the connection between positioning and making money,
take a look at my 2017 book called The Business of Expertise.
We aim to fix all that in this manual, and I hope you’ll read it care-
fully and with an open mind. Some of the content is just good old
fashioned common sense, but some concepts are truly unique and
will stretch you a bit.
My suggestion in reading this manual is to take it one chapter at a
time through chapter 11 (there’s a joke in there about bankruptcy, but
I’ll resist), reading each chapter slowly and methodically at a pace that
allows you to understand every single point.
From there, just skim chapters 12 through 21 and refer to them
as necessary. Other than chapters 2 through 4, each chapter is self-
contained and can be digested on its own.
Thank you for buying this manual, and thank you for raising the
bar at your own firm. Best wishes as you implement sound financial
management at your firm.
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M x

1
Y O U R C O M P E N S AT I O N &
OWNERSHIP AGREEMENT
This chapter begins by explaining the rationale for a compensation strat-

egy and then distinguishes between a hobby, a job, and a company. From
there, we detail how to get paid for three things: what you do, what you
own, and what risk you take. We then suggest several means to set your
own compensation level and check its validity, followed by some specific
suggestions for formalizing compensation in ownership agreements.
How much money should you make?

Good question. Our own mission
statement says, in part, “We will
always seek potential clients actively
so that we can serve only those who
need and want our help; we will
charge enough to maintain our
core competence without
losing our core character; and
we will have fun while we provide
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 1

Yo ur Co mpensatio n & Ow n ers hip Agreeme n t
substantive answers to clients in a sustainable business environment.”

That pretty much says it all, though it’s not satisfyingly mathematical.
Surprisingly enough, we receive many questions about principal
compensation. Often it’s just a curious question, inspired no doubt
by a desire to see if you measure up
to your peers. As we often say around
here, money is the currency of respect,
and so asking how much you make
is tantamount to asking how you are
doing. But other times, the question is
prompted by some event that befalls
a firm with more than one partner. In
these cases, someone’s workload is
falling off, perhaps because he wants
to work less or she wants to take time
off to have a child or whatever, and the partners are wondering how
to adjust compensation to be fair.
In this chapter, we will look at how to pay yourself, and then we’ll
conclude with some safeties to build into your partnership agree
ment that relate to this same issue. Even if you don’t have a business
partner, having a life partner (married or not) requires that you plan
accordingly. That’s because your business is impacted if a personal
relationship goes through a transition. In other words, a non-
participating spouse can impact a firm.
W H Y YO U S H O U L D THI NK ABO U T
W H AT YO U M A K E
There are several reasons why the issue of compensation deserves
your attention, and I’d like to get you thinking about your salary in
a different way.
First, money is about respect, as noted above. In contrast, how
much you make is not a measurement of how much you need. In
other words, even if you don’t need a certain level of income, your
income should match the value you bring to the firm you manage,

and by extension the clients

you serve, or several things
will happen. You’ll get bored
with what you do; your clients
won’t listen to you; and you
will not force your firm to
achieve a level of profitability
that is really an appropriate
measure of health.
How much money you
make has no bearing on your
value as a human—but in a
business environment, it is
a relevant question to raise,
and unless you make a lot of
money, you really don’t have a
viable business, unless it’s just
a temporary aberration. So, even if you give most of it away, you must
make a lot of money. If you don’t, something is wrong. It could be you
or it could be your clients, but it is something.
Second, profit defines the extent to which you have a business.
Put differently, do you have a hobby, a job, or a business? Really, now,
when you are honest with yourself, what do you have? The lines are
blurred, obviously, and sometimes the answer is not intuitive. If you
have less freedom and more responsibility than ever, you might very
well have a company. If you enjoy it, you certainly don’t have a job.
And if you have visions of getting rich, you might very well have a
hobby. Just kidding!
If you want to be taken seriously, you should have a company. And
it doesn’t matter if you have no employees or dozens of them. But if
you think of what you do as a business, you’ll do more planning, craft
a compelling positioning for the marketplace, and think quite differ-
ently about the financial component of what you do.

More specifically, how does money relate to these three options

(hobby, job, or company)? Here’s the relationship as it seems to unfold
in real life.
A hobby costs you money. In other words, you spend more money
than you make, even factoring in the fact that you don’t pay yourself
anything. My main hobby is motorcycling (historically 20,000 miles
per year, on and off a racetrack). Believe me, even without paying
myself a “driver’s fee” I still don’t make any money from the riding.
From a purely financial perspective, it’s a big hole.
A job pays you for working. The actual amount varies, depending
on your skill and ability to convey that skill and negotiate on your own
behalf. The pay comes at regular intervals in fixed increments. There
are no surprises, usually. You work, and you get paid. You don’t work,
and you don’t get paid.
A company delivers profit beyond expenses. This occurs after

paying all the salaries, including a fair one to yourself. The profit is
not optional, ideally, and it should be substantial. Sure, the times that
some of you have gone through are making it more difficult to achieve
a substantial profit, but that too is an aberration from the norm.
If you just have a job, you might as well work for someone else. Of
course you’ll be giving up some control and some flexibility, but you’ll

also be giving up significant risk, loads of management hassle, and

untold encumbrances.
A few years ago I was conducting a ReCourses roundtable. One of
the principals stopped the meeting and turned to me and said: “I just
realized something. I started this company to give myself more free-
dom and control, and now I have neither. As an employee I could walk
away, and now I can’t. I’m trapped.”
What he really had was a job, plus all the responsibility of a busi-
ness—but without the profit that would compensate for the risk and
the management energy that was required to run a company well.
But why is it that profit is so important? Important enough to dis-
tinguish a job from a company? Here are the three reasons you should
not think of profit as an optional component in your business plans.
First, profit compensates you for risk. Making lots of money at
some point compensates for the times when you aren’t making money.
By starting your firm and
continuing to run it, you are
taking significant risks that
must receive compensation.
If your landlord requires a
personal guarantee, it’s your
butt on the line, not some-
one else’s. If that new client
wants you to ramp up just
for them, nobody but you will own all the equipment now sitting idle
on someone’s desk should something go wrong.
Second, profit is a good indication of your management ability. It
tests your aptitude to manage the process of bringing in new business,
keeping the business that you have, making money on the clients you
are servicing, and keeping expenses low. It is a fair measure that you
should pay attention to, and your business should be poised to make a
profit year after year no matter what external forces conspire against
you. It’s your job to plan ahead so that you can do less reacting and
more benefiting.

Profit is what appears when you do things right. And without it you
have a restrictive job with enormous risk for which you are not being
compensated. You are not obligated to give people jobs. You are not
obligated to subsidize clients. You are charged with making a profit
above any fair market compensation you pay yourself.
Third, compensation is the largest portion of your overhead
expense, and it must be managed. More specifically, your total unbur-
dened compensation load (including a reasonable salary for yourself)
should not exceed 45 percent of your gross profit. So managing what
others make, and leaving enough for yourself, is rightly a consuming
part of your responsibility as a business owner.
In sum, you must think about what you make. And the goal is to
make as much as you possibly can without cheating other people or
hindering the growth potential of your firm.
T H E TH R E E R E AS ONS WHY YO U GET PAI D

Let’s take this a step further and discuss the three reasons why you
get paid. After I lay this out, I’m going to illustrate why it’s so important
to think in these categories. First I’ll talk about how partners should be
compensated when they are doing different things, and second I’ll talk
about how these concepts relate to a key employee who wants to get
paid like a partner … but shouldn’t be.
You get paid for what you do. This is known as a salary. You
shouldn’t get paid for who you are, how long you’ve been doing it, or
what relationship you have with the person who hired you. You should
get paid because of what you do, defined primarily by what you’d have
to pay someone to replace you. Are you working as an art director or
doing the actual job of an account manager at a public relations firm?
The pay for what you do should approximate what you’d pay someone
else, or at least that portion of your pay should only be for what you do.
You get paid for what you own. Many publicly held companies pay
dividends to shareholders, and that’s the best example there is of
getting paid because you own something. Small businesses are simi-
lar; you make a salary (getting paid for what you do), and excess profit

gets distributed to you at the end of the year (getting paid for what
you own). It doesn’t matter if you work in the company, and it doesn’t
matter if you are taking any risk: if you own something, you have a
right to the profit it generates.
You get paid for the risk you take.
The interest rate on a loan is meant to
pay the note holder for the risk being
taken. If you’re being charged 10 per-
cent interest, that assumes that there
will be some default (the note holder’s risk), but that the 10 percent
will more than compensate for that and the use of the money (oppor-
tunity cost or, in this case, coverage for inflation). So, if you are taking
a risk as a principal, you should be compensated for that. Typical
risks include loaning the company money (in which case the payment
schedule already assumes a set interest rate) or a personal guarantee
on a loan, a lease, or even a credit card master account.
Now let’s illustrate why this way of thinking is important.
First, let’s assume that there are two partners in your firm. Nancy
and Jan each own 50 percent of the shares. Neither of them has pro-
vided any personal guarantees, and there is no personal (financial)
risk. Nancy has an aging parent and wants to work half time to care
for her. How should her compensation be adjusted? If Nancy is being
paid properly, her salary is the same as Jan’s, and if she’s moving to
half time, her pay should be cut in half. Since she is not taking any
risk, there’s no component in her compensation that allows for this,
so the second issue is not a factor. But she still owns 50 percent of the
firm, so she should receive 50 percent of the profits—the same as Jan—
even if she’s working only half as much.
Second, let’s assume that a creative director wants to make a lot
more money than he is now. So Bill comes to you—likely not even
knowing what you make—and says that he wants to make $180,000
instead of $140,000. And he wants to share in the profits of the firm
as a partner, feeling like his contribution has a large bearing on how

much money the firm makes. But of course he has no money. Instead,
he feels like he’s earned equity from all the years of work.
You have to explain that he doesn’t necessarily own anything
unless he builds it himself, or buys what someone else has built. You
also have to explain that he won’t be taking any more risk by suddenly
being a partner, since you’ve already personally guaranteed every-
thing that required it. So that leaves the fact that he should get paid
for what he does. In that vein, maybe Bill is worth $180,000. Just make
sure it’s no more than is necessary for what he does or what it would
cost to replace him, and the situation will be fair.
HOW S H O U LD YO U PAY YO U RSELF ?

Some of this might go without saying, but you’d be surprised at how
many situations we encounter where this is not the case.
First, pay yourself a fixed amount regardless of the particular tax
consequences of the entity you own. In other words, put yourself on a
fixed salary or a fixed draw, whether you have a partnership, regular
“C” corporation, sub-chapter “S” corporation, LLC, or no corporation
at all. This forces your firm to be profitable at a level that makes sense
for you personally. In sum, don’t just pay yourself “as you are able.”
Think of yourself as an employee.
Second, set this compensation level high enough to make sense
for your position (see below) and then make sure you can live on it
personally. If you keep having to take more money from the business
to meet your personal bills, either raise your fixed compensation or
adjust your lifestyle.
Third, assume that large periodic distributions for things like tax
payments will fall outside that fixed compensation level.
HOW M U C H S H O ULD YO U PAY YO U RSELF ?

The simple answer to this question was provided above: as much as
you can without cheating others or hurting your company. But that’s
a little simplistic, especially if you want to fit in with your peers. So let

me suggest a few ways to think about this. You can use one of them,
or use them in combination.
Pay Yourself in Relation to Other Highly Paid Employees

Take the compensation paid to your highest paid employee (i.e., s/he
is not a partner) and pay yourself 150 percent of that amount. This
method works better in firms with a number of senior-level employees.
Pay Yourself a Percentage of Your Personal Budget

Determine what you need to live on, and pay yourself 120 percent of
that amount. Put the rest aside, though, and still live on that budget.
Pay Yourself According to Salary Surveys

There are salary surveys done every year by the trade publications.
Find a good comparative base and pay yourself something similar.
Pay Yourself for Three Things

When you’ve landed on a number, run it through the grid above. How
much should you pay yourself for what you do? Think about what it
would cost to replace you. Then factor in something for the risk you
take. The factor for “what you own” will get paid to you at the end of
the year based on how profitable your firm is.
Specific Suggestions
I believe that there are some minimum thresholds that should be
observed. Of course this assumes that, first, you are good at what you
do. Second, it assumes that you are confident in those abilities. Third,
it assumes a certain level of systemization to ensure that you are not
subsidizing clients. Fourth, it assumes that your firm is positioned
such that there are clients who seek you out for your expertise. Given
those caveats, let me suggest a few thresholds.
So, if all four of these things are true, you should be making at least
$100,000 if your firm has a total of four employees (including your-
self), $170,000 for a total of eight, $210,000 for a total of 12, $275,000

for a total of 16, $320,000 for a total of 20, and $410,000 above that.
This is the minimum—you will ideally be able to make more, and during
many years there will be a profit distribution at the end of the year.
In fact, your actual total compensation will be 150 percent of the
threshold above.
The typical creative principal will make less than this; the typical pub-
lic relations principal will make more. And in firms with more than one
partner, obviously the total compensation is lower because it is shared.
Please note that there are many, many exceptions to this in that we
have many clients who make more than this, including small firms and
big ones. It’s all about how you package yourself, your own expecta-
tions, and how you take all those plans and actually implement them.
Checking Your Numbers

When all is said and done, the total unburdened compensation of the
entire employee pool should not exceed 45 percent of your agency
gross income (AGI). If it does, you are subsidizing clients, overpaying
staff, or just not charging enough because you don’t have a strong
enough positioning and marketing plan to control your destiny to the
extent you should. Please note that this equation is specifically for the
unburdened compensation number, which is calculated before taxes,
benefits, and bonuses.
F O R M A LIZ I N G C O MP ENSATI ON
I N A N OW N E RS H I P AGR EEMENT
As noted above, you need an ownership agreement. This is obvious
if you have a business partner. It’s less obvious if you are the sole
working partner but have a life partner (married or not). In real life,
ownership transitions are a frequent source of difficulty.
In fact, divorce is a very common “triggering event” in your own-
ership experience. It could be your divorce, your partner’s divorce,
or even the severing of a long-standing (and unmarried) relation-
ship that has assumed the ownership roles of a traditional marriage,
whether conventional or not.

An ownership agreement relates to compensation issues because

of the theory above: You get paid for what you do, the risk you take,
and what you own. And just like there are disputes that relate to com-
pensation levels for what you do, there are certainly debates related
to compensation levels for what you own.
Absent some written agreement
otherwise, an uninvolved spouse
(or even life partner, in some cases)
shares ownership of your portion
of the business, and when your
personal relationship fails, it
will become a sticking point.
So, if there are two working
partners, Cindy and June, and each
of them is married, Cindy and June would typically operate as if each
owned 50 percent of the business. The problem is this: If Cindy and
her husband, Ron, are divorced, Cindy would soon discover that Ron
owns 25 percent of the firm and she really only owns 25 percent, not
50 percent.
Cindy, Ron, and even June agree that they don’t want to be part-
ners. But what they don’t agree on is how much Ron’s 25 percent is
worth; nor do they agree on the terms of said transfer if Cindy and
June agree to purchase his shares. And of course the time to formalize
this agreement is before there is any tension in the relationship.
C RA F TI N G A N AG R EEMENT
This should be done by a competent attorney who has experience in
working with creative service firms. They’ll know how to ask the right
questions before crafting one, and they’ll make it no more adversarial
than it needs to be.
This agreement will need to be reviewed every few years or when-
ever there are changes that warrant it. The business itself might
change, or the personal relationships of the owners might change.
In either case, make sure the agreement is current.

AG R E E M E N T S C OP E
I am not an attorney and you should not view this as legal advice. But
I have found that most (not just many, but most) agreements are woe-
fully inadequate. The basics are usually covered well, but the tougher
issues are usually not addressed at all. Over the years we’ve learned
to call these the “Five D’s”—make sure your agreement addresses
them. Your agreement should detail what will happen in the event of
death, disability (of a certain level), dismissal (involuntary), departure
(voluntary), or divorce (or separation, even if the two parties are life
partners and not married).
In terms of compensation, you should craft an agreement that
addresses other events that impinge on compensation, too.
Sabbatical
Provide for full pay for either partner, provided that the sabbatical does
not extend beyond a certain length of time and has been determined
with adequate advance notice. There should be a certain sabbatical
period every so many years of full-time work (three months for every
five years is a good starting place). If it is not taken, it is forfeited.
Reduced Hours
An agreement should reduce pay
if a partner’s hours are reduced
by more than 20 percent for
more than a month.
Geographic Move
Your agreement should allow a
buyout if a partner moves to a
location that requires him/her
to spend more than 20 percent
less time physically in the office.

Unequal Financial Risk

Should times get tough and partners are required to take less compen-
sation and/or to infuse cash into the company, and if that sacrifice or
support is unequal because of personal circumstances, your agreement
should address the risk/reward of such arrangements. The same holds
true if one of the partners has personally guaranteed more or less of
the corporation’s financial obligations than the other.
BEF ORECAST
Instead of comparing our lot with that of those who are more fortunate
than we are, we should compare it with the lot of the great majority
of our fellow men. It then appears that we are among the privileged.
—Helen Keller, We Bereaved, 1929
The man with a toothache thinks everyone happy whose teeth are
sound. The poverty stricken man makes the same mistake about
the rich man.
—George Bernard Shaw, Man and Superman, 1903

2
F I N A N C I A L S TAT E M E N T S
PA RT 1: D E F I N I T I O N S
& REPORTING
This chapter examines the basics of reporting, looking particularly at

the role of financial statements and how they are used to detect under-
lying conditions that can be addressed. We discuss the balance sheet
first, followed by the income statement. We then touch on accounting
software, fiscal years, and how to work with an accounting firm. Finally,
we highlight nine common mistakes.
The financial statement is the little pill your mother would have
covered in applesauce just to fool you into eating it. Understanding
the deeper financial aspects of our businesses is easily beyond reach,
but oddly enough, satisfying once the basics are in place.
I N T E R PR ETI N G THE PAST

Why even bother understanding financial data? At the very least, and
probably most obviously, financial data is useful in interpreting the
past. It speaks to how well you have kept employees busy, how effec-
tively you have managed vendor costs, how successfully you’ve kept

Fi nancial Statement s Pa rt 1: D ef i n i t i on s & R e p ort i n g
overhead in check, how responsibly you’ve incurred fixed obligations

such as loans and leases, and how quickly you’ve responded to the
inevitable changes in business conditions.
The cumulative effect of these decisions is reflected in financial
statements: how much equity you have, how profitable you have been,
how much you have spent on employee salaries, and so on.
While financial data is telling, it does not tell the entire story. From
a financial standpoint your firm might be healthy, even while employ-
ees are treated poorly. Or you might have made a conscious choice
to be less profitable in order to create a certain environment. We are
not talking about ruthless capital markets here, and financial deci-
sions need to be moderated based on your goals. But no matter your
philosophy of finance, understanding financial statements is a basic
requirement of running your firm well, according to your own principles.
P R E D I C TIN G TH E F U TU RE
Hopefully, though, you’ll be able to move beyond interpreting the past
to predicting the future. You’ll be able to make changes now, knowing
in advance how those changes will affect later financial statements.
Unless you eat differently and exercise more, the next cholesterol
screening is going to say
pretty much the same thing.
This highlights a major
issue with your advisors.
Many internal controllers and
external accounting firms are
struggling to provide you with
accurate reports in a timely
manner, let alone advise you
on what they mean. If this
describes your situation, make
it clear that you want this additional leadership and give them a chance
to comply. If they don’t demonstrate the appropriate initiative after that
one conversation, consider other advisors. It’s difficult to overestimate

the value of strong financial advice, and in our consulting practice we

can always relax a little when we discover that strong advisors are
already in place. “Strong” is identified as competent, timely, and fearless.
The issue is that the numbers themselves must be interpreted.
They point to an underlying condition, if read properly. An example of
this is the relationship between profit and cash flow. More on that later.
C H A N G IN G TH E F UTU RE
As we discussed in the previous chapter, cash flow difficulty is a fancy
term for not having cash when you need it. It speaks to a temporary,
nonrecurring shortage of cash in an otherwise healthy company.
This might be caused by a large client who isn’t paying their bills,
an unusual one-time expense, or a disruption in normal business
operations.
By definition, cash flow difficulties cannot be recurring. Firms that
consistently struggle with cash flow cannot be profitable in any real
sense. Yet we talk about “cash flow difficulties” because that phrasing
makes it seem like we are being tossed by the vagaries of the market-
place, as if somehow this is a problem that is out of our control.
Strong advisors, whether inside
or outside your firm, would never
let you believe this. They would look
beyond the cash flow difficulties and
help you see that the real problem
is lack of profitability. And then they
might even help you assemble a
plan to solve it.
Remember: Financial analysis
is motivated by a desire to look
beyond the numbers themselves to
detect underlying conditions that
can be addressed.

BAS IC S C O M P O N ENT S OF
FI NA N C IA L R E P ORTI NG
The basic data you’ll need is usually found in two different state-
ments. The first is the income statement, also known as a profit and
loss statement or simply P&L. The second is the balance sheet. (From
here forward you might want to have your own financial statements at
hand to refer to—you might also want to keep the sample statements
in the last section of this manual close by to refer to from time to time.)
A balance sheet is a snapshot in time. It shows what you own and
what you owe on a given date. These numbers change from day to day,
and the statement is only valid for that point in time.
An income statement shows a series of transactions that culminated
in the condition described by the balance sheet. It logs all the money
coming in and going out that contributed to the snapshot contained
in the balance sheet.
Put differently, the income statement describes the transactions
that culminated in the balance sheet. As such, an income statement
is a movie composed of many frames, and a balance sheet is a portrait
that freezes the elements in the viewfinder at that moment.
BAL ANCE SHEET

A balance sheet is organized in three
major categories: assets (what you have),
liabilities (what you owe), and equity (the
difference between the two). Picture a
home that is worth $250,000 (the asset).
Imagine that you owe $100,000 to the bank
for your mortgage (the debt). Your equity
is the difference, $150,000. It is called a
balance sheet because it captures your balances in various categories,
not because the categories balance financially.
Each of these three categories has subcategories, as illustrated
by the supplementary materials at the back of this manual.

I N CO M E STATE M ENT
An income statement is organized in five major categories: sales (the
sum total of all your invoices to clients), cost of goods sold (the direct,
outside costs of those same invoices), agency gross income (fees and
markup income, or what’s left after you pay those outside suppliers),
expenses (internal overhead), and profit (how much money is left
after all external and internal costs are paid).
Sales are also known as billings. Cost of goods sold is also known
as direct costs. Agency gross income (AGI) is also known as gross
profit, gross margin, or revenue. Expenses are also known as over-
head. Profit is also known as net profit or net margin.
Each of these categories is organized into a chart of accounts, and
as each entry is made in a software accounting package, it is keyed
to a particular entry in the chart of accounts so that the appropriate
balance is affected, up or down. Bad numbers are shown as negatives,
in parentheses, or in red.
A chart of accounts is very complicated, but the sample that
appears in this chapter is a simplified illustration of the various
categories you might see on your income statement.
The sample income statement shown is based on an accrual method
of accounting, which without exception should be the appropriate
method of accounting at your firm. Your tax accountant will convert
your income statements to a cash basis once a year, simply to avoid

paying taxes on any money you have not yet received, but from an
internal management standpoint you must be using accrual statements.
The difference between “accrual” and “cash” methods relates to
when income and expense is recognized. For example, you might rec-
ognize something as income when you invoice the client, or you might
recognize it when the client actually pays you. From a management
standpoint, you want to recognize that income close to when you
earned it, not later when the client pays you.
The same is true for the expense side. You should recognize the
expense when the vendor bill is received, not when you later pay it.
Accrual accounting is essential because of the following. First,
accrual accounting allows you to use more current data since you
don’t have to wait 30 to 45 days before getting paid from the client or
paying the vendor. Second, a large portion of your assets is accounts
receivable (the total of your outstanding invoices to clients), and cash
accounting won’t account for any of that asset until you have been
paid, providing a very inaccurate picture of your health. In fact, you
might owe a disproportionate amount to vendors (because they’ve
invoiced you but you haven’t paid), leaving you appearing much less
healthy than cash statements would indicate.
CASH F LOW STATEMENT

Cash flow is composed of four basic cate-
gories. These include a beginning position
(how much cash there is), inflows (how
much more comes in), outflows (how much
of it goes out), and ending position (how
much is left after the inflows and outflows).
Keep in mind that all these descriptions
are greatly simplified to promote basic
understanding of the issues. Financial statements can be much more
complex than this might lead you to believe, and these descriptions do
not strictly follow generally accepted accounting principles (GAAP).

T H E AC C O U N TIN G F UNCTI ON
Your accounting should ideally be done on-site at your facility, both
to maintain control and to facilitate rapid exchange of data. In other
words, don’t gather the data periodically and send it to an external
source for regular monthly reporting. (See below for how to work
with your accounting firm.) Your accounting function might depend
on an outside contractor who is using software remotely, and that’s
fine, but you should “own” the data.
This data should be tracked in software, not manually. This will
lessen mistakes, create a data trail, facilitate different forms of analy-
sis, and be lots easier to read than handwriting.
Stand-alone software accounting packages include Great Plains,
SBT, Peachtree, MYOB, QuickBooks, and many others. There are
dozens of integrated packages for this industry, including Workamajig,
Clients & Profits, AdMan, etc. Our IP is licensed to some of these.
L EGA L F O R M O F O RGANI ZATI ON

Your firm should be incorporated. This will make it easier to segregate
your financial reporting, but the primary reason is for legal protection. A
corporation protects everything that’s not in it, like your personal assets.
In general, too, the corporation’s fiscal year should match the
calendar year. Some legal formats, notably the regular C corporation,
allow you to choose a fiscal year that straddles the calendar year. But
the benefits are negligible, and the disadvantages never stop. Besides,
you’ll have to demonstrate to your taxing body why you should use
anything besides a calendar year.
WO R K I N G W I TH YO U R ACCO UNTI NG F I R M
A competent, proactive accountant is indispensable, and it is likely
that more than half of you are getting neither from your provider. If
that’s the case, consider sitting down with them and explaining what
you want. Set expectations—and the attendant budget—together,
and then provide them with what they need on a timely basis. Give
them a chance, then, to lead and inform. If they don’t, ask around your

community to find a better one. Ideally you’ll be using an accounting

advisor that has experience with firms like yours.
Though the raw accounting should be done under your own license
of the software, expect your accounting firm to support you in various
ways. First, they should periodically review your pending income tax
obligations to eliminate undue surprises. Second, they should peruse
your financial statements, spot-checking the accuracy and classifica-
tion of the entries. Third, they should provide basic financial planning
advice (minimizing taxes, maximizing income, preparing for crises,
etc.). Fourth, they should file your tax returns. Fifth, they should
assist in your defense in the event of an audit. Overall, they can pro-
vide invaluable advice in many areas, though human resources and
marketing are typically not on that list.
C O M M O N M ISTA K E S
There are several mistakes that frequently invade financial reporting.
Here are the more common errors.
Late Statements
In general you should have basic financial statements by the 10th of
the following month. In other words, statements for August should
be on your desk by Sept. 10. Frequently they will be ready sooner,
waiting only for bank statements so that the checking account can
be reconciled.
Long-Term Liabilities
Make sure these are not omitted from the balance sheet. If you have
agreed to a long-term obligation (one that extends beyond the next
12 months), the sum total of the payments should be recorded on the
balance sheet (the next 12 as current obligations and the remainder as
long-term ones). Facility leases are considered assumable operating
obligations and are not classified in this way.

Current Liabilities
Make sure the current portion (the next 12 monthly payments) are
recorded appropriately.
Loan to Shareholders
Technically, any loan the corporation makes to a shareholder is a
corporate asset, since it is money the corporation expects to receive
back someday. In reality, this is usually a tax-planning tool. Typically
the shareholder will take money from the corporation but not have
the additional money, or simply not take the time, to pay the attendant
taxes. So the money is classified as a loan so as not to trigger (yet) the
tax payment. The problem is that these loans are seldom paid back
with real, external cash. Instead, additional funds must be “bonused”
or “payrolled” out to the shareholder (on paper only) so that it can be
paid back (again, on paper only). For example, if a corporation is show-
ing a $50,000 loan to the shareholder as an asset, the real truth is that
this is a $15,000 liability, assuming the shareholder is in a 30 percent
tax bracket. That’s because the corporation will issue a $65,000 pay-
ment to the shareholder on paper, which will net out at $50,000, which
the shareholder uses (on paper) to pay back the $50,000 original loan.
The difference between the $65,000 and $50,000 is used to pay the
taxes. All this is proper from an accounting standpoint, but you’ll need
to recast the data to get an accurate picture of your firm from a finan-
cial management standpoint.
Cost of Goods Sold

The first mistake relating to cost of goods sold is calling it something
else. It is a very small point, but “cost of sales” is a term more appro-
priate for describing commissions for sales. And calling it “direct
costs” can be confusing because it’s difficult to determine what is
direct and what is not. The second mistake is widespread and critical.
Cost of goods sold (COGS) should include all outside expenses, and
only outside expenses. The item that usually slips into this category
is wages for internal employees. The proper definition of COGS is

expenses incurred on the outside, whether marked up or not, that are

specifically tied to projects. This would include freelance labor, media,
printing, etc. It would not include any internal salaries no matter how
direct they might seem.
Depreciation
From a tax standpoint, depreciation only has to be calculated once per
year, but it should be adjusted at least quarterly in order to provide
an accurate picture of your condition. Some firms don’t account for
depreciation at all, and others use data that is not current.
Work in Progress
This refers to work that has been done but not yet billed to the client
(at which point it becomes a receivable). If you are using an auto-
mated management package, you will be able to get an estimate of
“WIP” (pronounced “whip”) and include it properly as an asset.
Client Deposits
On the flip side of the ledger is any client deposit you have received for
which you have not either done the work or billed the client. Until that
happens it is properly viewed as a liability, almost as if the client has
loaned you money. You have to pay it back (return the deposit) or work
it off (complete a project). It’s also referred to as unearned income.
Goodwill
While there might be good tax reasons to show “goodwill” on your
balance sheet, doing so is misleading from an accounting standpoint
and is best left out if you can. It captures the gap between what you
paid for something and what the marketplace thinks it’s worth.
These are the common mistakes made on financial statements. You

might go through them with your financial statement at hand and
determine if there is any room for improvement.
Whew!

We’ve just covered many of the basics, getting the terminology

right and making sure we aren’t making fundamental mistakes.
The next chapter will use a real balance sheet and income statement
to illustrate how a specific firm is doing. In the process we’ll give you
guidelines for measuring the health of your firm, as well as some sug-
gestions on how to use information from the past to change the future.
BEF ORECAST
Some people, because of their personality or training, see the world

as being one-dimensional. For instance, I’ve a friend who’s a dentist.
He’s single, and my wife and I are always trying to match him up with
someone. But whenever we introduce him to a woman and later ask
what he thought of her, he always says something like: “She has a
terrible overbite.” He doesn’t see a person; he sees a set of teeth.
That’s the problem with accountants, except they’re fixated on
taxes rather than teeth.
—Stephen M. Pollan, Die Broke, 1997
Balancing the budget is like going to heaven. Everybody wants to

do it, but nobody wants to do what you have to do to get there.
—Phil Gramm, in a television interview, 1990

3
F I N A N C I A L S TAT E M E N T S
PA RT 2 : I N T E R P R E T I N G
Our second chapter on financial statements examines the basics of inter-

preting them, looking first at how the same financial event can appear
from different reporting perspectives. Using a sample balance sheet and
income statement, we explore six interpretation guidelines, then walk
through four important features of monthly statements and four additional
features of quarterly statements. Finally, we look at three industry bench-
marks you can use immediately in managing your firm well.
This is the second of two chapters dealing with financial statements.

The first dealt with reporting financial data, and this deals with inter-
preting that data.
The first is important because it establishes common definitions
for key reporting categories and suggests how the data should be
organized. As a supplement, we included a sample balance sheet and
income statement. In this chapter, those financial statements actually
include sample numbers that we will use to interpret the condition
captured in the statements.

Fi nancial Statement s Pa rt 2 : I n t e rp ret i n g
T H E TH R E E STATEMENT S
A balance sheet is a snapshot in time. It shows what you own and what
you owe on a given date. These numbers change from day to day, and the
statement is only valid for that particular point in time. A balance sheet
is a portrait that freezes the elements in the viewfinder at that moment.
An income statement shows a series of transactions that culmi-
nated in the condition described by the balance sheet. It logs all the
money coming in and going out that contributed to the snapshot
contained in the balance sheet.
An income statement is a movie
comprised of many frames.
Though we are accustomed to
paying more attention to income
statements than balance sheets,
the latter is actually more important
because it concentrates on our cur-
rent condition as affected by all the
previous income statements, with
an emphasis on the latter. In contrast, an income statement merely
tells us about the factors that have changed our condition from one
balance sheet to the next, not the ending result.
For instance, any particularly unprofitable month might be dis-
couraging. But if it means that an unusually strong balance sheet is
just a little bit less strong, there is seldom cause for alarm.
As with most financial discussions, actual results are not as
important as the direction of movement (better or worse). Because
your balance sheet changes slowly, it is the best indicator of your
overall financial condition.
The third statement, which we will only allude to here, is the
statement of cash flow.
See how each of these three statements might capture the
purchase of $40,000 of computer hardware.

Example No. 1
CASH F LOW VI E W
We are out $40,000. A specific check for that amount was written from
our main checking account, and now we don’t have the cash. Our cash
flow was negative $40,000.
INCOM E STATE M E NT VI EW
We are out $8,000, already having “expensed” (see below) the max-
imum allowable this year. The remainder of our hardware expenses
must be depreciated over five years. From a cash standpoint we are out
$40,000, but we can only claim one-fifth of that expense now, leaving
the remaining four-fifths to be captured in the next four years.
BA L ANCE SHE ET VI E W
Not much has changed except that we have moved some things
around between the categories. We took $40,000 cash (from our
“current assets” section), and then purchased equipment that will
be listed in our “fixed assets” section. Our overall equity is the same,
but that equity is comprised of more equipment and less cash. If we
hadn’t made that decision, our cash might earn a small amount per
year in interest. But if we have made a smart decision, the equipment
we purchased will enable our firm to create much more value than the
interest earned, and slowly this will show up on the balance sheet as
our cash is more than replenished from more productive work, higher
billings, less down time, etc.
Look next at what happens when a client pays a bill, from the same
three perspectives.

Example No. 2
CASH F LOW VI E W
We are up $100,000 because they paid the bill. We received a check for
that amount.
INCOM E STATE M E NT VI EW
We are even. Nothing changes. We already booked the income, (since
we are on an accrual basis, or at least we should be) and it shows up on
the income statement. Our cash position is simply catching up to our
income statement.
BA L ANCE SHE ET VI E W
We are even. Nothing changes here, either. We have merely substi-
tuted one form of asset (“receivables” within the “current assets”
category) for another (“cash” within the “current assets” category).
Though we are only going to look at balance sheets and income

statements in this chapter, you can see how all three statements
work together to provide slightly different perspectives on the same
event. And you can also see how wildly cash flow moves, how income
statements are more stable indicators, and how a balance sheet is the
ultimate measure of your health.
Think of a compass that usually points north. As you walk past
rocks and buildings, it will swing temporarily back and forth as it is
influenced by things nearby (cash flow). But set the compass on a
stable platform in the middle of a field, and it will point steadily north.
That’s the balance sheet at the other end of the financial spectrum.
I N T E R PR ETATIO N GU I D ELI NE S
Here are some guidelines to follow as you interpret the statements
at your firm.
• Be accurate. Obviously that means spot-checking a given entry or
two by requesting backup data, but in this context it’s more about

reporting the information in the appropriate categories. See the

nine common mistakes discussed in the previous chapter.
• Don’t read too much into short periods. In other words, don’t make
any deep assumptions from an income statement that covers less
than one quarter (three months). This is especially true if invoicing
has been delayed or accelerated, yielding associated income and
expenses that don’t fall within the same time period.
• Pay attention to direction, not speed. The point here is to watch
for trends, like increasing profit, increasing equity, increasing cash
cushion, etc. That will indicate sustainable progress.
• Look at the whole picture. Measure the trees, and look at the
forest. A single ratio might be off, but how is the overall picture? Is
that one bad indicator an aberration, or a hint of bigger issues that
should be addressed?
• Distinguish between types of profit. There is pre-incentive net,
pretax net, earnings before interest and taxes (EBIT), earnings
before interest, taxes, depreciation, and amortization (EBITDA),
and home-grown definitions to suit your own purposes. These
examples use pretax earnings (another word for “profit” or “net”).
• Use common size percentages. This is the technical term for
correlating percentages with actual numbers. So net profit should
be expressed as a real number (in dollars) and as a percentage of
something (usually agency gross income, or AGI). Unless your firm
is absolutely stable, the percentage indicator is more telling since
most of the categories on your income statement should remain
constant as a percentage.
MO N TH LY I N TE R PR ETATI ONS
There are several things you should measure monthly, preferably
by the 10th day of the following period (e.g., expect your accounting
department to give you at least a preliminary balance sheet and
income statement for July by Aug. 10). If the accounting is kept up to
date, data is current within a few days of the month’s close, and the
only remaining item is reconciling the checking account as soon as

the statement arrives. The next chapter contains the items that you
should specifically note and interpret.
Q UA RTE R LY I N TER P R ETATI ONS

As noted above, certain measurements should not be done monthly
because they will vary too widely (like looking at your financial port-
folio every day). But measuring them quarterly is ideal, which is why
you should expect the same financial statements by the 15th (instead
of the 10th, since there is more to do) following a quarter. Keep your
eye on the following basics explained in the next chapter.
FI NA N C IA L S C A NNI NG
All of this can be confusing. Remember, though, that the goal is to
get accurate information, and then to arrange it so that the essential
substance can be scanned quickly, like the instruments in an airplane.
Take whatever you find useful here and create a spreadsheet. Before
long you’ll be looking forward to getting those financial statements
and seeing the impact of your management decisions.

BEF ORECAST
We currently have only $3,000 in working capital and will require

approximately $200,000 to commence operations. We do not
currently intend to pay regular cash dividends on our common stock.
We do not anticipate paying dividends on our common stock in the
foreseeable future. We have a limited operating history and have
no certainty of future operating results. Since our incorporation
in 1999, our activities have been principally devoted to positioning
ourselves to achieve our business objectives. We have had no
material operating revenue to date and expect to incur losses and
administrative expenses until we begin the sale of our products or
we receive revenues from any of our proposed operations. We have
so little funds that there is a substantial likelihood we will never
begin operations. If we do not receive additional financing, we may
not be able to develop our business and you could lose your entire
investment. We currently have only $3,000 available for working
capital. We need additional capital but currently we have no revenues.
—From SEC prospectus by the Sea Shell Gallery

4
B E N C H M A R K I N G YO U R
FINANCIAL PERFORMANCE
This chapter looks at how to quantify your firm’s financial performance as

measured against benchmarks for your industry. We begin by explaining
the role that benchmarks play, then walk you through the process of read-
ing ratios safely. We want you to overcome your own possible ratio inertia,
get the numbers right, and then plug them into these fifteen benchmarks.
This chapter builds upon the information in the previous two chapters
on financial statements.
The first of those chapters covered reporting, and guided you
through the process of constructing your financial statements in stan-
dardized fashion. Unless your statements follow conventional rules, it
will be very difficult to benchmark your firm accurately since the data
will not conform to the way others are reporting theirs.
The second chapter focused on interpreting these financial state-
ments, showing you how balance sheets and income statements
interact with each other and how to read them meaningfully.

Benchmarking Yo ur F inan cial P erf or ma n ce
It included a sample balance sheet and income statement, with real

numbers. Later in this chapter we’ll use that same data to illustrate each
of the benchmarks. You will want to refer back to that information as
you work through this.
Let’s talk a bit, first, about the role of benchmarks (and financial
ratios).
W H AT B E N C H M A RKS D O
In any significant checkup, a nurse will check your blood pressure,
respiration rate, pulse, and body temperature. Similarly, financial
benchmarks are life signs that indicate sickness or health. And just as
your respiration rate should not lead to conclusions in isolation about
your health, financial benchmarks must be used in groupings so that
the implications of one ratio do not have undue influence on the cure.
A high respiration rate could indicate hyperventilation, or merely that
you have recently finished a healthy run! Either way, the individual
indication does mean something, and learning how to interpret the
signals will lead to increased health.
What we are doing in ratio analysis is first measuring forward and
backward movement against our own track record (from statement
to statement), as well as comparing our progress with established
benchmarks within our field of business. Keep in mind that the data
you are reading here is not about any small service firm. It is about
firms like yours.

Folks, free enterprise is often made out to be more complicated

than it really is. Essentially, a company provides a service at a certain
cost. If they sell it at a higher price, we call that profitability. In order to
produce the service, they must have certain assets, which are usually
purchased with cash from owners and/or creditors. This mix of equity
(owner contribution) and debt (creditor contribution) comprises
their leverage. Since commerce is not entirely predictable, a certain
amount of cash must be available to ensure liquidity. These three
words classify all relevant financial ratios; in other words, key ratios
measure profitability, leverage, and liquidity. (By the way, liquidity
ratios are more variable with company size than other ratios.)
These various ratios are used for different things. In addition to
judging the health of a firm, they might be used to value a business,
to determine if it’s a safe bet to
lend to or invest in it, or even
to determine levels of incen-
tive compensation.
In some cases we are tak-
ing one measurement and
comparing it with a similar,
earlier measurement. But in
most cases we are measuring
the results against an established benchmark (you’ll see these below),
and this is precisely the value you’ll see in a manual like this: How do
I compare with other firms like mine?
R E A D IN G RATIO S SAF ELY

Bear in mind that ratios can be very misleading, even when compared
to valid standards. The reason is relatively simple. Ratios, like balance
sheets, reflect the condition of a company at one point in time. Even
income and expense ratios that span an entire accounting period
reflect conditions during that period only.
When using ratios to measure your company’s health, it’s necessary
to apply the same ratios to your firm over several years, dismissing

extraordinary events that cause variations from the norm. Such a view
will yield trends—either favorable or not—and provide a reasonable
picture of where you are and where you are headed.
The acceptable range with some ratios varies with the size of
your firm, and even with the rate of inflation. Most, however, are
fairly predictable.
We use ratios first because the raw numbers are too large to be
meaningful. Second, we use them to focus on the relationships between
the numbers, not the numbers themselves. Ratios are merely propor-
tions, and they allow you to account for the fact that numbers do not
change at the same rate. If your cost of goods sold rises by the same
amount as your sales, there is a problem because it should rise at a
slower rate. The fact that your sales have gone down may mean that
you aren’t selling as you should … or it may mean nothing. For instance,
it could be good news if your net profit has gone up in the same period,
meaning that you’ve probably been working for more of the right clients.
OV E RC O M I N G RATI O I NERTI A
Perhaps we don’t use financial measurement because we are too
project oriented, because we don’t know how to do it well, or because
we are afraid of what it will show us. Though these reasons are under-
standable, each carries significant implications. If we are too busy, we
will not likely grow safely or acquire the mental discipline of thinking
from a long-term perspective. If we don’t know how to use financial
measurement, we need to learn the basics … or delegate the process to
someone who can. If we are afraid of what the measurement will show
us, we may learn that the truth is not usually as bad—or as good—as we
imagine. But we should be more afraid of not knowing than knowing.
GET TI N G TH E N UMBERS R I GHT

Let’s dive in. We are ready to do so if the numbers you are using are
accurate. If you are using your own numbers and haven’t yet made
them accurate, make sure that your financial statements are con-
structed conventionally for this field. Make sure you aren’t making

any of the nine common mistakes detailed in our first chapter on

financial statements. If you don’t have the time or the knowledge
to make those changes now, just use
the sample financial statements
included later in this manual.
Here are the things to track
for yourself. Mix and match
them to personalize the
view, yielding a picture that
makes sense to you.
Monthly Overhead
These are the internal, fixed
expenses that don’t vary signifi-
cantly with sales volume. As such they are not charged directly back
to the client. And they exist even if there is no matching income. For
example, your facility lease payment will go on whether or not you are
busy. But the bill for printing that you are reselling to the client won’t
be a factor unless the client places the order. In this case our overhead
is $2,734,670, or 81 percent of agency gross income (AGI), which would
leave 19 percent net profit before income taxes. (The percentage of
overhead and percentage of net profit should always equal 100 per-
cent, since they are both benchmarked against AGI.) The point is to
watch your overhead so that it doesn’t creep up without your knowl-
edge. To keep overhead low, pay attention to your largest expense
categories. They are typically salaries, facility, and health benefits.
Fixed expenses, too, should be avoided wherever possible, since they
cannot be trimmed if trouble looms. E.g., give a random bonus instead
of creating a higher fixed salary. Pay cash for equipment instead of
leasing it. Or negotiate a six-month exit clause in your facility lease.
Interestingly, in our management consulting practice we have a
process called the “Total Business Reset” under which we examine
and advise about 50 firms per year. Several years ago we conducted
an experiment, asking principals to identify their monthly overhead

without first consulting a financial statement. Principals in firms that

had not seen much growth typically guessed their overhead within
10 percent of the actual number. But principals in firms that had been
growing quickly typically underestimated their overhead by 20 to 30
percent. They had lost track of things.
Months of Cash
Our overhead for the 12-month period captured in this income state-
ment is $2,734,670, which would mean that we are spending $227,889
per month in overhead. Looking at the balance sheet, we have $504,143
in liquid assets (the total of petty cash, checking, savings, and invest-
ments). So we have 2.21 months of real cash (cash available divided by
fixed monthly expenses). Generally you should keep no less than 2.00
full months of cash in your business. And to be intellectually honest,
“cash” means “cash,” not receivables, and not access to a line of credit
or other debt instrument. If you have a client-concentration problem,
defined as any single related client that represents more than 25
percent of your AGI, your months of cash should approach 4.00. Even
though you might elect to strip the cash out of the corporation for tax
purposes, a sufficient amount should be left liquid so that it can be
loaned back if the corporation needs it before reserves are replenished.
This is one of the most significant measurements you can make. It’s
like altitude in a plane when you start having engine trouble because
it gives you options and time to implement them. Many firms have
managed to operate more on a hand-to-mouth basis and don’t quite
see the need for such a luxury. But they often find out otherwise the
hard way, with sad impact on staff, clients, and themselves.
Collection Period
You should be examining the age of individual receivables and han-
dling delinquent accounts, but it is useful to take a broad view of your
collection efficiency. To do this, take total revenue ($12,048,291) for
the year, divide by 365 (days in a year), yielding $33,009. Divide that
number into your accounts receivable ($1,514,841), yielding 46 days,

which is the average time clients are taking to pay their bills.
The target is 45 days, and so this would imply that your firm
is doing OK.
There is no harm at all in having a result that’s less than 45
days. In fact, the shorter that period the better. But if it’s greater
than 45 days (some would set the bar even shorter), you have
a collection problem. This could be due to large amounts of old,
bad debt sitting in your receivables or simply clients who regularly
pay late.
Payment Period
Just like you want to know how long clients are typically taking to
pay you, you might want to know how long you are typically taking to
pay vendors. In our example firm, subtract net profit from operations
($626,913) from total revenue ($12,048,291) to yield $11,421,378 in total
expenses (cost of goods sold, or COGS, and overhead expenses). If the
typical invoice is paid within 30 days, your typical accounts payable
balance will be total expenses ($11,421,378) divided by 12, or $951,781.
In our example firm, their accounts payable balance, at this particular
point in time, is $951,782 and their total current liabilities are $1,087,810
(the latter is probably a more accurate measurement). So they are right
on track for meeting the typical obligation within 30 days.
As with the one above, you need to measure it at the same point
regularly and then average the results. For example, measure it at the
end of every month and average at least three of these together to get
a good feel for things. Otherwise, depending on where large invoices
in and out of the shop fall, the results will be skewed.
Debt/Asset Ratio
For every $100 of assets, it’s reasonable to have between $20 to $60 in
liabilities. To calculate this, divide total liabilities ($1,220,787) by total
assets ($2,459,026) to yield 0.50. That is within the acceptable range,
though ideally the ratio would be lower. Even if you have no “debt” in

the technical sense, accounts payable count toward your debt (or
“obligations”).
Of course this particular benchmark is a great place to point out
the importance of constructing your financial statements accurately.
Unless you have accounted for all known obligations (except for
your facility), you might think that you have fewer obligations than
you do. The sum total of all leases and loans (excluding facility lease
payments) should be included in total liabilities.
Equity
This is calculated by subtracting total liabilities ($1,220,787) from total
assets ($2,459,026) to yield $1,238,239. There is no specific ratio for
this calculation that is important, but you do want to measure this
from period to period to see if there are any trends. Typically equity
will change slowly but still remain a telling indicator. Your equity is
also your net worth, which can indicate two things to you. First, it tells
you what you’d keep if you closed the business, just walking away
without a buyer. Second, your equity would form the floor of any valu-
ation. In other words, a valuation of your firm could not, by definition,
be less than your equity. The variable portion is the “goodwill,” repre-
senting the difference between your equity and the valuation.
Current Ratio
If you owe your bank anything, they’ll want to know about this ratio. It
is calculated by dividing current assets ($2,219,235) by current liabili-
ties ($1,087,810). In our sample firm, that yields a 2.04 ratio. It would be
typical for a banker to insist on a number of at least 2.00, giving them
some hope that your firm has enough assets to meet operating needs
and then some. (Calculating your quick ratio is similar, but it leaves
out your accounts receivable, and the standard is lower.)
AGI
This is also known as gross profit, gross margin, or revenue. In the
example firm, we are looking at an entire year, not a shorter period.

On your statements, you’ll typically see a number for a specific period

(the most recent month) and then a year-to-date figure, or a compar-
ison with the same period last year. In this case our AGI is $3,361,583.
AGI increases when you land more work, charge a higher markup
on expenses passed through to the client, or estimate the same job
higher than you would otherwise. There is no guideline for your AGI,
though the higher the number, the more you should be “managing”
instead of “doing.” Because we have isolated COGS, these ratios all
work whether you have, e.g., large media bills or not.
Size of Largest Client

You should be nervous if any
single client—or source of clients—
represents more than 25 percent
of your AGI. You can use revenue
to do this, but AGI is much more
appropriate, since COGS will
disappear if the client does. This
is also referred to as “client con-
centration.” Experience shows that
a firm suffers measurable harm if
any client loss exceeds 25 percent of AGI, and in many cases the firm
suffers permanent damage if the client loss exceeds 35 percent. The
remedy, of course, is to have several “months of cash” (see above) set
aside, as well as ongoing marketing (to avoid the inevitable spool-up
time normally required to see results from that marketing), and then
to adjust expenses quickly.
AGI Billings/FTE
One easy way to measure utilization is to divide your full-time equiv-
alent (FTE) employee count into your AGI. If our sample firm has 18
full-time employees and six employees who each work half-time, the
FTE count is 21. Dividing 21 into $3,361,583 yields $160,075. For this

measurement, the benchmark ($220,000+) is far above the average

($155,000-160,000).
Please note that this ratio is calculated without distinguishing
between billable and non-billable staff. This prevents the situation
where an efficient core of billable staff is supported by a bloated
administrative staff. If you want to do the calculation based on just
billable staff, the AGI would need to be much higher per FTE. I work
with clients regularly where we get their billing significantly higher
than $200,000 per FTE, including all billable and unbillable staff, and
my best clients are far above that.
In this field, the distribution is roughly like this: $100,000-$150,000
is a developing firm; $150,000-180,000 is a typical or classic firm;
$180,000-220,000 is a solid firm; and $220,000+ is an exceptional one.
Salary Load
Your unburdened compensation (not including taxes, benefits, or
bonuses) should not exceed 45 percent of your AGI. So the allowance
for our example firm is $1,512,712, vs. the compensation listed on the
income statement of $1,781,639.
In a downturn, which we’ll discuss in more detail later in this man-
ual, you will pay close attention to this ratio because it will reveal the
depth to which you must trim staff expense.
This does include your compensation as the principal, though you
might have to “standardize” this. In other words, if you are on track
to take out $300,000 gross in the course of a year, you might use a
standard “salary” (without the extra “bonus”) just for the purpose of
calculating this. If you don’t have access to benchmark salary data, a
quick rule of thumb is to use 150 percent of the highest non-principal’s
compensation on your staff. This is explained in an earlier chapter.
Facility Expense
You can comfortably spend 6 percent of your AGI on facility expense,
which includes your monthly lease payment, cleaning, security, taxes,
insurance, etc. If you have a triple-net lease (meaning that you are

responsible for your own utilities, taxes, and insurance), all those
expenses should fall within the allowance. Even if you are buying the
building you occupy, you are likely purchasing it yourself and leasing
it to the corporation. The monthly allowance for our example firm is
$16,808 (AGI times 6 percent divided by 12 months in a year).
Operating Profit
After paying yourself a fair salary, expect to earn 15 to 40 percent
post-bonus, pretax net profit, with 20 percent being a minimum target
to be healthy. In other words, after paying bonuses you should expect
to retain a 20 percent pretax profit (or more). Our example firm has
$621,790 in pretax net profit, which is 19 percent of AGI. Of course any
unusual distributions to you, the principal, will come from that net
profit (the bonuses paid to employees are paid before the net profit
calculation).
Be sure that you do not calculate this on sales. It needs to be
calculated against AGI.
Effective Hourly Rate

Hourly rates are only hourly rates if you charge the client for each
hour that you spend on their behalf, without subsidizing them, as most
firms do. Your effective hourly rate accounts for this subsidization,
isolates markup income (which should compensate you just for risk),
and yields a very useful measure of your utilization.
Let’s presume that our sample firm has 21 FTE employees (18 full-
time and six half-time). And let’s further assume that they work, on
average, 42 hours per week, and that their average weighted markup
is 10 percent.
To isolate their markup income, multiply COGS ($8,686,708) by
10 percent to yield $868,671. Subtract this from AGI ($3,361,583) to
arrive at $2,492,912, this firm’s income from fees. (Remember that
AGI is composed of fees and markup income—we have just isolated
the income from fees.)

There are 21 FTE employees working an average of 42 hours, likely

for 46 weeks per year (after holidays, vacation, personal, and sick
time). This is 40,572 hours per year.
Divide that into the firm’s income from fees ($2,492,912), and we
end up with an effective hourly rate of about $61 per hour.
If you keep an eye on that number, you’ll discover that it’s a very
useful indicator of your marketing, systems, hourly rates, and staff
load. It should rise over time, too.
Gross Profit/Sales
As we’ve discussed elsewhere, total sales is nearly meaningless sim-
ply because the percentage of pass-through expenses (COGS) is so
variable. While there is no benchmark for this, it’s still useful to look
at because it indicates the trends of the amount of direct expenses
you are being asked to manage for clients.
In the case of our sample firm, gross profit ($3,361,583) divided
by sales ($12,048,291) yields .28. Stated differently, gross profit is
28 percent of sales, while COGS represents 72 percent of sales.
It doesn’t matter what this number is as long as you see and
understand the trends.
Finally, measure these at fixed intervals, throw them into a
spreadsheet, and begin to understand your business even more
than you do now.

BEF ORECAST
Our Values
Communication: We have an obligation to communicate. Here, we
take the time to talk with one another…and to listen. We believe that
information is meant to move and that information moves people.
Respect: We treat others as we would like to be treated ourselves.
We do not tolerate abusive or disrespectful treatment.
Integrity: We work with customers and prospects openly, honestly
and sincerely. When we say we will do something, we will do it; when
we say we cannot or will not do something, then we won’t do it.
Excellence: We are satisfied with nothing less than the very best
in everything we do. We will continue to raise the bar for everyone.
The great fun here will be for all of us to discover just how good we
can really be.
The following financial statements of Enron Corp. and subsidiaries
(collectively, Enron) were prepared by management, which is respon-
sible for their integrity and objectivity. The statements have been
prepared in conformity with generally accepted accounting principles
and necessarily include some amounts that are based on the best
estimates and judgments of management.
—Taken verbatim from the last annual report Enron filed

5
FUNDING GROWTH
This chapter examines the options for funding growth, why fixed obliga-
tions can be dangerous, how fixed obligations and failure are connected,
and why you might want to fund growth with cash.
I’m frequently asked how to fund growth. I’m going to answer that
question here, too, but first I want to lay a foundation for why I answer
that question a certain way. In the end you may disagree with me,
which is fine, but you at least deserve more than just a simple answer.
Let’s first review our options for funding sources.
First, growth can be funded from ongoing operations. When more
comes in than goes out, there’s a certain amount of leftover funds
called profit, and that profit can be used to make investments in the
future of a company. These investments may take the form of hiring
an employee before you really need him or her, purchasing equipment
for that employee, building out a nice new space, etc. The money to do
these things isn’t missed because there’s plenty of money there in the
form of ongoing profit.

Fu nd ing Grow th
Second, growth can be funded by deferring expenses. Even though

you may be on the hook for certain obligations, you may decide to not
pay them promptly, stretching the vendor out and using the money in
other ways until new money comes in. So a client might prepay you
for media expenses, but in this scenario you don’t set it aside for that
media expense but instead use the funds to cover growth.
Third, growth can be funded with outside funds. These can come
in the form of a line of credit, a loan, or the simple use of credit cards.
You are borrowing money, and in the process borrowing from the
future. That’s because the money eventually needs to be paid back,
and you’re betting on the fact that in the future you’ll not only have
enough money coming in to cover expenses, but you’ll have enough
extra coming in to cover the cost of paying back the funds. One import-
ant point to keep in mind: the proceeds of a loan are not taxable—but
the amount of principal that you pay back isn’t deductible, either.
Fourth, growth can be funded with operating or capital leases.
An operating lease is essentially a locked in rental agreement. A
capital lease is a locked in purchase agreement. These are expensive
propositions and very inflexible.
Fifth, growth can be funded with a personal loan to the company.
Say you have more liquidity in your personal assets than your corpo-
rate ones, and you decide to loan money to the corporation. This is
really a self-dealing loan between parties at arm’s length, but it can
be a useful tool to cover temporary shortfalls.
Sixth, growth can be funded by cheating or stealing. You wouldn’t
think that I’d need to put this on the list, but you’d be surprised at how
many principals do this. For example, they withhold deferred retire-
ment funding from an employee’s paycheck, at their request, but then
don’t remit the funds to the retirement plan. Or taxes are withheld
from a paycheck but not remitted to the proper taxing authority.
W H Y TH I S M AT TERS
So those are the possible sources of funds, but why does this matter?
Most importantly, it matters because there is a strong correlation

Fu nd ing Grow th
between your choice of funding sources and

the (eventual) possible failure of your business.
Debt is like a pain pill. It numbs the
underlying condition and you can get
hooked on it.
Think of it like this. You need something,
or at least you think you do. But you don’t
have the cash for it. On the other hand,
you feel so strongly that you need it that
you’re willing to try one of the other funding sources listed above just
to get it. Doing so allows you to ignore the real problem, and that’s this:
if you need it so badly, why isn’t the business profitable enough to be
throwing off enough cash so that you can pay for it up front? There’s an
underlying condition there that really should be addressed, but your
use of debt enables you to ignore that condition and just let it continue.
Some of the firms not making much money use debt inappropri-
ately. Stated otherwise, not using debt doesn’t ensure a profitable
operation. On the other hand, wildly profitable firms never seem to
borrow from the future.
“Of course,” you say. “Because they are wildly profitable they have
enough cash to fund operations!” It’s a chicken and egg thing, though.
Why are they profitable? Because they don’t ignore operational issues
but rather deal with them directly and promptly. There’s nothing (like
debt) to mask the problems they face. At a more practical level, they
have no payments going out, so they have more money! Using debt
is a vicious cycle.
There’s a fair bit of overlap in how you use money in the business
and how you use money personally. The “personal” in “personal
finance” is just that. So it’s a little hard to talk about this without
getting personal in the process. There is some overlap.
I’m not beating you up, though. Learning the value of money and
avoiding debt didn’t sink into my own way of life until I made my own
mistakes with money, and that’s when I learned the tough lessons.

Fu nd ing Grow th
I have also had some good mentors who have demonstrated financial
values and been terrific guides.
I’ve also learned by watching my clients make many, many mis-
takes with fixed obligations instead of facing the music and paying
cash for things.
All this to say that I hope you’ll take these recommendations in
the proper spirit, knowing they are coming from someone who made
mistakes, has seen mistakes, and cares about the outcome.
BAS IC PH I LO S O PH Y
In a nutshell, I would only incur fixed obligations (loans, credit lines,
balances on credit cards, and capital leases) for appreciating assets.
And even for them I’d be hesitant to incur fixed obligations.
How realistic is this? Very. I follow this myself, and probably one-
half of my clients follow it. It’s difficult to make that initial transition
to an obligation-free business life, but with determination it’s quite
possible. Afterward, you’ll be surprised at how much money you have
and discover that it’s easy to pay for things as you need/want them.
I’m a huge risk taker, but I’m very conservative with funding growth
and operations. Being conservative that way actually enhances your
ability to take risks. That’s because even in the worst case scenario you
just drop down to zero. You don’t drop below zero (via fixed obligations)
and thus there’s nothing in the past that must be cleaned up in the
present or the future.
So the basic philosophy is this: avoid fixed obligations entirely, but
maybe consider them for appreciating assets. Assets in that category
include real estate, some art, etc. But the typical exception you’d carve
out is buying your own building. That is addressed elsewhere in this
manual, but generally it makes sense to buy a building if you can pay
30 percent down and then pay off the note within fifteen years.

Fu nd ing Grow th
S O M E F I N A L R E AS ONS TO AVOI D
FI X E D O B LI GATI ONS
In addition to masking other issues that should be addressed in other
ways, there are a few other good reasons to consider running your
firm without fixed obligations.
First, you spend less. There was a study by Consumer’s Union
that found that paying cash for things like a dinner resulted in lower
spending. There was something about paying cash that made people
look more carefully at their expenditures. Try it yourself some time.
Pay for a nice dinner out of cash instead of with a credit card and see
if it doesn’t feel a little different.
Second, avoiding fixed obligations makes it much easier to cut
spending during a downturn. Having fixed obligations usually means
that you have to cut deeper on the personnel side of things, which is
unfortunate.
Third, funding growth with cash forces you to grow at a more man-
ageable pace. Spending only cash acts as a natural brake to runaway
growth because there’s only so much cash you can safely spend with-
out jeopardizing your business.
BEF ORECAST
So many aspiring entrepreneurs I talk with believe that at the heart

of self employment must be passion for your work, a journey towards
self fulfillment, an end to repetitive, unchallenging tasks assigned
in the corporate world. While all of those things are reasonable
goals to have, the true heart of self employment is making a profit.
Becoming self employed isn’t limited to filling the hours of your day
in a constructive fashion, you have to make a profit or your attempt
at starting a business is just an unpaid vacation.
—Morris Rosenthal, Becoming Self-Employed Without
Losing Money, 2010

6
P ROJ EC T I N G YO U R FI R M ’ S
CASH FLOW
This chapter starts by defining cash flow, contrasting it with other financial
statements, discussing the implications of poor cash flow, and explaining
how poor cash flow is a symptom, not a disease.
Next we examine the data you’ll need to build the
projection, how to build the file, and how to extract
the data from your financial reports. Finally, we
suggest how to act on the predictions based on
where they point.
Cash flow is like blood. When it’s healthy and

flowing, nobody thinks about it, and rightly so.
Cash is how we transfer value from one party
to another, whether that involves a client, an
employee, an investor, a lender, or a vendor. Like
blood carries oxygen, cash carries business life.

P rojec ting Yo ur Fir m’s Cas h F low
W H AT I S C AS H F LOW ?
Cash flow is the difference between what comes in and what goes
out during a given period. If more comes in, it’s positive cash flow.
Otherwise it’s negative cash flow, and the difference between what
comes in and what goes out must be taken from your reserves or
other sources. When no more is left to supplement this continuing
cash flow deficit, you’ll be insolvent.
Cash flow must be understood in relation to accounting methods,
too. The accrual-based accounting system presents financial results
as though all the transactions have already been settled in cash. Cash-
based accounting contrasts strongly with that approach by recording
only what actually did take place in cash terms. Each method distorts
what really goes on in the business. The cash-accounting approach
misrepresents the underlying business and economic realities of the
firm in terms of the flow of value. The accrual method leads people
unfamiliar with cash flow to believe that the income statement reveals
cash truth when in reality it reveals an “as though” cash truth.
It can all be simplified to this. All cash comes from customers,
investors, and lenders. And each source has costs, delays, limits, risks,
and expectations associated with it. These must be balanced no mat-
ter what your condition. If your business is very healthy, you need to
make sure that your cash flow doesn’t impede that health, very much
like making sure a race car has fuel. No matter how fast the car can be,
if there is no fuel, there’s little chance you’ll be able to take advantage
of opportunities when they arise. You have the luxury of focusing on
the long term with an occasional glance at the short term.
But if your business is not healthy, balancing these sources of cash
without hindering your long-term viability is the focus. You must focus
on the short term, with an occasional glance at the long term.
FI NA N C IA L PE RS P ECTI V E S
There are three key financial statements that each tell a different part
of the story about your firm. Your balance sheet speaks to your finan-
cial condition at a moment in time. Your income statement speaks

of your financial profitability over a given period of time. Your cash

flow projection speaks to your financial viability in the near future.
Your balance sheet is the most accurate, telling statement of how
well you’ve run your company. Even though it doesn’t predict cash
flow per se, a quick glance at the cash balances will give you a pretty
good idea of what’s happening. It speaks to cushion, profitability, lever-
age, etc. Changes in your balance sheet are very slow, but also telling.
If your balance sheet is more like a snapshot, your income state-
ment is more like a movie, composed of many frames. The sum total of
the financial events is reflected in the balance sheet. It’s an important
statement because it measures efficiency without regard to billing
issues. Look at your income statement now and you’ll soon discover
where your balance sheet will be in the very near future.
A cash flow projection looks ahead to see what actual, usable
money will come in and go out of the company to keep it running.
These varying perspectives make it clear why projecting your cash
flow is only appropriate under certain circumstances, namely, when
there isn’t much of it sitting around! Otherwise it’s a waste of time and
not terribly indicative of your firm’s health.
Here’s a quick rule of thumb. If your cash position ever dips below
the equivalent of two full months of overhead expenses, start project-
ing your cash flow. If you have a single large client, start earlier.

I M PLIC ATI O N S O F P O OR CASH F LOW

Insufficient cash flow is rare, but when it happens, the implications
are significant. Here are the major ones we see.
Diminished Staff Effort

Your employees might not know the details, but they know if you are
struggling with cash flow issues. If it’s more than occasional, they’ll
adjust their expectations—and confidence—to a lower level. This
translates into a bit of apathy.
Diluted Management Attention

As a manager, you’ll be forced to expend valuable energy managing
cash flow instead of other tasks that your firm might very well need
from you, like marketing. Even if managing cash flow doesn’t require
much actual time, it is distracting.
Missed Opportunities
It’s a cash world, and many opportunities require quick action. If you
have a sufficient cushion, you might very well do something in the short
term that lowers your income or raises your expenses, like expending
time and money to pitch a major account. This is an acceptable risk
because it will not cripple your firm.
Inconsistent Positioning and Pricing

When cash flow is tight, you’ll find it more difficult to maintain an even-
handed approach to pricing. You’ll set prices high because you really
need the money, and then you’ll set them low because you really need
the project! And of course this doesn’t affect just pricing. It affects your
positioning, too, as you flirt with casting the net wide in order to land
as many fish as possible—never mind that nobody likes to eat carp.
Uneven Staff Management

The same frustrations can also seep out in your interactions with staff,
as you alternate between gratitude and panic.

SY M PTO M O R D ISE ASE?

Cash flow difficulty is not a disease, and thus it cannot be treated.
Cash flow pressure is a symptom of one or more things that are wrong,
and as with any symptom, it can be masked. But without treating the
underlying disease, the symptom will reappear as the untreated disease
progresses. If your firm is struggling through cash flow issues, one or
more of these seven reasons are causing the difficulty.
Insufficient Cushion
Business volume levels are not steady, which is why you should plan
for eventualities. Many circumstances could precipitate a need to
reach into your reserves, and if they are exhausted, you are faced
with a cash flow issue. Your cushion should be sufficient to relieve this
pressure. The actual cushion should be no less than two and no more
than four months of overhead in cash.
Overreaching Growth
If you have been growing quickly, you have incurred some expenses
for which you have had to expend the cash far in advance of realizing
the deduction. That, plus just increasing capacity before the income
catches up, can strain cash. If you have been using cash as a natural
filter to slow your growth (a very good idea indeed), you will have
encountered situations where fund-
ing your growth with cash would have
depleted your cash reserves below
that optimum level. That’s precisely
when you know that you are growing
too quickly and it’s time to take a deep
breath and reassess where you are.
Client Concentration
If you have a normal cash cushion and
lose a client that represents up to 25
percent of your fee base, the impact

will register in your financial statements, but within a few months

you should have recovered. This is especially true if your client
agreements specify an appropriate amount of prepayment and an
appropriate advance-notice clause. Any drop in income before your
new business efforts pay off will have been offset by cash reserves.
But if you lose a client that represents more than 25 percent, there’s a
good chance that your cash reserves are not sufficient to restore you
to health quickly.
Collection Difficulty
All your profitability is typically measured in terms of accrual
accounting. In other words, your accounting assumes that the client
will pay. But if they don’t, these same accrual statements will need to
be adjusted, lowering or eliminating your profit and then reflecting
your actual cash position. Even if you eventually get the money, the
delay must be accommodated with your own cash.
Inappropriate Overhead
Regardless of the cause, not adjusting overhead downward to match
a corresponding drop in income will cause cash flow difficulty.
Overhead doesn’t need to be adjusted immediately, but the firmness
of your reaction should be indirectly related to the amount of reserves
you have on hand.
Embezzlement
As immune as you think
you are to embezzling,
remember that everyone
felt the same way until they
discovered it. Embezzling
is very common among
marketing service
firms, and if it goes

too long before it is caught, it can create a very severe cash flow crisis
that might take years to reverse.
Poor Financial Reporting

Do you get accurate, regular, timely financial statements that you
understand? Do you chart the trends to keep your finger on the pulse
of your firm? Don’t ever be surprised at financial performance, even
if that’s not one of your management strengths.
To reiterate a key point, cash flow is a symptom of a disease, caused

by one or more of the seven things discussed above. To avoid cash
flow difficulty, maintain an appropriate cushion, manage your growth
carefully and pay as you grow, build extra cushion if you have a
client-concentration issue, keep a tight rein on accounts payable,
adjust your overhead in a timely fashion, put embezzling controls in
place, and create a culture of appropriate financial reporting. Then
you’ll be all set.
C AS H F LOW AS A P C CONCEP T
Hopefully you agree that cash flow difficulties are a symptom.
Unfortunately, you’d be in the minority. To hear principals talk about
what they are facing, you’d think that cash flow is something outside
their control. It’s not, and most situations labeled as cash flow chal-
lenges are more about profitability problems. It’s politically correct
terminology for mismanagement.
By definition, cash flow difficulties cannot be recurring. So if you
are regularly struggling with cash flow issues, you are really strug-
gling with profitability issues.
People talk about their cash flow issues as if someone else has
done this to them, when in fact it is their job to make sure that other
people do not have that power over their businesses.
Your best bet is to be honest about what’s happening, identify the
causes, and then fix them. If your solutions don’t start by recognizing
your problems, you’ll equate having cash with business health, and

that’s not safe. To illustrate this with just one example, if you fall into
this trap you might authorize expenditures based on whether or not
you have the cash, not whether you can afford the purchase.
GET TI N G R E A DY
There are three things you’ll need to consider as you prepare to put a
cash flow projection together. First, communicate clearly with others
whose efforts you’ll depend on to make this happen. This includes
your accounting department, key managers, and the person responsi-
ble for new business development.
Second, gather the financial data you’ll need. This includes your
cash position (checking and savings), aged accounts payable, aged
accounts receivable, projected overhead expenses, and new business
prospects.
Third, collect any previous cash flow projections you have made
and compare them with the actual results. This will help you discover
where you’ve consistently estimated incorrectly.
BU I LD I N G TH E PROJECTI ON
How Often?
As explained above, normally you don’t want to focus on cash flow
projections. Once you slide over the boundary that indicates you
should start doing projections, do them monthly. If your situation
doesn’t stabilize or improve, do it every two weeks.
How Long It Takes

The first projection will probably require one or one and one-half full
days. Updating the projection should require only a half-day to com-
plete. At that point the file is already built and you know how to do it.
Projection Period
You should project your cash flow for at least two months into the
future, but no more than three months. If you don’t project it at least

two months, you will not have sufficient notice of an impending crisis
to effect change. If your projections extend beyond three months into
the future, the income portion will be so inaccurate that you won’t
know what to do.
Who Does It?

You and your internal controller should do the first one. From there
your controller should revise it.
Who Sees It?

Everybody who helped provide information for the analysis should
get a copy of it. In addition, if you happen to be an “open book” firm,
all managers will see it, and perhaps all staff. Most people will only
opt to share this with the group that helped develop the projection.
Format
The final projection should include a one-page summary projection,
followed by no more than one page of recommendations that flow
from the projections. Attached to this should be copies of the support-
ing data that informed the projection.
P ROJ EC TIO N F O RMAT
Software
The projection should be built in a spreadsheet, for two reasons. First,
you’ll be able to change the variables and instantly see how each move
affects the outcome. For example, if you put off that key replacement
hire until three weeks later than originally planned, you’ll be able to
keep your payables current. Second, by using a spreadsheet format,
you’ll avoid math mistakes.
Elements
Cash flow projections are very simple, and there are only four elements
in each. Begin with your starting position: how much cash you have

on hand now. Second, determine how much additional cash will come
in for a given period, usually one month. Third, determine how much
cash will go out for that period. Fourth, calculate your ending cash
position. The next month’s projection starts where the last month
ended, since that’s how much cash is carried into the new period.
Keeping Score
For each month, include an “actual” column to be completed after the
month ends. Your purpose is to learn from any mistakes you’ve made,
thereby improving future projections.
P LU G G IN G I N TH E DATA
Start with Cash

List your balances, creating a separate line item for each type of
account you have (checking, payroll, savings, investment, petty cash,
etc.), then total them.
Add Receivables
Next, print out an aged accounts receivable. (The “aging” will tell you
how old each balance is in addition to how much it is.) Check off those
invoices for which you believe you will actually receive payment
before the month ends. List these separately on another sheet, then
transfer the total to the cash flow summary. You need the detail so
that later you can go back and determine how you came up with the
number, as well as compare “actual” with “projected” payments. If
you are using a spreadsheet, create a different worksheet behind the
summary, list each invoice, and then have the file automatically carry
the balance to the summary.
Check your work by dividing the total estimated sales for the year
by 12. Does this match your projection? If not, why? High sales this
month? A dispute over an invoice? Sales are climbing rapidly?

At first you can lump all sales together. Eventually, you will want to
project income (and expenses) by category, separating labor from any
out-of-pocket expenses that are re-billed to clients.
After calculating your starting point, cash on hand, always cal-
culate your income first. If you calculate your expenses first, you’ll
subconsciously predict enough income to cover them. To be intellec-
tually honest, you need to start with income so that you aren’t unduly
influenced by expenses. The best method is to average the last three
months, then adjust for any known aberrations.
Read the Pipeline

The most important component of your cash flow projection is the
new business pipeline, and unfortunately that’s also the most difficult
to predict. In a normal environment, combine the total value of the
proposals you have made and then assume that one-half will material-
ize. This fraction will go up or down depending on your skill in closing
new business deals, apart from requests for proposals to which many
firms respond.
Be Realistic
As an entrepreneur, your tendency is to seldom be realistic. You are
either optimistic or pessimistic, and your unique job requires both.
You need to be optimistic when things are tough and the new busi-
ness development fires are burning. You need to be pessimistic when
it comes to designing contingency plans and accounting for them. It
requires significant personal discipline to make realistic projections.
The total of your starting balances, plus the cash you expect to
receive from invoices, new business, and other sources, is the amount
of money you will have to work with this month.
Determine Expenses
Start with your variable expenses. These are the ones associated with
particular jobs—the ones that you mark up and charge back to clients.
To do so, print out an aged listing of your payables, selecting and listing

any that you will pay within the month. Enter them individually as you
did with receivables. To make sure you’ve dealt with all the significant
ones, flip through your receivables listing and note any large bills that
will be coming and which you will pay before the end of the month
(a large printing bill, a meeting planner’s bill, a photo shoot, etc.).
Check your estimate by dividing last year’s total cost to vendors by
12 to get a monthly figure, and add a percentage based on how much
you expect to grow this year. Does it match? If not, is there a large bill
out of the ordinary?
Subtracting your variable expenses (what we sometimes call
“cost of goods sold”) from your total income leaves the remaining
cash available to cover operating expenses.
If you have a budget, get your average operating expenses from
there, modifying them only if some month will be out of the ordinary.
If you don’t have a budget, look through your income statement to
prompt you for all the expense categories that are appropriately
“overhead” (payroll, associated taxes, rent, insurance, etc.).
Remember to only list what you will actually pay in that month.
If you pay your business insurance policy yearly, it should show up
as a large expense in only one month.
Calculation
Take your starting position, add your income, and subtract your
expenses. What remains should be your cash balance at the end of
the month. Do be sure that you include other sources of cash, like
investor infusions, proceeds from a loan or credit line, or refunds.
You’ll start next month’s projection with the ending balance from
the previous month.
AC TIN G O N TH E P R ED I CTI ONS

What’s left after subtracting your operating expenses is called “positive”
or “negative” cash flow. Positive cash flow occurs when you have more
money left over after paying all expenses. Negative cash flow is a
misnomer—the cash quits “flowing” before the expenses do!

If it’s obvious that you’ll need to make some adjustments, start

by deferring or eliminating expenses. Maybe you don’t need that
new software or whatever. Do not adjust your income to cover your
expected expenses. That’s not intellectually honest.
If that’s still not enough, you might make those tougher decisions
now. That removes some of emotion and agony from it. For example,
make a note to yourself that on the 15th you will be forced to dismiss
Bill from the copywriting department. You’ll give him two weeks of
severance pay. But, if you exceed your new business projections
during that period, you can delay the decision. In other words, set
tough actions into motion and then just execute them at the appro
priate time, unless your situation improves.
STA RT TH IN K IN G LONG TER M

Hopefully any cash flow issue is not recurring. If it is, as we discussed
above, your trouble is with profitability, not cash flow. The problem
with continually struggling with enough cash is that you start to get
used to it and might be tempted to relieve the pressure in counterpro-
ductive ways.
If any of you are in that
position, it’s time to bite the
bullet and make some tough
decisions. Start thinking
long term and don’t put
another single patch
on that tire. Draw a line
in the sand, suck it up,
and make very painful
decisions now that will
put you on a smarter,
healthier path. More
specifically, avoid these
five things.

• Factoring: Don’t sell your receivables to an outside firm, who will

front you the money for a percentage of the value.
• Borrowing your way out of debt: This probably doesn’t need much
explanation except to say that it doesn’t work.
• Skirting payroll taxes for yourself: Don’t front yourself money as
a loan from the company just because you don’t have the funds to
pay the withholding taxes.
• Not remitting withheld taxes: And if you’ve withheld payroll taxes
from employee paychecks, send it to the government when you
should. Don’t live off it.
• Masking difficulty with outside money: Don’t avoid tough
decisions by bringing in outside money that will make it worse
in the long term.
Best wishes as you balance short- and long-term decisions for the
health of your firm.
BEF ORECAST
With few exceptions, debts have to be paid in cash. Salaries have to

be paid in cash. Virtually everything has to be paid for in cash. You
may get two weeks, or 30 days, or other terms on which payment is
due, of course, but when it’s due, it’s due in cash. When your enter-
prise has a bill to pay, nobody really wants the wondrous things your
designers, architects or programmers could do for them. Nor does
anyone want to be paid with a stack of receivables due, even from
your very best customers.
—Bill McGuinness, “Cash Rules,” 2000

7
COLLECTIONS
This chapter looks at whether you have a problem with collections,

then presents four causes that might be contributing to the problem.
Next we look at the most common reasons why clients don’t pay, how
to determine whether your collection problems are typical or atypical,
and thirteen suggestions to lay a foundation for getting paid. From
there, we offer specific guidelines for collection behavior, and then
provide seven early-stage reactions that are most appropriate when
less than ninety days have passed since the unpaid invoice was issued.
Then we list fourteen late-stage techniques to collect your money after
that threshold has been passed.
It certainly isn’t fun to chase money. It’s worse, even, than chasing
new business! At least then you have some fun work to look forward
to. Here, you’ve already done the work but not gotten paid for it. It’s
a personal affront to not get paid, and it produces a mixture of anger,
panic, and despair. This chapter is meant to help you collect as much
of what’s owed to you as possible.

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I M P O RTA N C E O F COLLECTI ONS

This topic of collecting what’s rightfully yours is important for several
reasons. First, that outstanding money will go straight to the bottom
line with minimal effort. Most companies do 80 percent of their work
just to meet expenses and stay in business. It’s the final 20 percent
that enriches the principals above and beyond their salaries.
But in the case of uncollected receivables, you’ve already covered
the expenses and you are still in business. And all 100 percent of the
proceeds will go straight to the bottom line. In other words, collecting
the money is a good investment to make. When the money arrives,
particularly if you’ve been chasing it for some time, it’s like a gift.
Second, having to chase the money at all is demoralizing, irritat-
ing, frightening, and distracting. It’s far better to run your firm in such
a way that it seldom becomes an issue. The “collectability” of these
funds drops precipitously as time passes, too, so you need to learn
how to prevent these situations in the first place, and then how to
resolve them quickly when they pop up.
Third, this topic is particularly important if you are a small firm.
Dun and Bradstreet tells us that the firms least likely to get paid are
those with ten or fewer employees. Even if you have more than that,
when it comes to receivables, there are unique risks in being a small
service firm.
P RO B LE M O R SY M P TOM?
On the surface, the problem we are dealing with is clients who don’t
pay. In other words, if they pay, the problem is solved, right? That view
is flawed because it doesn’t take the big picture into account. In other
words, why didn’t they pay? That’s the problem. The symptom is non-
payment. The problem is the kind of client you have, and/or the lack
of safeguards in place.
You very seldom don’t get paid because you didn’t do good work for
a client, or even because you didn’t treat them well. Once again, their
nonpayment is a symptom. It could be that they don’t like you, they
are thieving idiots, they don’t have any money, or they’ve received

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greater pressure from somewhere else. And the only power they have
is to withhold payment.
YO U A R E TH E PROBLEM
Don’t you love to pick up a manual to find solutions and then be told
that you are the problem? Well, it might not be a popular thing to say,
but you actually have far more control over the situation than you
think, if you act sooner and with greater resolve.
For example, how desperate were you in accepting work from this
client, when all the while your instincts were screaming “run”?
Why did you relax your standards and just dive in, neglecting to fash-
ion a fair agreement and get an appropriate amount of money up front?
Once things turned sour, why were you afraid to jump in more
quickly and with greater conviction?
In many sports, the only time you are in complete
control is at the serve. The only time you are in complete
control of a client relationship is at the outset, and
only then if you have options (coming from a strong
marketing plan) and patience. We compromise for
several reasons.
Afraid to Lose the Business

We’ve worked mighty hard to land this new client, and
we remain tentative about the relationship. “If I press
any point too hard, will that tip the scales and lead them
to my competitor instead?” We figure that we’ll hook
them with our stellar service and product, and then they’ll have no
choice but to abide by the terms we demand. We’d rather get a foot in
the door, believing that leverage—however small—will get us all the
way into the boardroom, where we’ll be granted a seat at the table,
with our own water pitcher and all! Instead we end up with a bruised
foot and little money to show for it. And thirst.
But if formalizing the terms and requiring a reasonable deposit
tips the scales, we have another problem on our hands. Namely, they

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aren’t coming to us for the right reasons in the first place. Which leads
to the next point.
Wrong Customer in the First Place

No amount of customer service will turn a bad client into a good one,
just like no amount of management will turn a bad employee into a
good one. Part of what it means to be a good client is the notion that
they want you to make money, and understand fundamentally that
you won’t make money unless you are paid. Do your clients begrudge
you the money or do they pay it, grateful to have found you?
Untrained Collectors or Unclear Roles

Who is responsible for this at your firm? The account person?
Bookkeeper? You? Clear role definition is the place to start. From
there, make sure people know what is expected of them, and give
them the tools and information to do it.
Unclear Policies to Client

Walk the client through it while there is no tension, making sure they
understand. Then follow the policies, obviously, in accordance with
how you have explained it.
W H Y TH E C LIE N T MI GHT NOT PAY YO U R BI LL

There are five primary reasons for not getting paid. In some cases
more than one of these applies, but there is usually one overriding one.
Intentional Thievery
It is not very common, but occasionally you’ll run across a client that
doesn’t pay their bills as a matter of course. Their personal and busi-
ness lives are full of deceit, and the employees who don’t leave are
often cut from the same cloth. They are very good at promising the
moon and delivering a moon rock. The best antidote is to speak with
previous providers and to do a credit check. And don’t ignore your
instincts, either.

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No Money Due to a Quick, Unexpected Change

This class of client has good intentions and generally operates ethi-
cally, but something unexpected has occurred in their business that
makes them unable to pay. It might be a collection problem on their
end, an employee caught embezzling, the death of a key partner, or
the loss of a client who represented a large portion of their business.
Funding Doesn’t Materialize

This occurs frequently when working for companies that are in the early
stages of becoming a publicly traded company. They are building mar-
ket share, spending tomorrow’s dollars today, and as long as the funding
is not interrupted, you’ll be fine. But if their climb up the public ladder
hits a bad rung, you’ll be the one left holding the empty bag. Many times
this is out of their control, and they feel badly, but their fortunes have
turned from boom to bust so quickly that they are left scrambling for
every available dollar. And what they owe you is quite secondary.
Unhappy with Service or Product

Your last big bill might not get paid because that last big job was a bad
experience for both of you. Only this dispute is different because they
don’t feel like they have to negotiate in order to keep the relationship
with you alive and well. They are moving on, and they’ve decided to
make a statement about the things they don’t like about you and your
firm, even if it means you sue them. It’s on principle, and unless you
have some significant leverage, they’ll likely win.
Change in Client Contact

Remember the hurried call you received, begging you to help with a
last-minute project to “make me look good”? And how you agreed to
skip the normal paperwork in order to get right to it? Well, the same guy
who was always doing things at the last minute (and going over budget
in the process) finally gets fired, and your new contact isn’t sure if you
were part of the problem or part of the solution back when his nemesis
ran things. So he says: “We have no problem paying what we authorized,

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but I don’t see any authorization. Please send me whatever you have
and I’ll get it in the system.” Of course you are stuck at this point, and
it’s just one of the ways that a change of contact can cost you money.
HOW B I G A PRO B LEM I S THI S?

Most firms lose a lot more money subsidizing projects than not getting
paid what the client agreed to, so in that context this is not a big prob-
lem. If more than 2 percent of your receivables are “doubtful,” to use
an accounting euphemism, you have a problem. When you calculate
this, you’ll find that you skate along for years at a time with zero or very
little that is uncollectible, and then one year you get hit with a whopper
of a write-off.
Is it ever possible to have that percentage too low? It depends on
why you never have problem receivables. If it’s because you have
great systems and take special care to work for only the right clients,
bravo. But if you never press the envelope and cave to clients too fre-
quently, your negligible receivables problem is not a compliment but
a statement about your lack of courage.
ME AS U R IN G TH E P ROBLEM
There are three ways to identify the problem, and all are important.
Your instincts about whether or not you have a problem are probably
correct, but it is always useful to benchmark your firm against others.
Amount of Yearly Bad Debt

See above for a discussion of this. The lower this percentage is, the bet-
ter off you are, but regardless of where you fall, it should not be more
than 2 percent of your revenue. The vast majority of you are paying
your taxes on a cash basis and so that money is never getting reported
as income, and you don’t need to worry about credit and so forth.
Overall Receivables
You should be examining the age of individual receivables and han-
dling delinquent accounts, but it is useful to take a broad view of your

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collection efficiency. To do this, take total revenue (e.g., $2,000,000)

for the year, divide by 365 (days in a year), yielding $5,479. Divide that
number into your accounts receivable (e.g., $235,000), yielding 43 days,
which is the average time clients are taking to pay their bill. The thresh-
old is 45 days, and so this would imply that your firm is doing okay.
There is no harm at all in having a result that’s less than 45 days. In
fact, the shorter that period the better. But if it’s greater than 45 days
(some would set the bar even lower), you have a collection problem.
This could be due to large amounts of old, bad debt sitting in your
receivables or simply a few clients who regularly pay late.
Individual Receivables
Speaking of a few deadbeat clients, you need to age your receivables
and then print them out in that format: current, 30+ days, 60+ days,
and 90+ days. Then scan the columns and note any that are over 45
days old, especially from a newer client, because these are the ones
likely to give you trouble down the road.
For what to do when any single receivable gets older than 45 days,
see below. The age, coupled with the amount, will help establish
marching orders for collection activity, and you should
have a system that simply gets enacted, rather than
inventing one based on each particular client.
L AY IN G A F O U N DATI ON
TO G ET PA I D
It might take more patience to do this,
but you can’t do anything more import-
ant than setting the groundwork to get
paid. Here are thirteen suggestions to
do just that. These guidelines will raise
your chances of later getting paid. If
payment is slowed, below you’ll learn
many specific ways to get that money.

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U ND E RSTA N D W HY THEY CAME TO YO U

Some things are too good to be true. For instance, a new client calls you.
You are excited about the prospect of working with them, and they seem
to have significant itches and the money to scratch them. All is good.
But it isn’t until later that it hits you: The primary reason they left
their last firm was because they were cut off for nonpayment, or they
beat them up over money.
You should almost always have a clear understanding of why your
new client left their old provider. It may even be possible to verify this,
though few of us would have the courage to actually ask the firm we
are replacing!
D O A C R E D IT C H ECK
There’s no need to do a credit check for a large multinational corpora-
tion. If they are in trouble you’ll have heard about it on the news. But it
is a good idea to do a credit check on any company that is not publicly
held, and the smaller they are, the more important it is. You are likely
a smaller company, working for other smaller firms.
Publicly traded companies have strict reporting requirements and
their financial health is independently rated by third-party agencies.
But for other firms it’s difficult to get real financial information. In fact,
the financials you’ll get by calling Dun and Bradstreet, for example,
are generally worthless because they are self-reported.
What is helpful, though, is to find out payment history. It is not
self-reported, and it’s even more valuable than financial information
because it’s real-world data on how they pay their bills.
D O A R E F E R E N C E CHECK
For the smallest companies, have them provide credit information.
This will include full legal company name, corporate officers, D & B
(Dun and Bradstreet) number, bank name and address, and at least
four trade references. These references must be firms like yours.
And call these people! There is a lot at stake, and it’s worth the
investment of time.

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F O R M A LIZ E TH E AGREEMENT
First, the definition process itself is more important than any docu-
ment that might be formulated as a result of the process. That process
will expose potential issues before they surface on their own. In fact,
think of any written agreement as a discussion outline to help both
parties address their perspectives on key points, at the outset.
Second, if a relationship is dismantled, something has already
gone wrong, and the time to determine an exit strategy as it relates
to payment has already passed. That time is at the outset of the rela-
tionship, before undisclosed hurt and silly posturing rule the day. A
written agreement should spell out how the relationship will end so
that any decision to sever the relationship—by either side—will be
merely implementing a plan that has already been devised.
E STA B LIS H A N AUTHOR I TATI V E

C L I E N T C O N TAC T
At the outset of the relationship, one person should be designated
on the client side as the person with authority over financial matters.
And you should not accept another person’s word over financial mat-
ters unless they are authorized to make them.
At times you’ll encounter a company that says “they were not
authorized to incur that obligation on our behalf.” You are partly at
fault for not ensuring that it was authorized, but they should techni-
cally stand behind it anyway.
You are more likely to get in trouble when someone without bud-
get authority asks you to do something and then gets in trouble for
doing so when the boss finds out. It’s not as if your client is now off the
hook and doesn’t have to pay you, but sorting it all out can cause long
delays in payment. The process itself can also harm the relationship
you have built with the client.
GET A DVA N C E PAYMENT

This should be obvious, I suppose, but it’s amazing how many com-
panies don’t do this. Other than for cash flow, it’s not particularly

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important to get deposits once your relationship with the client is

established, but at the outset of a relationship it’s difficult to imagine
a better means of diminishing the risk you are facing.
Money is a great leveling force. No matter how exciting this project
is, and no matter how much you need it, you’ll lose more money by
violating your own policies in this regard than in any other way.
And by “getting money up front” I don’t mean “invoice them and
wait for payment.” The whole point is to ensure that you are not work-
ing from behind financially, so that if they (or you) stop the work,
there’s not much to settle up on. Of course you can relax on this point
once you’ve worked together and know the kind of company they are.
AC T LIK E A C O M PANY
Be professional. Help them see that they are dealing with a company,
not an individual. Individuals are easier to dismiss without conse-
quence, and frequently are.
KE E P G O O D R EC O R D S
As a delaying tactic or because they really want to know, many clients
who are disputing your bills will ask for backup on how you’ve spent
your time or how you’ve incurred outside expenses. You have to
decide for yourself on the point of how much disclosure is appropriate,
but even if you don’t turn over copies of your records or printouts
from your timekeeping software, you’ll certainly welcome the data
when answering a client query.
Good records include invoices for the cost of goods sold, time-
keeping, change orders from the client, and of course the proposal
that they signed. In addition, on that first project you’ll probably have
them agree to certain terms.
BI L L PRO G R E SS IV ELY
If your projects are not over and done with quickly, establish a policy
that allows you to bill the client as you go. The usual time period is
monthly, though it can be more frequently if you wish.

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The point is to not let the client ever owe you too much money,
limiting the damage that can be done if they don’t pay.
S ET A D O R M A N T-P ROJECT F EE
Your policies should provide for projects that suffer delays. Specifically,
if a project is put on hold, the client should always expect to pay for all
work done to that point. They might already feel a little guilty in stopping
it, and now is the time to let them assuage their guilt by paying the bill.
If you don’t get payment now, you are far less likely to get it later,
when they view all the time and expense invested in the project as
wasted. The idea of paying for something they have no intention of
using sticks in their throat. Never mind ethics—that’s just how some
clients think.
S ET A C A N C E LL ATI ON F EE
You might want to craft a cancellation policy into your client agreement.
This would spell out the procedure if they stop work on a project before
it is finished. The general theory is that you have protected your capac-
ity and perhaps even hired people or purchased equipment to meet
their deadlines, only to be left high and dry when their plans change.
These fees are difficult for a client to accept, and even more diffi-
cult to pay. But many firms are successful with it.
E STA B LIS H FA IR SERV I CE CHARGE S

Some states limit the actual percentage rate you can charge. Apart
from that consideration, it is customary to charge 12 to 18 percent
on overdue balances.
It is also customary to not collect it, but rather to use it as a bargain-
ing chip when trying to get the “principle” paid back.
T RU ST YO U R IN STI NCT S
All this is well and good, but client relationships don’t “go bad.” They
are bad from the start. Furthermore, you are likely to know this from
the start, too. Pay attention and step out of denial.

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S PEC IF I C C O LLECTI ON TECHNI Q UE S

Let me suggest some specific techniques on collecting money owed
to you, including an examination of how to enhance your chances of
collecting it by establishing and maintaining the right relationship
with a client initially.
Previously, we looked at why you might be having this problem, the
five primary reasons why you might not get paid in a given situation,
how much “bad debt” is acceptable, and how to improve your chances of
getting paid when you are in the process of formalizing the relationship.
Now we’ll deal with guidelines for your behavior in collecting
money, both ethical and legal. We will then look at quite a number
of early-stage reactions that would be appropriate as the problem
escalates. Following this we will examine more than a dozen specific
strategies to get your money in the later stages, when you know for
sure that it’s a problem but don’t know what to do about it.
GU I D E LI N E S F O R BEHAV I OR
You can’t mandate ethical behavior, of course, but it’s a good idea to
use it even if there is no legal requirement to do so. Put yourself on the
other end of the collection effort, and you’ll quickly see that treating
people honestly is most likely to result in real collections.
That’s not to say that you can’t be tough and even harsh with peo-
ple, but you can do that without being unethical. Such behavior would
include misrepresenting who you are, how much they owe, and what
you’ll do if they don’t pay.
The legal implications of your actions are another thing altogether.
Fortunately for you, and unfortunately for them, nearly all the legisla-
tion that specifically addresses this topic applies to collection agencies,
not you as an individual business owner trying to collect what people
owe you.
The regulations that affect collection agencies are housed in the
Fair Debt Collection Practices Act (FDCPA). I bring this up because
often the people you are trying to collect from will throw this in your
face: “You can’t call me at work.” “You can’t call me after I’ve told you

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to stop.” “You are calling too often.” “You can’t talk to anybody else
about this.” Nonsense. From a legal standpoint, there is very little you
can’t do. But I would urge you to be guided by ethical standards when
collecting money.
Unfortunately, while the FDCPA places strict limits on what col-
lection agencies (and attorneys who are collecting bills on behalf of
clients) can and cannot do, these regulations are routinely and widely
broken by collection agencies, especially.
Keep in mind that any laws that apply to you are often state-based,
which means that they will vary widely. Your best bet is to hire a local
attorney to make sure your activities are legal. You won’t need an
attorney to help you decide if they are ethical.
E AR LY-STAG E R E ACTI ONS

Good collection work is a three-stage process. The first, which we
discussed above, involves setting the stage with the right homework
and policies.
The second stage is dealing with clients who owe you
money that is not more than ninety days old. In other
words, you’ve invoiced them and they have not paid
you, but three months have not yet passed since
the invoice date. These are the strategies we’ll
talk about in this section. The third will deal
with late-stage reactions.
W E A RY PE RS I STENCE
The first suggestion is to be a squeaky
wheel, which will then usually get the
grease (or money, if you prefer). If it’s an
issue of not having enough money to pay
all their bills, the debtor will usually try
to relieve pressure, and those applying
the most pressure will get what they
want: money.

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This only works, though, if you do it responsibly. If you make the

debtor furious with your demands, they’ll withhold the money just to
punish you. So calm, persistent, serious requests are the way to get
the most results.
R EG U L A R STATE MENT S
It might seem like a very simple suggestion, but I’m always surprised
at the number of firms that don’t send regular statements to clients.
Some feel like they don’t have a collection problem. Others don’t want
to “bother” their clients. A few just don’t have the systems for it.
The first statement should be sent thirty days from the first project
you do for a client, either at the outset of the relationship or after a
long pause between projects. Subsequent statements should be sent
every fifteen days (probably at the beginning and middle of every
month), as long as there are outstanding invoices. Obviously this
will require an automated accounting system.
I N F O R M E D AC C O UNT REP RE SENTATI V E

Be sure to let the interfacer know what’s afoot. This is the person most
responsible for managing the day-to-day account activity, and inter-
facing between your firm and the client.
They need to know for three reasons. First, they’ll be embarrassed
if they find out about the delinquency from the client and not from you.
Second, they’ll obviously have to enforce whatever action you deem
necessary, which later might include stopping work on behalf of the
client. Third, they might have valuable insight into why the client is
late in paying, as well as how the communication should be framed in a
manner that will result in the client wanting to act as you hope they will.
D E S I G N ATE D C O NTACT P ERSON

If no single person is responsible for shepherding the collection
process, your results will be unremarkable. The same is true for the
specific contact point with the client. This designated person does not
need to be the same person who establishes policy—and approves the

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exceptions—but everybody in your firm and at the client level needs

to be clear on the appropriate channel for collection discussions.
There are three choices, and in our terminology we call them the
Engager, the Measurer, or the Director. The Engager is the account
person, as described above. Whether or not the Engager is designated
as an account person, she is the primary information conduit. The
Measurer is the person who is primarily performing the accounting
function, internally. The Director is the owner (whether referred to as
principal or president or whatever) who manages, among other things,
the accounting function.
I cannot offer you a clear guideline on who should be the messen-
ger to clients who owe you money, largely because it depends on the
size of your firm and the personalities of the people filling these three
roles. Generally, though, the Director should be establishing the pol-
icy, and the Measurer should be managing the process (monitoring
the timing of actions, and prompting the appropriate people to carry
out the prescribed steps). But it’s not always easy to determine who
the messenger should be.
One could argue that the Engager should not be the messenger
because she needs to avoid anything that might erode the relation-
ship. Someone else might argue that the Engager has the strongest
relationship with the errant client, and thus has the greatest likeli-
hood of getting the client to pay.
I can’t make a blanket statement in this regard, but answer it for
yourself based on the size of your firm and the personalities of the
people involved. There is some escalation in this area, too, in that
contact should move up the ladder as the delinquency escalates.
A P PRO PR I ATE C ONTACT METHOD

There are five possible methods of contact (if you don’t include hiring
bouncers to do your bidding). These are a letter, an email, a phone
call, a personal visit, or a third party hired on your behalf. There is an
aspect of escalation with these, too, and the list has been placed in just
such an order. In other words, start from the beginning of the list.

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Obviously you’ll need to be flexible in your use of the different

methods, but it helps to have some system defined, and then deviate
from it as necessary. Start with a letter. It’s private and nonconfronta-
tional, but also very clear. In this category I would include statements
and friendly notes. Even a handwritten note on a statement is
appropriate.
An email is next because it is more difficult to ignore and because
it carries the assumption that the recipient will reply. It is also more
personal, but not as threatening as a phone call. Finally, it allows recip-
ients to compose themselves before replying, rather than having to
stammer around on the phone as they think of what to say.
A phone call is next. You aren’t likely to get anything but voice-
mail, but that will work. If you try several times and are unsuccessful
in reaching the decision maker, offer to hold, no matter how long,
until they speak with you. If that still doesn’t work, it’s appropriate
to express your frustration with the receptionist, accounting depart-
ment, or anyone who will listen. Word will spread.
Finally, have a third party (usually an attorney) contact them. Short
of being served with notice of a lawsuit, there’s no sterner messenger
than that.
These are just the five means of contacting someone who owes
you money—the “how,” if you will. As we talk about the “when” and
the “what” of your contact points, we’ll try to overlay these methods
on that discussion.
P E RS O N A L IN TE RACTI ON
During these early stages, personal contact (whether or not it’s in per-
son) cannot be overestimated. And perhaps because it is important,
it is also difficult. People (unless they aren’t very human) find it more
difficult to treat people they know dishonestly, and so they need to
know you.
This personal approach carries over in actual meetings, but also
in the language you use through other, less personal forms of contact.

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S PEC IF I C E S C A L ATI ON
Wrapping these early reactions up, let me suggest some guidelines
for the “when” part of the escalation.
• Thirty days: A new client should receive a statement thirty days
from the invoice date. And then every fifteen days thereafter. If
they are already a client, and you are doing ongoing work for them,
they’ll already be in the correct rotation.
• Forty-five days: If they haven’t paid in two weeks, another
statement will automatically be mailed to them. In addition,
the designated collector will call.
• Sixty days: If two more weeks go by, email a PDF and then mail the
original. Call them, too, but this time insist on meeting with them
within a day or two. Tell them that all work will stop until the issue
is resolved, and explain what else might happen (see late-stage
reactions, below).
• Seventy-five days: Send another statement. Stop all work.
Try to get another meeting in person.
• Ninety days: Send another statement. Make a final decision on
where to go next. By the time ninety days have passed, you know
where you stand and it’s time to take serious action.
Uncollected accounts are not like fine wine—they do not improve

with age. Before four months have passed, a firm like yours can collect
70 percent of the problem accounts. Past that time, the average per-
centage collected is about 20 percent.
L ATE -STAG E R E ACTI ONS

So now we’ve looked at the first stage: doing your homework and
enacting the appropriate policies. And we’ve just finished looking at
the second stage: early-stage reactions during the first ninety days
after the invoice is issued. This third stage deals with late-stage reac-
tions when payment is outstanding (i.e., not yet made) and the invoice
is more than ninety days old.

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But before looking at specific suggestions, let’s talk about some

things to keep in mind. You will greatly improve your chances of col-
lecting money if you remember that this is a negotiation. You want all
your money, and you want it now. She wants to pay you nothing at all,
if she has a choice, or failing that, she wants to pay you less, and later.
So what does she gain by moving toward your demands? There are
four things that could be true. You might or might not mention them,
but keeping them in mind is a good idea.
First, she will retain some self-respect. This highlights the impor-
tance of treating the debtor with respect, which she will want to retain.
If you are already yelling at her and threatening her, she isn’t going to
care about losing your respect.
Second, she will avoid legal hassles by paying what she owes.
Regardless of who wins, she’ll still have to spend time and money
(and reputation) defending her stance.
Third, she will avoid further damage to her credit if she pays you.
Of course if the company’s credit is already damaged, this will carry
no leverage. And even if they are still considered creditworthy, there
is little you can do to affect that, since most rating firms will not accept
your assertion of a bad debt. But if you prevail in court and a judgment
against them is issued, that will be detrimental. As will turning an
account over to collection, after which the agency will certainly file
a report that will end up on the client’s credit report.
Fourth, she may be motivated to comply out of appreciation for
your bending the rules. In other words, you need to be flexible and

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still be firm. This only applies if you have rules to bend, of course,
which is partly what this manual is about.
Now let’s look at fourteen specific suggestions you might use to
get your money, particularly if none of these earlier methods have
been effective.
C O N V E RT R EC E I VABLE TO LOAN
One of the things you want to prevent is disputing the debt, which is
typically only a delay tactic. It is much easier to collect a note than a
receivable, and this is why you might want to pursue this route.
But why would they be willing to do this? For one thing, you are
establishing a payment schedule rather than demanding all of the
funds at once. For another, you can agree to a deferral of a few months.
For example, suppose a client owes you $100,000, which you are
demanding right now. But they don’t have any money, so you can
demand all you like and you still won’t get paid. Worse yet they might
want to dispute the debt, knowing they’ll lose, just to buy more time.
So, work with them and agree to a two-month deferral, after which
they’ll pay $10,000 per month. You agree to this in exchange for turn-
ing the receivable into a formal note. By allowing you to do that, they
are re-acknowledging the debt and cannot dispute it.
ASK F O R A PE RS O NAL
GUA RA N TE E
Coupled with this first suggestion, ask for a
personal guarantee. You are not likely to be
successful unless the debtor feels so badly
about not being able to pay you that she
doesn’t think clearly for just one moment!
And of course this suggestion only applies
to small, privately held companies.
I have been able to negotiate this in
about one of ten cases, believe it or not.
The purpose is to nullify the results of a

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corporate bankruptcy by spreading the obligation beyond the corpora-

tion to the guarantor (usually the majority shareholder). Then, should
the company be dissolved in bankruptcy proceedings, the guarantor
is still obliged to pay you (unless he or she also files for personal bank-
ruptcy protection).
P U T PR E SS U R E O N REF ERRAL SO U RCE

How did this client find you in the first place? If it was a mutual acquain-
tance who put the two of you together, by all means call them and talk
about it. You could say something like this: “Janet, thanks again for
sending us Acme. We did some great work for them and they seemed
very happy with what we did. But I do have one question, prompted
by the fact that they haven’t paid us. In fact we can’t even seem to get
a firm commitment from them. It’s getting difficult because we are a
small company and the amount outstanding is creating quite a problem
for us. Have you heard anything that we should know about? Do you
have any suggestions on how we might collect this money? If you hear
anything that would be helpful to us, please let us know.”
You can bet that the client will get a phone call. It might not result
in full payment, but it may be useful in bringing additional pressure
to bear.
D I SA LLOW U S E OF WORK P ROD U CT

Regardless of your policy on usage or ownership, if your work on
behalf of the problem client involved a product, no rights should
transfer until they have paid in full (it might be time to review your
client agreements). In other words, explain that they still owe you
the money, and until that is paid in full, they are using material(s) for
which they have no rights. In other words, their use is both unethical
and illegal.
How creative you want to get with this depends on how much
money is at stake and how badly they need the work you have created
for them. And if you control the DNS records ….

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AC C E PT A P O ST- DATED CHECK

One of the most frustrating things about collecting money is pinning
people down. Getting them to agree, in writing, to certain amounts by
certain dates is half the battle. And then even if they agree to this pay-
ment schedule, you might have to keep chasing each payment.
You can take some of the mystery from this exercise by accepting
post-dated checks for specific amounts. It’s not as if they can’t issue a
stop order or simply let you deposit the check without any funding to
cover it, but you will get slightly ahead of other creditors.
If your client agrees to this, call the bank early in the morning of the
first day on which you can cash the check and ask them if the funds
are available. If they aren’t, keep trying, every day, for at least a week.
Keep calling the client, too.
The legal ramifications of writing a bad check are serious enough
to put additional pressure on the client.
U SE A N AT TO R N EY
Hire an attorney with experience in collections to compose a very
stern missive, on their letterhead, demanding payment. Most such
attorneys have a series of letters they’ll send on your behalf for a set
fee. This suggestion is separate from hiring an attorney on a contin-
gency basis (see below).
S U E IN S M A LL- C L AI MS CO URT
Every business has the option of taking a client to small-claims court,
provided that the amount in dispute falls below the maximum allow-
able in that venue. No attorney is required and judgment is swift.
If your documentation is clear, you are likely to secure a judgment.
But collecting it can be a different matter, and your remedies will vary.
But so little effort and expense is involved that this is often a viable
option if there are, indeed, any assets to satisfy the judgment.

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S U E IN C I V I L C O URT
Sometimes filing a lawsuit is appropriate: you believe you will prevail;
a large amount is at stake; the lawsuit itself might generate appropri-
ate publicity; or nothing else has worked. In such cases it is foolhardy
to do this on your own (in fact, a clerk will not be helpful in this venue
like he will be in small-claims court). You can use
the same attorney you did to send the earlier
letters that threatened a lawsuit, in fact.
You may have to fund the
action with a retainer, or the
attorney might take it
on a contingency basis
(typically 30 to 50 per-
cent). The arrangements
will depend on how much money is at stake, how long the obligation
has been outstanding, how able the client will be to pay any judgment,
and the strength of your case. But don’t quibble over the fee, particu-
larly if they are willing to do it on a contingency basis. If it’s gotten this
far, you aren’t likely to get anything without their help.
U SE A C O LLEC TION AGENCY

A collection agency does this for a living, and they are good at it. The
only downsides are these: the fee they’ll charge (15 to 50 percent), and
the fact that it’s not easily reversible.
S E E K A R B I TRATI ON
If there is a dispute, you might offer to submit to binding arbitration
to settle the matter.
P L AY TH E PR C A R D
In cases where the client has exhausted mezzanine financing and the
next step is raising funds in a public offering, one thing they’ll avoid at
all costs is any negative publicity that might scuttle the entire process.

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Once you’ve played that card, though, their fear is replaced by anger, so
holding that particular card without playing it will be far more effective.
F O RC E I N VO LU N TARY BANK RU P TCY

The laws vary by state, but in many cases you can force an involuntary
bankruptcy if the amount you are owed is over a certain threshold. In
some cases several (e.g., three) debtors must act in concert to force this
action. Whether or not you want to use it merely as leverage or actu-
ally do it will depend on what other creditors might be in line and the
amount of funds you think will be disbursed in a bankruptcy proceed-
ing. This is one of the most powerful tools you’ll have at your disposal.
GRA N T A D I S C O UNT F OR F U LL PAYMENT

If you sense that they have some money and that they are seeking
ways to stop the pressure you are applying, consider making them a
one-time offer. The offer would be a “settlement in full” for less than
the total amount owed, if you receive it by a certain date. You need
to stress that it will not be extended, and that you will seek the full
amount due if they do not accept the offer.
W R ITE I T O F F A N D MOV E ON
Finally, it might be best to write the amount off and move on. If you
formalize client relationships properly at the outset, and then pay
close attention to receivables as the relationship progresses, there
may not be much more for you to do.
It’s possible, too, that anger is blinding you to the real possibilities
of collection, simply because you want to “hurt” the deadbeat client.

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BEF ORECAST
If a person lets himself become a slave to money, he’s constantly

denying those near him the agreeable things that money will buy
because somebody once told him that $10 a week compounded at
4 percent will double or triple or do something to itself in twenty
years. Tossing it away as if it grew on trees is just as crazy. Most of
us get our ideas about money from somebody else, and so we come
to adopt a pose about it. The commonest pose is to act as if there is
something indecent about money. The man who gets touchy when
money is mentioned is generally a man who cares entirely too much
about it and loves to pretend that he doesn’t. Money can’t be left out
of a person’s plans any more than the weather can be ignored. To get
money enough to make yourself happy and to find a way of making it
that will keep you happy while doing it is the best insurance against
being found sitting around in a high-hat when a rainy day comes.
—Roy S. Durstine, This Advertising Business, 1928
The fact that our business, as a whole, has grown up wrong, by

establishing as general practice a billing method which risks the entire
agency capital over and over, is no reason for the individual agency
to follow the crowd. It does so, I assure you, at its peril. This unique
assumption of risk, this loan without collateral, found nowhere else
in industry, is the greatest single cause of agency failure.
—Kenneth Groesbeck, The Advertising Agency Business, 1964
Nothing so cements and holds together all the parts of a society as

faith or credit, which can never be kept up unless men are under some
force or necessity of honestly paying what they owe to one another.
—Cicero

8
MAKING THE DECISION

TO OWN OR LEASE
YO U R FAC I L I T Y
This chapter addresses how your facility needs might be a little differ-
ent from other small service firms, then details eight advantages and
eight disadvantages of owning your own facility. We then suggest six
questions to ask yourself before making the decision, and offer fourteen
suggestions to make the process go smoothly should you proceed to be
your own landlord.
You know that feeling of owning something? How the grass actually
feels different if it’s growing on your land instead of someone else’s?
Home ownership is not a decision made solely on financial grounds.
There’s a psychological component to it that we won’t be exploring
here, as strong as it may be. But we will be examining the cold, hard
pros and cons of owning your own space instead of leasing it from
someone else. And those facts might help balance the strong emo-
tional components of owning something.

Making the Deci sio n to Ow n or Leas e Yo u r Faci li t y
The technical term for such a building is an owner-occupied or

owner-user property. This distinguishes it from a building owned
purely as an investment, which you lease out to another tenant.
HOW TH IS N IC H E I S D I F F ER ENT
As you know, ReCourses specializes in serving clients in the creative,
advertising, marketing, and digital realms. Their needs are almost
always unique, and it’s no different when it comes to the subject
of owning their own buildings. As it stands, less than 20 percent of
our clients own their own buildings. That’s probably an appropriate
percentage, but it’s possible that you should own your own building
and don’t. The main purpose of this chapter is to help you evaluate the
decision carefully. Here’s how different it is because of issues unique
to companies like yours.
Control
Most principals in the creative services field place a high value on
control. This is such a strong component of the entrepreneurial per-
sonality that some decisions that are known to be wrong are favored
over others, simply because they allow them to maintain control!
Owning your own building might not be the best decision, but it
does give you more control.
Lack of Transition Options

Firms like yours do not always wear well.
You won’t find many colleagues still in a
thriving business in their late 50s or early
60s. Realizing this, principals begin to
look elsewhere for places to build wealth,
rightly assuming that they are unlikely
to sell their business in order to cash out
after years of hard work. It naturally occurs to them that turning all
that rent money into a wealth-building stream makes sense. Whether
it does or not is something we will explore.

Overdone Leasehold Improvements

Other than in specialty retail environments, I’ve never seen a segment
spend more money on leasehold improvements than creative service
firms. They desperately want to be in a creative environment that is
also quite different from anything else.
Putting that money into a leased facility that they will eventually
walk away from does not make good sense. That’s why buying a facil-
ity comes into play.
Major Expense
We have suggested for many years that up to 6 percent of your agency
gross income (AGI) can be spent comfortably on facility expenses, all
in. That’s somewhat higher than other service industries.
All this begs the question of why there may be increased interest in
this issue. First, when interest rates happen to be low, the cost of own-
ership may be more attractive. When they are in that lower range, and
if they are not likely to be lower for years to come, it may make sense.
So evaluating the decision purely on financial grounds, purchasing a
building could be more attractive than at other times in the past. Of
course occupancy rates would typically be low, too, so sellers would
be more motivated to sell cheaply.
Second, there is no other routine event that causes more introspec-
tion than facing the decision to sign a (typically five-year) lease. It forces
you to say: “Do I want to do this for another five years?” In the middle of
that introspection, you might recognize that owning your own building
might build something with more lasting value than your business.
Third, when the stock and bond markets are not generating high
returns, investors are more open to other vehicles, like real estate.
It’s not necessarily a good strategy, but it is reality nonetheless.
R E A L A DVA N TAG E S
As you examine your own situation to determine if it makes more
sense to own or lease a building, consider these real advantages.

Some will be more real than others, but they should all be considered
as you make your choice. These are the things you can do if you own
your own building.
Predict Costs
A lease almost always allows you to predict costs, but only for the
term of your lease. After that term expires, if you are fortunate, there
will be a “CPI escalation” clause, meaning that the lease is adjusted
according to what has happened with the consumer price index. But
it’s more likely that your lease has language that calls for an increase
according to “market rates,” if it addresses that point at all. Either way
you are at the mercy of the landlord, and the pressure to stay comes
from three quarters: the cost and disruption of moving, the pain of
leaving your leasehold improvements in the old facility, and the cost
of new marketing materials. The landlord knows all this, of course,
and your bargaining position is not what it could be.
Contrast that with a note that is 10 to 15 years (the typical term for
a commercial loan). Whether or not you like the interest rate, there
should be no surprises for the entire term. Even if it’s a variable note,
the swings will generally follow the economy as a whole.
Save in Taxes
Other than building equity, this is usually the impetus for buying your
own building. Your tax accountant will explain that owning the build-
ing personally and having the business make lease payments to you
will allow you to get money out of the company in a tax-advantaged
manner. In the United States, the spread between your personal costs
and your income is not subject to Social Security (FICA) taxes. So pay-
ing yourself a hefty rent can save money (you need to be careful about
making sure it’s a market-defined rate).
Then there are considerations for deducting your depreciation and
your mortgage interest and so on, while your company deducts the
lease payment to you as an expense.

All of this is well and good, and you should take advantage of it,
but the net tax savings are not substantial unless your income is also
substantial.
You should always own the building personally and lease it to your
corporation. But that is not driven only by possible tax savings, and
you should keep your expectations realistic when it comes to how
tax-advantaged this really is.
Avoid a Difficult Landlord

Truth be told, owning your own building won’t eliminate the land-
lord, it’ll just be more difficult to whine about the landlord since it’ll
be you! But seriously, some landlords can be difficult in that they are
unresponsive or slow in addressing issues with your space. No more,
if you own it yourself.
Forced Savings Program

This is one of the primary benefits of owning your own building. In
essence, the payments you make are steadily building equity. It doesn’t
even matter so much that the building appreciates, leading to a capital
gain when you sell it. Even if it doesn’t appreciate, you’ll have the equiv-
alent sum of your principal payments.
You really want to concentrate on getting rich now, not later. When
principals think they’ll “get rich later,” the assumed mechanism is
cashing out their equity or selling their business. Neither is likely to
happen, frankly. Cashing out requires that the business is doing well,
and people don’t frequently walk away from a business unless it’s not
doing well. And selling your business is so unlikely that playing the
lottery is not a lot riskier.
Diversify Portfolio
We all recognize the danger of having a large retirement account
at work where the investment itself is largely company stock. If the
company suffers, the portfolio value will plummet and the worker
might lose his or her job. In your case, your company is also your job,

and investing in a building is a means of diversifying your holdings

because if you lose your business your building is still a viable asset.
Own an Appreciating Asset

Commercial real estate is likely to provide capital preservation (it
won’t drop in value) and some level of appreciation, though it might
not be much more than just above inflation. This capital appreciation
is greatly enhanced if you purchase the real estate at a substantial
discount, realizing the gain at the later sale.
In fact, the near certainty that it will appreciate is the sole justifi-
cation for borrowing money to fund the purchase. This appreciation
allows you to sell it knowing that the proceeds of the loan will nearly
always cover your obligation to the lender. My mantra is no fixed obli-
gations (loans or capital leases) for depreciating assets.
Eliminate Sublease Requirements in Business Dissolution

More than 75 percent of firms have personally guaranteed their facility
lease. In a business dissolution, then, they will need to sublease the
facility for the remaining term of the lease to avoid paying that obliga-
tion personally.
A traditional lease provides very little flexibility compared to
owning your own building. If you must vacate your own premises, the
lease payments you are making to yourself will obviously stop. But in
addition to having the option to find a tenant (much like subleasing,
above), you are likely to find a better tenant since you are not locked
into a term that mirrors your own lease. For example, if you have a
traditional lease with a third party, you might have 18 months remain-
ing on your obligation. It will be difficult to find a tenant willing to
occupy the entire space for that short period. If you own the building,
you can present many more options to the tenant.
Owning your own building always provides the escape mechanism
of selling it, too, in which case you are likely to meet your remaining
obligations and realize a profit, instead of subleasing, usually at a loss.

Create Two Levels of Partnership

Adding a minority partner is fraught with danger, but at times it’s still
the right thing to do. If you have a partner and you both own the busi-
ness and the building, chances are you have created a separate entity to
hold the building. In such cases, the percentages of building ownership
would typically mirror the percentages of business ownership. In other
words, you might each own 50 percent of the business and the building.
When you add a minority partner, it usually makes sense to limit
initial ownership to the business, excluding ownership in the building.
This keeps your initial costs lower, creates different levels of par-
ticipation (and thus profit), and simplifies any later transaction that
would eliminate one partner. In this case each of you might still own
50 percent of the building, but only 45 percent of the business.
A number of business owners stumble onto this solution acci-
dentally when they realize that owning a building requires that all
partners infuse equity, have good credit, and are willing to sign a
personal guarantee. Those three issues might or might not apply
to owning part of a business.
R E A L D ISA DVA N TAGE S

As you might predict, there are also real disadvantages to owning
your own building. These are important to highlight because they are
seldom given sufficient consideration during this process of deciding
whether it makes more sense to own than lease. Here are the disad-
vantages that might accompany owning your own building.
Become an Unwitting Landlord

Being your own landlord is one thing, but being a landlord to someone
else can be a real disaster. You could get impatient calls at strange
hours when something leaks or when a particular switch is inoperable.
Drain Extra Cash Flow during Vacancy

The above point assumes that something happens that prevents you
from occupying the building again. The reason might be innocuous

(you outgrew it) or difficult (you’ve had to downsize), but either way
you’ll have to find a tenant before they can begin annoying you! If the
reason you need to do this is difficult, chances are you won’t have
much of a financial cushion to tide you over during the search. And
that can result in lowering your standards just to get the cash flowing.
Why is this an issue at all? Remember that the note you signed in
order to buy the building certainly carries a personal guarantee.
Face Difficult Expansion Options

Unless you occupy only a portion of the building you are going to own,
your expansion options are limited. Even if you lease out a portion of
it to a third party, you’ll be obligated to abide by the terms of that lease
or face an expensive buyout, subject to their ultimate agreement.
Contrast this with leasing space in a commercial building where you
are surrounded by contiguous space, some of which might become
available. Since most owner-occupied space is fully occupied, your
options to expand and contract are limited, though expansion is the
more difficult option.
Dilute Working Capital

You’ll need a down payment for this building purchase, and that will
likely come from your working capital. Eventually you’ll get that
money back, but for now it will reduce your cushion to a less comfort-
able level. And frankly, you are most likely to need that cushion during
times like these, since cost overruns and your own distraction might
put you at a disadvantage.
Demand Personal Guarantee

You will almost certainly be required to provide a personal guarantee
for the loan, which means that you will not be able to walk away from
the obligation without affecting your personal credit and resources.
Many commercial leases require the same personal guarantee, but
careful negotiation can eliminate or modify that requirement in one-
half of the cases.

Become a Property Manager

You will not have a landlord to rescue you if you are both the landlord
and the tenant. This is going to be good if you are used to working
with bad property managers. But it’ll be bad if you have worked with
good ones.
Struggle with Cost to Build

If there are cost overruns, you will have to absorb them. And there
will be cost overruns!
Absorb Real Estate Losses

If real estate prices plummet, you may need to take a loss if you
must sell the building. Incidentally, this is why a lending institution
demands a down payment, hoping a property that drops in value
will still not drop below the amount of the outstanding note.
C O N S ID E RATIO N S
If you’ve carefully considered these advantages and disadvantages,
the next step is to apply some specific principles to your situation to
determine whether owning a building is a good fit to you specifically.
Walk yourself through these questions and you’ll know where you are
compromising and where owing a building makes very good sense.
Is Your Growth Rate Steady?

Until recently, firms like yours were increasing their AGI by 30 per-
cent year over year. That’s a growth rate that can outpace your supply
lines, which is why many firms face an early demise. The two statistics
are related. In regard to this discussion, your growth rate has a signif-
icant impact on how much space you’ll need. And since expansion is
difficult in your own space, think carefully about doing this until your
growth has leveled off. The alternative is to overbuild, which increases
your risk, and lease a portion of the building out to a third party.

Do You Really Need to Grow?

We work through many management consulting situations where
firms are facing the challenges that come with growth. Growth is
not good or bad, but unintentional growth is bad because you are
letting external demands determine your destiny. Before biting off
that building project that you keep talking yourself into, do a little
self-examination. Are all your clients profitable ones? Are you trying
to buy some credibility that could be had in cheaper ways? Are you
adapting well to the increasing management load? More than anything
else, growth means that your role must change. If you are embracing
that evolving role, the growth will not be an issue.
Will Tax Savings Be Substantial?

Unless you make an enormous
amount of money, and unless
state laws are in your favor,
don’t give too much weight to
the tax-savings idea. After all, the
vast majority of CPA firms do not own
their own facilities, and who is in a better
situation to understand the tax savings than
tax accountants.
Is It Within Your Facility Allowance?

If you are buying the building personally, the
amount your corporation pays you must cover the note plus main-
tenance plus any excess profit that you’d like to extract from the
corporation in a tax-advantaged manner. The corporation will pay
the taxes, insurance, utilities, security, and cleaning. All the expenses
together should not amount to more than 6 percent of your AGI.
Can You Fund a Down Payment?

Down payments are designed to serve as hurdles to weed out the
investor who is not serious, and to protect the lending institution

should the appraised value fall or the property have to be sold in non-
ideal conditions. That’s from their perspective. From your perspective,
having a serious down payment helps to ensure that you really can
afford this building now. It also makes it more likely that you’ll be able
to get out of your obligation later should you be required to sell it.
How much down payment is appropriate? With some govern-
ment-backed loan programs, you’ll need 10 percent or less. My advice
would be to never buy a commercial building unless you can make a
down payment of at least 20 percent, and ideally 30 percent. If you
can’t do that, it’s likely that you cannot afford it and you are talking
yourself into something without considering all the implications.
Will Size Fit Geography?

There are two things that can be at odds with each other: what size
building you need, and where you’d like that building to be. Since
you’ll likely own the entire building, where can you then feasibly be
located where buildings that size are acceptable? Leasing space in a
large commercial office building allows you to be located where large
commercial buildings are located? That might not be important to you,
but do think about location.
OWN I N G TH E R I GHT WAY

Finally, if all this analysis leads you to the conclusion that an owner-
occupied building is in your future, here are some specific suggestions
for you.
Board of Directors
Get an informal board of trusted advisors and have them all meet
together as a group. This would include your architect, interior designer,
banker, general contractor, accountant, attorney, and realtor. They
should all hear your vision and be on the same page. And the advice
that each of them has should be heard unfiltered by others.

Personal Ownership
You should own your building separately from the corporation. You
might own it personally or you might create a separate corporation,
depending on the legal protection you need, but I know of no exceptions
to this advice, and there are many reasons for it besides tax advantages.
First, it will be easier to sell the business separately from the build-
ing. Second, it will be easier to create two levels of partnership. Third,
partnerships will be easier to untangle. Fourth, your building will not
need to go through the probate process if you die. Fifth, you can strip
assets from the business to protect them from legal claims. Sixth, you
can protect assets in the event of a business dissolution.
Purchase vs. Sale

Remember that you are most in control just before you buy a building,
not when you are trying to sell it. For this reason, keep telling yourself
that you make money when you buy the building, not when you sell it.
You must assume that you will get a market price for the building—so
buy it below market now.
Space Requirements
To determine how much space you need, start with 500 square feet
and then add 200 to 250 square feet per employee. So a firm with
30 employees should have a building with 6,500 to 8,000 square feet.
You can adjust up or down based on your marketplace.
Time Requirements
Don’t rush things. Plan on three to four months for a build-out, and
nine to eleven months for new construction. Don’t pay any attention
to what the realtor or architect or contractor tell you!
Money Requirements
It’s no surprise that you’ll always spend more than you plan, unless
you leave a significant margin of safety. So build it in from the start.

Tax Ramifications
Remember to factor in depreciation advantages. Movable objects that
you can easily remove from the building (like cubicles) can be depre-
ciated on a quicker schedule.
Maintenance Factor
When budgeting, be sure that you don’t underestimate your short-
and long-term maintenance expenses. Many projects are artificially
profitable only because maintenance estimates are underestimated.
Distraction Avoidance
One unfortunate side effect of a building project is the distraction that
it represents to the principal.
Good Help
Put a plan in place, and then delegate, not just the building purchase
itself but also the move. You need organized and professional help at
every step. Don’t use this as your personal opportunity to get into real
estate development unless you are sure that you have the aptitude for it.
Contraction Options
As you plan the building, try to allow for contraction. In other words,
picture how the building could be subdivided and a portion of it rented
out. That might include a separate entrance, common bathrooms, a
common conference room that can be accessed from two directions,
etc. Not only will this make it easier to subdivide, but the property
itself will also be more valuable when it is sold.
Best Use
Put your stamp on the building, but don’t make it so unique to your
needs that it becomes difficult to sell later. In other words, plan it so
that most any small service business could use it well.
F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 10 0

Marketing Opportunity
We’ve found that one of the most effective marketing tools is the
announcement you send out telling people that you have moved.
It seems to symbolize how dynamic and exciting your business is,
so don’t neglect it.
Watershed
Moving to a building you own will be a watershed. That much we know
for sure. If you plan it well, it can be a good one. That’s the result you’ll
want to aim for.
BEF ORECAST
Men honor property above all else; it has the greatest power
in human life.
—Euripedes, The Phoenician Women, 411 B.C.

9
S Y S T E M S & U T I L I Z AT I O N
This chapter focuses on utilization, or billable efficiency. After putting

this in the context of one of the three big issues firms struggle with,
we look at how to measure it, and why it should be measured that way
(on a financial basis). We then look at what it means.
How much of your time are you really charging for? You think you know,
but you are probably reading the wrong gauges. For every hundred firms,
ninety-five of them have a significant problem with not only knowing
how much of their time is being captured, but what to do about closing
that gap. This chapter will deal with the context for this issue and how
to measure your own billable efficiency. Then we’ll walk you through
the steps necessary to close that billable efficiency or utilization gap.
T H R E E B I G STRU G GLE S
Since 1994, ReCourses, Inc., has done a “Total Business Reset” for
more than fifty firms like yours every year. And measured utilization
in several thousand others.

Syst ems & Utilizatio n
Patterns will obviously emerge during that exercise. Yes, every

firm is definitely different, just like every patient is different, but you
still begin by taking their weight and measuring their temperature.
Even when clients resist, claiming that “everything’s fine,” we still
insist on benchmarking their marketing services practice. And sure
enough, they are always surprised at what we find. Further, they are
motivated to use the same tools quarterly, on their own, to measure
their own progress in several critical areas.
HOW TO M E AS U R E I T
So let’s look at the billable efficiency of a typical firm. As we go through
this I’ll define a few terms that we’ll need to use in this exercise. The
first term is utilization, a synonym for billable efficiency.
Let’s start with a very important statement: The only way to legit-
imately measure your billable efficiency is on a financial basis. What
that rules out is measuring your billable efficiency (hereafter BE) by
simply looking at your timekeeping records, for two reasons.
The first reason why you can’t measure your BE from your time-
keeping records is this: It does not account for how much time is
written off at the invoicing stage. In other words, you estimate that
a project will be $240,000 at $200 per hour, for a total of 1,200 hours.
Employees spend a total of 1,300 hours on it, but the client is invoiced
for $240,000, according to the proposal they accepted, and $20,000
worth of time is thrown away. Few firms can account for the time
that is written off at the invoicing stage, but a financial method of
measuring BE would properly determine that they got paid for 1,200
hours of time, regardless of how much time was actually spent. And
if they spent 1,300 hours on it, they gave away 100 hours because they
over-serviced or underbid the project.

The second reason why you can’t measure your BE from your
timekeeping records is this: Unless your definition of billable time is
broad enough, you’ll get a skewed picture. Using this same example,
imagine that the total time recorded on this project was 1,200 hours,
making it look like the estimate was perfect and the work was efficient.
But suppose a considerable amount of time was spent on this that was
not deemed to be billable. For example, travel to and from the client’s
office was not entered as billable. In such a case, the project is only
artificially profitable because time that was properly billable was not
accounted for as such.
Both of these scenarios are common, and they both point to the
necessity of measuring BE from a financial perspective. Because
unless the client pays the bill, it’s not real money.
FI NA N C IA L TIM E KEEP I NG
Let’s walk through this financial perspective of timekeeping. What
we are going to do is look at two things: hours that could be billed and
hours that were billed on a financial basis. Then we’ll compare the two
to see if there’s a gap. If there is, we have a BE problem.
To calculate this, you multiply five things together. In this example,
we’ll use a smallish firm:
12 Full-time equivalent staff count

42 Average hours worked in a week
46 Typical work weeks in a year
$180 Weighted average hourly rate
.60 Expected Utilization Percentage
$2,503,872 Economic Opportunity
Let’s assume that our sample firm, though, is only billing $1,750,000
per year. That means that they are actually capturing 42% of their
time (which happens to be the national average) rather than 60%
of their time, which is the actual target.

The explanation could be that they just don’t have enough work.
The team is skilled and efficient, using well-honed processes to esti-
mate and actually perform the work, but there’s too much sitting
around. That would, actually, throw these results off, and the solution
to that would be more work without expanding the size of the team.
But in the vast majority of cases, the team is busy (and not sitting
around). And when that’s the situation, the problem isn’t enough
work but the right kind of work. Their current work is plagued with
under-pricing and over-servicing, and the solutions are quite different.
You’d start by implementing a better timekeeping system, but
with only one purpose: to check yourself and to improve the next
estimate. Once you were better at estimating, you’d drop timekeeping.
Timekeeping should be viewed as a temporary fix to inform your
estimating to make sure you aren’t leaving any money on the table.
Once you’re maximizing the capturing of your time, you’d move beyond
that with package pricing and value pricing, but it starts by not giving
time away, either with a bad estimate or by not catching scope creep.
And then beyond that, the fixes come from balancing the role of
the account manager and project manager. The former’s job is to grow
the client and keep them happy. The latter’s job is to protect the firm’s
profitability and the team’s work/life balance. Together, with both of
these in perfect balance, you’ll thrive.

MO R E O N TH E STANDARD
The first question people ask is this: “Why have you included non-
billable people in the calculation?” We could, of course, include just
the more “billable people” in the calculation, but that would bring two
problems. First, who is billable and who isn’t? I know some principals
who would take themselves out of that equation. Or what about the
employee with split roles? Second, measuring the BE of just the
“billable” staff allows for a bloated administrative staff, supported
by a hopefully efficient “billable” staff.
The second question relates to the 60 percent standard referenced
here. Where does that come from? In part this comes from other ser-
vice industries where charging for their time means making money. It
also comes from the work of other consultants—listening to them and
seeing what they’ve found. But mainly it comes from having worked
intimately with hundreds of firms like yours and knowing what a
healthy firm looks like. Incidentally, nearly every other branch of the
professional services has a standard above 60%, so the fact that we
aren’t really reaching even a modest goal should be telling.
The third question relates to whether or not that 60 percent ever
changes. The answer is that the “60 percent BE” rule applies to firms
with a normal client mix. If that firm has a client concentration prob-
lem, the standard is higher. Specifically, if your largest source of
related client work represents 35 to 60 percent of your total AGI, your
BE should be 65 percent. If that client concentration is greater than 60
percent, your BE standard is 70 percent. The theory is that servicing
larger and fewer accounts allows for much great efficiency.
Next, I want to dive deeper into some of the specific systems you
might use to close this gap. These are nearly all temporary measures.
C LO S IN G TH AT GAP
OK, if you have a gap, we must close it. How does that gap get closed?
First, internal management must have a perspective that is more
profit-based than deadline-based. Thus the term we often use: prof-
it-based management environment (PBME). This is the place to start

because it facilitates internal change that usually comes with little

additional expense. (The remainder of a BE gap can usually be closed
with strong marketing to find clients who don’t require subsidization.)
E X PL A N ATI O N O F A P BME
Many firms suffer from a management environment that has been
shaped more by client demand than by careful planning. If your results
weren’t all that good in this exercise, yours is one of these firms.
Ultimately client demands are an inevitable force in shaping the
delivery of services, but even clients are not well served with lack of
planning, in spite of the appearance (and sometimes reality) that the
client is running your firm from the outside.
At deadline-based firms, more attention is paid to when something
is due than to keeping the project on budget (internally) so that it
yields a profit for you.
As the components of the project move through the firm, what
pushes it is an upcoming meeting, deadline, or delivery date. For exam-
ple, an employee is handed a job and told: “I need this for a 9:30 meeting
tomorrow morning.” In a profit-based environment the same hand-off
would be phrased more like this: “I need this for a meeting tomorrow
morning at 9:30. By the way, we’ve estimated about 3.5 hours for this
section. Keep track of your time and we’ll look at it once this project
is done. I want to make sure we are estimating correctly, you have the
training and tools you need, and I’m not over-promising to the client.”
Having a PBME relates directly to quality of life issues, too.
Without one, details will frequently slip through the cracks, disap-
pointing clients; no one will be able to do a “mind dump” of those
details that are slipping through the cracks; and your firm will not
achieve the level of profitability it could.
One way I like to gauge the extent to which any firm suffers from
this is to ask one question: “Who is responsible for keeping projects
on budget?” If the answer is not consistent and does not point to the
appropriate source, preferably focused in what we call the Resourcing
Department (essentially project management), you have a problem.

T H E BAS I S F O R A P BME
There are several components that are critical to maintaining a PBME
on your way to closing your BE gap.
First, and most important, you will need a strong motivator. This
is usually anger at the fact that you have been “subsidizing” clients at
personal expense to your quality of life. It’s accompanied by overwork,
underpay, and the realization that client loyalty is thin indeed. Clients
are not the enemies, but they are also not your friends.
Second, you will need confidence that you are worth every penny
of the hourly rate you have set. Though everyone agrees with this
verbally, in reality they don’t believe it. How else can we explain our
charging practices? Confident people get paid for what they do.
Third, you will need to move from denial of the problem to actual
measurement of your progress by charting BE.
Fourth, you will need to create some sort of common language—
a common vision to keep this quest a corporate priority. Without
involvement from all quarters, change will not be as deep or lasting
as it could be. For example, communicate the purpose and program
very clearly. Build consensus. And consider offering incentives to the
entire staff, or at least those most in a position to affect the outcome.
C O M P O N E N T S O F A P BME
A PBME is woven through the fabric of any particular management
environment. None of the individual threads are critical, but together
they form a strong, flexible, lasting system that brings profit to your
company. Here are the steps I would recommend if you have a BE
problem and want to create a more PBME at your firm. (Aren’t these
abbreviations fun?)
In these twenty-four steps, you’ll encounter some unique termi-
nology that ties in with our ReCourses Functional Model. Here are
definitions of the key words:
• Engaging: managing a client relationship
• Resourcing: managing a project internally
• Planning: guiding the client strategically

• Shaping: leading the skill players

• Developing: doing the actual work, within the strategy set
by Planning and under the direction of Shaping
Now here are the specific recommendations on closing your

utilization gap:
1) Standard intake procedure by Engager so that those

downstream will have the information they need, yielding
less work that needs to be thrown away because it is off track.
This gathers crucial data in following four categories: budget,
schedule, mandatories, and strategy.
2) Component specific budgets (by Resourcing, with feedback

from Engaging, Planning, Shaping, and Developing) for later
comparison so that you’ll know which categories are being
under-represented.
3) Proposal collapses consultative categories with rounded budget

number but lists COGS separately to preserve positioning and
provide pivot room should client want to pick and choose.
4) If scope cannot be easily determined from client requests,

force one of two directions: time and materials or paid
diagnostic/roadmap to determine scope.
5) No significant work begins until client approves proposal,

in writing.
6) Iterative approval by Shaper, Planner, Engager, and client to

prevent the perfecting of bad ideas. Avoid the “big reveals”
and do it an inch at a time.

7) Broad definition of billable time (e.g., Resourcing, Engaging,

estimating, travel). What is billable? “Billable activity is anything
I’d stop doing if the specific client wasn’t on our roster.”
8) Everybody (even unbillable positions) account for all their

time, not just the billable time, so that people understand
that it’s about capturing a specific percentage, no matter how
many hours are worked, and so that we can calculate billable
efficiency (utilization). The targets are never expressed as a
number, but rather a percentage, or employees may just work
longer hours to subsidize a low utilization rate. And hours above
a normal work week should be more billable, not less billable.
9) Everybody needs to enter their time without exception or

it’s not part of the culture and the data isn’t very usable. This
includes principals. It also includes three positions where
it is especially difficult: Resourcing, Engaging, and Shaping.
In those cases, it may be necessary to look back over the
immediate day that has elapsed and assign blocks of time
to projects with the most activity.
10) No discounting (judgment calls) by employees at entry because

of pressure to achieve something. If discounting takes place, it
should be at the invoicing stage, not the entry stage. The mantra
should be: “the purpose of a good timekeeping system is to
improve future estimating.” If it takes an employee longer than
estimated, that’s what it takes—but at least you can learn from it.
11) Daily entry before leaving, not the end of the week, and not
even the next morning, to enable ….
12) Daily, centralized monitoring by Resourcing, comparing hours

budgeted to hours expended, looking for potential over-
servicing issues.

13) Full access to time budgets for all employees.
14) If there is downtime, use it to move the firm forward and not
over-service clients.
15) When you do over-service clients, make intentional choices

about it (like trading pollution credits at the outset of each
week, allocating the normal overages and/or borrowing from
other employees).
16) Substitute deadline-based hand-offs (“Here. I need this back

for a meeting tomorrow at 3:30p.”) with budget-based hand-
offs. (“Here. I need this back for a meeting tomorrow at 3:30p,
and I’m assuming you’ll need to spend 4 hours on it. If it takes
longer, then fine—maybe the estimate is bad. But that’s the
time we’re assuming it’ll take.”)
17) All promises to the client are approved by Resourcing

before being made by the Engager. To make this happen,
each promise should be delayed (“Let me get back to you.”),
centralized (“I need to check with Resourcing.”), and remote
(“I’ll call or email you from the office.”). In a perfectly balanced
system, the Engager needs to be slightly more afraid of
Resourcing than the client.
18) Clear filtering of change orders to catch “scope creep,” caught

first by Engaging and next by Resourcing, if they miss it.

19) Invoicing intervals should not be determined by accounting

conventions, but should be correlated with client’s highest
satisfaction levels as you pass along more costs to them.
This means seeking permission and/or getting money as near
as possible to the project outset, the change order, and the
completion of the project. Client need and gratitude present
the most power on your part.
20) Show discounted amount on invoices if subsidy still occurs,

in order to: a) get credit for extra work; b) signal a higher
price next time because we can’t make the same mistake
twice; c) allow the best clients to step in and volunteer higher
profitability on your behalf; d) you end up looking stupid and
that’s a good deterrent.
21) Selected debriefs of clients and projects in a short “stand up”

meeting, comparing budgeted hours with expended hours.
22) Quarterly monitoring of utilization (billable efficiency).
23) Structure retainers properly, if used, as minimum monthly fees

in exchange for guaranteeing non-renewable capacity. So clients
get a bill each month with three items: next month’s minimum
monthly fee; overages from last month; OOP expenses.
24) Change the culture, first. And only then consider whether your
software is supporting the environment described above. If
the culture is appropriate, software solutions are very useful
in supporting it. Otherwise they are just extra work.

T H R E E LE V E LS O F MAK I NG MONEY
One last thought—making more money starts by capturing all the time
you should. From there, keep capturing all that time at a higher hourly
rate. Finally, start using “package pricing” based on a defined, propri-
etary process, leaving timekeeping behind as an elementary process
that only takes you so far.
BEF ORECAST
The need for more than the traditional monthly reporting system
grew evident when the company implemented flat-rate pricing.
The pricing system is based on assumptions—assumptions have to be
checked and monitored for accuracy. “Monthly reports were spread
too far apart to manage operations and monitor our assumptions,”
McGuire adds. “I needed daily information. From the beginning,
I could see trends in the stream of information. So I started zeroing
in on what was important for me and my business. We all slept better
at night after that.” McGuire’s reporting system helped drive the
company’s billable efficiency consistently into the 70 percent range.
The Contractors 2000 average for a company this size is 57 percent.
—It’s 10am. Do You Know Where Your Company Is

10
PRINCIPLES FOR
PRICING WORK
This chapter looks at the four roles that pricing plays, the four goals of
pricing appropriately, and five components of the larger pricing context.
Then we examine the possible problems related to pricing, the three
different approaches to it, and point you to the best pricing source in
your firm. Finally, you’ll find six steps
to pricing well, several ways to handle
discounting requests, and then how to
present your prices to keep them high.
Based on the questions we hear, pricing

your services seems to be top of mind.
In a new business pitch, for example, you want to be competitive so
that pricing is not a distraction should the prospect choose to use
you, but you also don’t want it so low that you leave money on the
table. We’ve all had that sinking feeling after mentioning a price,
wincing because we think it might be on the high side yet watching

P ri nciple s f o r Pricing Wor k
the prospect be pleasantly surprised at the fact that your price is less
than they had envisioned spending! Argh.
Here’s an important point. The reason our pricing is so variable has
less to do with uncertainty as it does with our desire to cater to clients
or potential clients. We act like we are asking: “How much should this
cost?” when in fact we are asking “What’s the most that they will pay?”
And we aren’t sure if that latter number is higher or lower than what it
should cost, so we waffle. It’s very much like starting to make a state-
ment, but making it slowly so that you can watch for the audience’s
reaction and then change your point of view midstream.
This waffling is primarily about lack of options on our part, and as
you’ve heard us say many times, “marketing is about control.” This
chapter will touch on that briefly, here and there, but it’s mainly a dis-
cussion of the principles you can use to price your services effectively.
One important note before I continue. I’m not a pricing expert,
and what you’ll find in this chapter describes initial pricing at a very
basic perspective. Be sure to check out the work of Blair Enns around
Pricing Creativity.
T H E RO LE O F PR ICI NG
In simple terms, we can define pricing as the amount of money that
will change hands at particular stages of the project (when it’s done,
or perhaps divided into stages). But that’s a very simplistic view that
is too narrow to capture what pricing is really about. Here are a few
other things that pricing well can accomplish for you.
Filter for Seriousness

Picture this prospect, charging toward you with limitless energy,
demands, and (supposedly) resources. But there’s a voice in the back
of your head screaming that all might not be as it seems. Money is
a wonderful roadblock. Throw it out there, with pricing that’s fair
and reasonable (if they are a qualified customer), and then see what
happens. Even without knowing the scope of the project you can say:
“This all sounds good. We look for clients whose needs require at least

$70,000 per month in fees. That means you’ll fit well with our client
base and it will allow us to get deep enough to really serve you well.
It sounds like what you are describing would easily exceed that client
level.” Then see how they react.
Measurement of Respect
For many years I’ve said that “money is the currency of respect.”
Even if you don’t need the money or they don’t have it, unless money
changes hands, they don’t listen and you don’t work as hard.
Difference Between Profit and No Profit

Unless you also adjust the scope at the same time, discounting a proj-
ect means that something has to give. You won’t make as much money
for the same work. It’s not likely that you go back to your landlord and
say: “Sorry, my rent check this month is going to be less because I
had to discount this project.” And you certainly won’t ask employees
to take a cut in pay. What you are giving up is your profit. That’s the
variable. But without consistent steady profit in your company, all you
have is a job with lots more responsibility and risk than you would as
someone else’s employee. Pricing properly ensures the extra profit.
Means of Differentiation
Pricing will set you apart in a competitive situation, but keep in mind
that lower does not always mean better. Too low and you will be
discounted as a contender. Too high and they’ll be curious, perhaps
willing to pay the extra but needing a strong justification to do so.
Contributor to Morale
To employees, pricing too cheaply can indicate a lack of respect
for their work. This doesn’t apply to all but the best account people,
though, since many of them take the client’s perspective. They can
be more interested in landing the project than making money on it.
But in general, it’s demoralizing for employees to work hard in the
face of consistent underpricing.

T H E G OA L O F PR ICI NG
As we work through this, be sure you know what you want to accom-
plish with pricing. That way you’ll know where to compromise and
where to hold firm.
Do you want lots of client wins? Careful, though, because imme-
diate quality and eventual longevity are not to be dismissed. And just
where should pricing be in order to gain wins? If you are trying to snag
unqualified clients, cheap pricing is good. Qualified clients will usually
choose a price in the upper half of those that are submitted.
Do you want longevity? Set your price too low and they’ll be com-
ing to you mainly because of the price, which means that as soon as
someone cheaper comes along, they’ll bail. But before they do, they
won’t listen and you’ll resent working for them. Set the price high at
the beginning and their expectations will match. Keep meeting them
and you’ll be fine.
Do you want clients to listen to you? The only way that’s going to
happen is if they came to you because of your expertise, primarily.
Otherwise you are no more than a pair of hands, willing and able to do
things on time and on budget. “But just leave the thinking to us, okay?”
Do you want to make lots of money? Keep in mind that you’ll need to
land the client first, which rules out pricing that is too high. But as long
as your pricing isn’t too high to scare them off, keep it as high as you can.

As you’ve probably surmised from these simplistic scenarios,

in reality your pricing goals incorporate all these elements. So each
factor needs to be balanced with the others. And that’s why pricing
is such a complicated topic.
P R I C IN G I N A L A RGER CONTE XT
All this points to the five things that comprise the context of your
pricing. The first component is obviously the dollar amount. But
it’s simplistic to confine your thinking on pricing to that component.
The second component is the value they receive, measured against
the dollar amount, above. Remember that this is the value as they per-
ceive it, not as you perceive it.
The third component is how the pricing is communicated. A well
written proposal on an exceptional office package, tailored to the
client, will allow for higher pricing. A kind, clear explanation from
your employee, delivered on time and with all the promised
components, will allow for higher pricing.
The fourth component is how flexible you appear on the pricing.
If you are too flexible, you’ll seem desperate. If you’re not flexible
enough, you’ll appear arrogant.
The fifth component of pricing is the extent to which similar proj-
ects are priced similarly for different clients. They might wonder if
they are paying more, for some reason, or even if you are giving them
a deal that nobody else is getting.
The point is that you must have your act together if you want to
press the pricing envelope. Clients assign value not based just on what
you do for them, but how you do it. It’s the entire package. Better yet,
it’s your brand—and that’s something you’ve probably been telling
your clients for years!

A RE YO U S U R E THERE’S A P ROBLEM
W ITH PR IC IN G ?
You might think that you have a pricing problem when you don’t really
have one at all. Obviously, the things we’ve talked about could be con-
tributing to what otherwise might appear to be a pricing problem.
What’s Behind the Complaint?

While the “presenting problem” might be that your pricing is too expen-
sive, money can mask reality because it’s easier to talk about. Are they
disappointed in you personally because you aren’t spending as much
time with them? Have you made a mistake that embarrassed them?
How’s Your Billable Efficiency?

Not making enough money could tempt you to raise your hourly rates.
But if you aren’t making enough money, chances are that you are not
charging for enough of your time, instead subsidizing clients left and
right. Fix that, first, and then decide if you need to raise your rates.
See below for how those impact each other.
Do Clients Respect Your Work?

There are so many possible causes of this that pricing should not
automatically be viewed as the culprit. It’s possible that you are not
leading the client proactively or that you don’t have a point of view
in interacting with them.
Pricing problems should be fixed after all these others are. In fact,
the pricing problems might go away entirely.
R EL ATIO N S H I P O F P RI CI NG
A ND M A K IN G M O NEY
Every firm is somewhere on a continuum with three points on it.
There are no exceptions in our work with hundreds of marketing
service firms. Follow these three steps or you’ll be putting your shoes
on before your socks.

Pricing High School

If you want to make money, concentrate first on charging for all of
your time. See the previous chapter where we talked through the
components of a “Profit Based Management Environment.” As a group,
60 percent of all the time worked should be billed back to clients (not
just entered as billable, since those are separate things). Some people
within the group will bill more than 60 percent (up to 85 percent), and
some will bill lower (as in none), but as a group that’s how much time
you should be capturing on a financial basis.
If this is not true in your case, concentrate first on generating more
accurate estimates that reflect how many hours are really required
to get that kind of job done. This factor of billable efficiency has the
single biggest impact on making money. Do not raise your hourly rates
to fix something that should properly be fixed with billable efficiency.
Pricing College
If you want to make more money, concentrate second on still charging
for the right percentage of your time at a higher hourly rate. But keep
in mind that raising your hourly rate—if the first stage is well in hand—
will not only help you make more money but serve to position you
more highly in the prospect’s mind. Reversing those two will just
make you look silly.

Pricing Graduate School

If you want to make even more money, and your billable efficiency is
good and your hourly rate is high enough, develop package pricing.
This might be $80,000 for a defined project, like a brand audit or media
perception study.
At this stage you are not thinking in terms of hours required, and
here’s an illustration of how all three stages work. In the first stage,
you give the client an estimate for $18,000, which assumes 100 hours
at $180 per hour. But if you are a typical firm, and your definition
of “billable time” is broad enough, you might put 120 hours into it.
In essence you subsidized the client in the amount of $3,600.
In the second stage you would estimate a similar project at $26,000
just because you know it will really require 130 hours. But you’ve fixed
the billable efficiency and moved beyond that to solve two things: you’d
like to make more money and you’d like to be positioned more highly in
the client’s mind. So instead you estimate 130 hours at your new hourly
rate of $200 per hour, and the bottom line on the estimate is $26,000.
The third stage is next, then, but this requires two things that
might or might not be true of your firm. The first is that you must be
specialized/focused. You have to be an identified, established expert
to set package pricing. The second is that you must have a defined,
proprietary process. It’s not enough for it to be defined—it must be
proprietary.
Using this same example, your proposal is $80,000 for a brand
audit. There is no mention of the number of hours required to
complete it. But you are so good at this and have such a unique
process that it only requires 333 hours to complete it. If your hourly
rate is $200, this project would be $60,600 if you were just charging
by the hour. But that extra nearly $20,000 is all profit. Because you
are experienced, smart, and confident. That’s the graduate school
of pricing (sometimes called “value pricing”).

W H O S ET S PR IC ING?
Okay, but who should set prices to make them fair to you and to the
customer? We have conducted more than a dozen tests to answer
this question, and the results depend a bit on the personality of the
principal. But in general the principal underprices most every project.
What’s worse is that they think they don’t, but rather stay involved
in the project because “nobody prices like I can.” (Thank goodness!)
The point is that in general principals should stay out of pricing if they
want it to be accurate. They are not as concerned with market value
as they are in landing the account or project.
Our next option is the Engager, or account person. They are better
at it, though there are still many exceptions. Relationship driven
Engagers are not good at it and set prices too low in order to not
disappoint the client.
Another contributor is the Developer, our term for the people deep
in the bowels of your ship who do the work, “translating” a strategic
direction through implementation. They’ll scratch their heads and
look smart, but in the end they’ll be optimistic, too, about how much
of their time any given stage will require.
That leaves the Resourcer as our best option. Everything goes
through this position and they are most in touch with the timekeeping
records, past estimates, balancing workload, vendor costs, and the
knowledge of who works smart and who doesn’t. Often their title is
something like Production Manager or Project Manager, and they

will fight for an accurate estimate and will not hesitate to get in your
face if you insist on charging less. You know who I mean!
S ET TIN G PR IC E S WELL
First, have a good timekeeping system. We won’t discuss that further
here, but unless you have one, you’ll never learn from prior work. The
purpose of a good timekeeping system is to inform future estimates.
Second, ask the client about their budget. More sophisticated
clients gladly reveal this information, knowing that they can only get
the most for their money if you know how much there is. Conversely,
unsophisticated clients are wary of getting ripped off and will act like
they don’t know. But certainly ask.
Third, ask those who will be doing the work how long they think it
will take. Then multiply the total by a certain factor, depending on the
makeup of your staff. We’ve found that multiplying their estimate by
between 1.2 and 1.5 will yield a more accurate number. For example,
the total time might add up to 400 hours at $200 per hour, or $80,000.
In this case we’ll multiply by 1.2 and assume $96,000.
Fourth, estimate the total days that one person would require
to get the entire project done, just assuming that they are skilled at
every facet involved in the project. We’ll estimate that it would take
one person, working 40 hour weeks, about 16 weeks to do this project.
At the same hourly rate, that’s $128,000.
Fifth, pick a number between the two and that’s going to be close
to accurate. That means that $112,000 will be pretty close. Round up
to $120,000 and you probably have a pretty accurate number. You’d go
look at similar projects at this point (see step one) and see how your
estimate compares. Remember to look at hours entered as billable,
not hours actually billed (the difference between the two is the time
you wrote off).
Sixth, debrief everybody when the project is complete, comparing
the hours estimated versus the hours expended. If you went over,
determine why so that you can learn from your mistakes.

D I S C O U N TI N G YO UR P RI CE S
Since another party has the freedom to accept or reject our pricing,
some flexibility is appropriate. If your estimate is accurate, though, the
only reason you would be flexible is because you don’t have sufficient
options. But here are some suggestions on how to work through this.
First, in what sense is your price too high? Is it high in relationship
to other bids for the exact same project? Are you the only one giving
them a price but they just think it’s too high? The “why” of what they
think is the most important thing.
Second, can the scope be narrowed? This way the new lower price
meets their goal of spending less money and meets your goal of not
doing anything for free.
Third, can you justify a discounted fee without adjusting the scope
because they give you something in exchange for that donated labor?
It might be some extra publicity or a service/product they can give
you in exchange.
Fourth, would they be willing to commit to a longer relationship?
Sometimes you’d be willing to discount a fee if the relationship will
become long-term, but that same investment is not sensible if they
are going to go away. So ask them to pay the original amount and give
them a credit to be used for future services that you provide to them.
Fifth, whatever you do, make sure that it does not water down your
positioning. You’ve typically worked very hard to get to this place. You’ve
envisioned a solid relationship with a substantial client, and all that
remains is to seal the deal. This is not the time to compromise too much
just to “get our foot in the door, because once they work with us they’ll
invite us into the room and give us a seat at the table. That’s when we’ll
start making the big bucks.” The truth is that you’ll only end up with a
bruised foot. Do not water down your positioning or the client is wasted.
Finally, keep in mind why your client might be drawn to you in
the first place. Is it your specialization? Your media connections?
Consider this as you decide whether or not you can maintain the
integrity of your own brand and still charge less. As we learned
in Marketing 101, “never discount a brand until it is established.”

P R E S E N TIN G PR ICI NG
It’s not just the substance that matters, so don’t waste your good
thinking with a presentation that doesn’t complement your true
value to the client.
Consultative vs. Transactional

Everything in your proposal that relates to thinking and doing should
be consultative. Everything that you purchase on the outside should
be transactional. Consultative work is not broken out and is not
calculated to the nearest dollar.
Large Round Figure

The final price should be a round figure. It should certainly be rounded
up to the nearest $1,000 but ideally would be rounded to the nearest
$5,000 or $10,000.
No Itemization
You should list all the functions that you will perform on the client’s
behalf, in paragraph form, with a consultative number at the end,
summarizing the cost of the functions you’ve just listed.
Appropriate Description
Your description should be clear enough to give the client confidence
in the thoroughness of your work, but no more detailed than is neces-
sary to prevent “scope creep.” In other words, you should be able to
point back to the proposal and know when a client is asking for more
than was agreed to at the outset.
Good Words
Use good words. It’s not a “meeting,” it’s “client consultation.”
It’s not “traffic,” it’s “project management.” It’s not “estimating,”
it’s “project planning.”

So the pricing portion of your proposal might look like this:
Project Planning, Consultation, Plan Design, etc. $80,000

Media Planning 5,680
Photo Shoot 7,110
Total $92,790
Obviously, you’ll provide a lot more detail earlier in the proposal on

what each of these functions entails. But you are better off avoiding a
specific price on each function. This will give you room to pivot and
discourage them from picking and choosing. Obviously, you’ll have to
do it the way they want it, but you might as well lead with a presenta-
tion that reinforces your brand.
KE E PIN G PR IC E S HI GH
How do you keep prices high? First, make sure you are specialized
so that you are more than a pair of hands. You cannot be an expert in
everything. Be sure to read The Business of Expertise for more about
positioning. Second, have a concise and attractive marketing plan to
lend an air of seriousness to your work. It’ll be harder to mess with
you. Third, provide good service so that clients are not distracted by
the relationship itself and then mask it by talking about how expen-
sive you are. Fourth, do good work that’s effective in solving the
client’s problems.
FI NA LLY
Remember that pricing well depends largely on two things: having
options so that you can resist the urge to charge less than you should,
and being confident enough in your work to set prices at an appropri-
ate level.

BEF ORECAST
Nothing is intrinsically valuable; the value of everything is attributed

to it, assigned to it from outside the thing itself, by people.
—John Barth, The Floating Opera, 1956
That which costs less is less valued.

—Cervantes, Don Quixote, 1605
There is no such thing as absolute value in this world. You can only
estimate what a thing is worth to you.
—Charles Dudley Warner, My Summer in a Garden, 1871

11
HANDLING COSTS
OF GOODS SOLD
This chapter examines some fundamental beliefs about passing expenses

through your firm, details the options for handling them, and then suggests
some alternatives that might keep both you and the client happy.
Handling pass-through expenses is a delicate balancing act, and there

are significant ramifications to how you manage them. Historically,
and with ever increasing frequency, the trend has been for clients to
handle these expenses directly. That’s been true since the late 1980s
and continues today.
Clients think—whether they are correct on this point or not—that
handling the expenses directly will save them money without unduly
increasing the risk associated with the process. Or, they’re willing to
have you continue handling it as you have for them, but they don’t want
to pay the same markup as they did in the past, often without question.
The upside of all this pressure on markups is that firms are no lon-
ger tempted to hide utilization problems under a thick blanket of high
markups. There was a day, though, when firms told themselves that

Ha n d ling Co st s o f G o o d s S old
it was alright: “We’re not making as much as we should on an hourly

basis, but the markup will compensate for that utilization problem.”
Of course, when the blanket was ripped away, the firm was left with
an unprofitable account, only because the hourly fees didn’t cover
the hours spent on the account.
P O S ITI O N I N G I M PLI CATI ONS

There are two specific positioning problems
when handling marked up outside expenses.
The first positioning problem is
that you’ll push for the markup
to cover risk, which will
automatically take your
firm from consultative to
transactional in nature.
In other words, you’ll
be making money on
the goods and services
that are passed through the
accounting department instead
of the thinking that takes place in your
head. That’s a real problem, and it’s difficult to overcome.
The second positioning problem is that you’re selling a commodity,
typically, which is sold largely on the basis of price. You can’t expect
a client to make those subtle distinctions which allow him or her to
think of your services one way but think another way about the goods
and services you also sell, often on the same invoice.
S PEC IF I C STRATEGI E S
There are specific strategies I would recommend when passing along
outside expenses, whether that’s media, printing, contractors, or any-
thing else. There are three such principles that I’ll explain below.
The first principle that must govern pass through expenses is this:
if the billing runs through your firm, there must be a markup to cover

risk. That risk includes a client who pays slowly or doesn’t pay at all,
leaving you on the hook for the full amount. It also covers any mis-
takes for which the blame is difficult to assign. All the client knows
is that you’re responsible, and they want it done right, leaving you
to sort out the responsibility for the error(s).
The second principle is that you must charge for your actual time
to manage the expense independent of the markup. Remember, the
markup only covers you for risk—the hourly charge thus covers your
time. So that hourly charge needs to be there regardless of whether or
not you’re charging for the risk inherent in the pass through expense.
The third principle is that you cannot accept responsibility for
vendors unless you have some control over them. That’s just a basic
premise: there is no responsibility without control. That control might
be passing the expense through your firm, but it doesn’t have to be, as
we’ll see in a minute.
So keep these three things in mind as I suggest how to handle pass
through expenses.
A RG U M E N T S S U PP ORTI NG PASS
T H RO U G H M A R KU P S
Your best bet is to state your case for handling the marked up expense
and then leaving it completely optional for the client. If your arguments
are sound, and if they are thinking logically, they’ll let you handle the
expenses and you’ll make money on the process.
Here are the more salient arguments you can make. Some will sim-
ply not be true in your situation, in which case you’ll just ignore them,
but use whatever you like from this list.
• First, our combined relationships with vendors gives us inside
knowledge about capabilities. We know who can do what, and
how well they can do it.
• Second, our combined relationships with vendors gives us better
pricing because of the leverage we can exert on vendors.
• Third, our combined relationships with vendors gives us more
control when it’s necessary. It’s not just your job we’re managing;

we’re guiding hundreds of them, and so the vendor will listen

to us when we need to give any given project special treatment.
• Fourth, a single point of responsibility can simplify disputes should
there be a problem with the vendor. It’ll become our problem if the
billing runs through us.
Those are really the only four credible arguments when trying to
justify running something through your firm. All of them may not
apply in any given case, of course, but there’s usually some obvious
mix of truths.
A LTE R N ATIV E S TO THE TRAD I TI ONAL

A P PROAC H
All of this presupposes that you’re hoping the client will let you bill the
products/services through your firm. Let me say, though, that there
are real positioning issues with that. So much so that you may deter-
mine that it’s just best, and less risky, to let the client handle things
directly. Regardless of where you come down on this issue, there are
some alternatives that you can give clients, and clients love alterna-
tives, even if they aren’t likely to choose something else.
The first alternative to standard markup policies is bill forwarding
and approval. In this setup, the vendor invoices the client but sends
the invoice to your attention, first. You approve or disapprove it, and
then forward it to the client for payment. That gives you some control
over the vendor without any of the risk. And it saves the client money.
The second alternative to standard markup policies is full pre-
payment by the client. In such a scenario, there is no substantial
financial risk (something can still go wrong with the job, of course)
and so there doesn’t need to be any markup.
The third alternative to standard markup policies is have the vendor
bill the client directly but then cut a commission check to you. I think
that’s unethical, and fortunately the practice seems to be all but dead.
The fourth alternative to standard markup is to simply have the
client contract those services directly and take all the risk. There’s not

that much money to be made on pass through expenses these days,

anyway, and the hit you’ll take to your positioning is probably not
worth the benefit.
BEF ORECAST
A building springs a leak and starts flooding like crazy.

The building owner calls a plumber who comes and assesses the
damage and says the job will cost $5,000. The owner agrees and
the plumber pulls out a hammer and strikes a single pipe and the
flooding stops.
The building owner gets upset with the plumber and asks why
the job costs $5,000.
The plumber asked if it would help to break out the expenses and
the owner said absolutely. So the plumber said hitting the pipe costs
$1 and knowing where to hit the pipe costs $4,999.
—Cody Swann, discussion board entry, Freelance Switch, July, 2010

12
C O M P E N S AT I N G
NEW BUSINESS
DEVELOPMENT
This chapter examines your own role in business development, and then
helps you eliminate the barriers that might keep a salesperson from
being successful—assuming they are the right person. After defining key
terms, we then identify seven compensation options, explain the “draw”
in more detail, and highlight the key elements of your written plan.
Finally, the chapter addresses the salesperson’s departure.
Don’t we wish that performance was as easy to measure in all positions

as it is in the sales function! Because sales does lend itself to measure
ment, we leap toward that comfortable spot, relieved that our
management load has been lessened.
But just because it is measurable doesn’t necessarily mean that we
should view it primarily in that fashion. In fact, experienced managers
sometimes get this nagging feeling that they are missing something by
implementing commissioned sales in a service business.
It’s here to stay, though, and in fact brings tremendous advantages
with it. Just recognize that successful selling is more about the person

Compensating New Busine ss De v e lop me n t
and the positioning than about the plan. When we emphasize the com-
pensation plan we are likely avoiding some management responsibility.
Good commission plans do not provide self-management for the sales
people. Instead, they provide an appropriate incentive for a situation
that would likely succeed anyway, almost regardless of the plan.
This suggests that success hinges largely on the right person.
Unless you have that element in place, no plan is going to fix it. A great
compensation system will not work without a great salesperson. In fact,
it will harm you, delaying an inevitable personnel decision and putting
success just that much further out of reach. If you think you might be in
this situation, make a note to yourself that tampering with an existing
plan is often an attempt to continue denying that the person filling this
job isn’t the best fit.
YO U R RO LE
While we are on the subject of responsibility, keep in mind how central
your role is. The principal (or one of several, if there are partners) must
be involved (as in “ultimately responsible”) for the new business efforts
of the firm. This critical activity cannot be delegated entirely. You may
find it useful to think of this process in terms of four different roles.
Positioning Comes First

This mapping and marketing function involves setting the direction
for your firm, deciding what the niche will be, and how the marketing
will be accomplished. Essentially you decide who should be hungry
for your services, and how best to create that hunger. The result is
a marketing plan.
Attracting Is Next
This new business development function involves implementing the
marketing plan, getting mailing lists, qualifying the list, managing
the email campaigns, managing a digital ad campaign, responding to
requests, and setting appointments. Essentially it is making prospects
hungry for your services by surfacing need.

Closing Follows Next

This sales function involves persuading the prospect that it will be a
fit and closing the sale by getting them to sign on for that first project
or program. Essentially it means taking those individuals who have
raised their hand and said “I might be hungry” and getting them to sign
up for the meal plan, choosing between your firm and a competitor’s.
Engaging Closes the Cycle

This account management function involves interfacing between
the client and your company, where they gather strategic direction,
schedule, budget, and mandatory elements.
As the principal, you must do the Positioning. You can hire the
Attracting entirely (if you wish). The sales person will need to help
with Closing, though you will likely step back in to assist with that too.
And early in the process the Engager is introduced so that the client
can bond with them. So in this chapter about new business commis-
sions, we are talking about all of the Attracting and part of the Closing.

T H E R IG H T PE RS ON
As noted above, the right person is the key. Have they been asking for
a commission arrangement, like a dog straining at the leash of a fixed
(as in “capped”) salary? If they haven’t brought it up or worked under
that arrangement successfully in the past, you are about to face some
strong resistance.
The good news is that it’s not either “commission” or “salary” for
sales people. Below we’ll describe the seven different combinations
you can employ between those two extremes. Obviously it will be in
your best interest to tend as far toward a commission-only arrange-
ment as you can.
This presumes that you have such a person on staff. You won’t have
trouble spotting them, either, because the personality type is unmis-
takable. They dress well, often run late for meetings, drive a late model
car (that’s not always clean inside), live to the edge of their means or
beyond, work hard at being positive, press the boundaries looking for
special treatment, care more than usual about their title on the team,
and fancy themselves to be entrepreneurs—though seldom will take a
sizable risk. Yes, you’ll be able to spot the commission-only salesperson.
Incidentally, don’t hesitate to hire a part-time salesperson. You
may well find a seasoned candidate who chooses to work part-time.
This might be ideal, and there are no significant drawbacks to having
a part-timer.
A fact of life is that this position—along with receptionists—is often
the hardest to fill. You may not have the luxury of being as picky as
you would like.
A RRA N G IN G F O R SU CCE SS
Before walking through plan recommendations, it’s a good idea to
highlight the most common reasons for lack of sales success. You can
run your own situation through this checklist to be sure that any plan
you arrive at has the greatest likelihood of achieving what you want.
Here are the most common reasons for lack of sales results (other
than a poor plan or the wrong person):

Fuzzy Positioning
Unless you have clearly defined points of differentiation, even the
best salesperson will not be effective. They’ll be able to bust into
any room, but will have nothing to say once they get inside.
Diverse Duties
Unless new business development is their primary responsibility,
not much will get accomplished. New business is important but sel-
dom urgent. It’s easy to put it off while they handle a pressing client
concern. In fact, mixing Attracting with Engaging is the most frequent
mistake made in assigning roles.
No Clear Target
Have you clearly defined the kind of client you want? This would
include location, size, industry, prior experience, etc.
Insufficient Principal Attention

One complaint we hear is that the sales people can’t get enough of
the principal’s time in brainstorming, going to meetings, or helping
with proposals.
Inadequate Support Materials

More and more clients are demanding some sort of written statement
about your perspective and capabilities. If you haven’t provided those
tools, your salesperson will lack a certain credibility. Worse yet, the
prospect will suspect that you are having trouble with your own posi-
tioning (as opposed to thinking that you just haven’t had the time).
All these materials are now digital, of course.
These are the main obstacles to success. One additional reason you
may hear is this: “I haven’t gone after those big accounts because
we are so busy I’m afraid you won’t take them.” That’s typically
a smokescreen.

MA N AG IN G R I S K
Before charting the range of options, and then suggesting a template
plan, we need to define four terms that appear in sales commission plans.
Commission
This is the portion, usually expressed as a percentage of the total
value of the transaction, that the salesperson keeps as an incentive.
They only get the commission if the deal is closed.
Draw
This is a formalized mechanism to get paid in advance for commissions
that are not yet due. This portion of a salesperson’s compensation is
paid in advance against expected future sales, even if those sales are
not specifically identified. A draw is used to even out an otherwise
erratic pay plan.
Base
This refers to the portion of a person’s salary that is guaranteed and
not subject to actual results. The only difference between a base and a
salary is that the former assumes that some part of the salesperson’s
total compensation will be variable, keyed to specific results.
Expectations
An expectation quantifies the results that are associated with a base.
Until that volume of sales is achieved, no commissions would be paid.
S PEC TRU M O F O P TI ONS

There are seven basic steps on the continuum between total commis-
sion and total salary. Even though this is a bit simplified, it’s a useful
way to visualize the next step in any particular arrangement.
There is a set amount of risk in any arrangement like this. Essentially
the options simply transfer risk from one party to the other. These are
listed in ascending order of risk to you—descending order of risk to
your employee.

Full Commission
The employee only gets paid when they are successful. You have the
least amount of financial risk in this arrangement, though you are
risking some time and marketing dollars (e.g., in preparing materials
they ask for).
Full Commission with Draw

The employee gets paid as before, but you provide a draw against future
commissions. This is a bit riskier simply because a draw is traditionally
not repaid when the employee leaves. Any deficit in that account would
be forgiven.
Base with Expectations Plus Commission

In this arrangement you would provide a fixed base salary that came
with specific sales targets, before which any commissions would be
paid. In other words, commissions are paid on any successes beyond
those defined in the expectations that accompany the base salary.
Base with Expectations Plus Commission with Draw

This is similar to the previous arrangement except that you are
providing a draw against future commissions.
Base Plus Commission

In this arrangement there is a base salary plus a commission on any
sales (not just the sales that exceed the expectations). In most cases
the commission rate is reduced.
Base Plus Commission with Draw

This is similar to the previous arrangement except that you are
providing a draw against future commissions.
Salary
This arrangement brings a fixed salary that isn’t tied directly to results
in any way.

Note that there is no right or wrong method of paying sales people.

You are far more likely to have the wrong person than the wrong plan.
The right person will perform almost regardless of their compensation.
But the right plan can provide additional incentives that will reinforce
the results you are seeking, provided the right person is in place.
MO R E O N D RAWS
A draw is a common device to level out compensation, to keep the
salesperson interested, and to formally recognize how long closing
a big relationship takes.
Draws are typically forgiven. That is, when an employee leaves, if
the unpaid commission checks are not sufficient to cover the advances
(otherwise known as draw) that they have taken, they don’t owe you
that money. We would not recommend any other arrangement. The
more palatable way to protect yourself is to cap the draw, usually
expressed in terms of a set dollar amount or a set amount of months
in base salary. From one and one-half months to three months would
be a typical cap on the draw.
T H E G OA L
Keep the goal in mind: strong relationships (which may or may not
start with a project). Pursuing relationships does mean extra build up
time with less initial success, but it throws the focus more on clients
who have the potential to give you ongoing work. Remember that
repeat business is lots more profitable. Make sure the plan encourages
this. And if your salesperson has a transactional background (media,
printing, copiers, etc.), be sure you watch them carefully so that they
focus on the right goals.

S U G G E STE D PL A N
Written
Your plan should be in writing. The process itself will clarify any
needed points, and you’ll also limit resulting disputes.
Simple
Keep your plan simple and explainable in just a few paragraphs.
Complexity strips motivation. Ideally you’ll reduce this plan to the front
of one sheet of paper (excluding a non-compete or restrictive covenant).
Continuity
Don’t have a “plan of the year” as you tweak it to achieve the desired
results. It’s demoralizing to the salesperson if you keep changing it.
New Accounts
Your plan should apply to new accounts that the salesperson brings
to the firm, not existing ones.
Gross Profit
Any commissions should be based on AGI (gross profit after outside
expenses), not total revenue and not net profit. This is a very import-
ant point. You should be setting the prices since they have an incentive
to set them too low (regardless of profit potential) simply to earn the
commission. And since you are setting prices, the salesperson should
not be responsible for profit. If they are, they’ll be tempted to manage
the project internally, which is a bad idea on two fronts: they won’t be
out there selling and they’ll be mucking up the delivery of good work.
Commission
An appropriate commission would be to pay them 10 percent of that
AGI for any work from a new client during the first twelve months of
that client relationship. During the second twelve months (months
thirteen to twenty-four), they would be paid 5 percent. Most firms

would not extend it beyond that two-year period, but if you did,
you could pay 2.5 percent during months 25-36. The theory behind
this suggestion is as follows: if they get an extended payout, they’ll
concentrate on finding relationships with long term potential. The
commission is reduced over time because great work and great
service will have as much to do with their staying on as a client.
Calculation
Their commission is calculated based on signed client agreements.
But it is not paid until you receive the money from the client. So the
calculation is made on an accrual basis, and payment is made on a
cash basis.
Caps
There would be no cap to how much money they can earn. There is
no point in it. It’s in your best interest for them to get filthy rich, since
you’ll get rich in the process and they’ll stay interested in the job.
Mixing Base and Commission

Of the seven options above, the most fair to all parties is probably
base with expectations plus commission with draw or base plus
commission with draw. To calculate the resulting agreement, first start
with a target salary. Assuming you want the person to make $100,000
per year and bring in $1,000,000 worth of work, here is how each of
these two options would work.
For the “base with expectations plus commission with draw” option,
you would probably pay a base that is roughly two-thirds of the target
compensation, or $72,000/year. Commissions would only be earned at
a 10 percent rate (for the first twelve months of the client relationship)
on AGI above the $720,000 “expectation” that accompanied the base.
You might allow for a draw, capped at two months of the expected
salary (or $16,000).
For the “base plus commission with draw” option, you would pay
the same base ($72,000 per year), and then pay a reduced commission

on all sales, not just those that exceeded the expectation. In this
case the reduced commission would be 3 percent of the revenue for
the first twelve months. If they brought in $1,000,000 of work, their
compensation would be $72,000 in base and $30,000 in commissions
(3 percent of $1,000,000). This option would help the salesperson see
an immediate reward for their work instead
of waiting until the expectation was met.
Trailing percentages would also be at about
one-third of normal levels.
If you have a salesperson who is just
starting out, you could set the base salary
higher than normal, phasing the extra out
slowly over a three or six month period.
C O M M O N Q U E ST I ONS
Related Parties
What if they sign a particular department and then another depart-
ment seeks your firm out, without the salesperson’s influence? Should
the salesperson receive a commission on that second department,
which probably would not have become a client without the salesper-
son’s first efforts? That’s a difficult question, but most firms would not
pay a commission on other fruit from a different branch on the same
tree unless there was a strong relationship between the two. The
important thing is to discuss this up front.
Sliding Scales
We’ve seen plans in which the salesperson received a greater percent
age of larger numbers (called a “kicker”). We have even seen a lesser
percentage, on the theory that proportionally there is less work in
landing a bigger account. Our recommendation is to leave it fixed
regardless of the volume.

Allocating Sales Efforts

This will not be an issue if you only have one new business person.
But if you have more than one, you’ll need to establish some means
of defining their selling activities by geography, type of client, type
of work, or any other means that works.
Benefits
Other than the normal employee benefits, it is customary to pay for
the salesperson’s cell phone usage (within limits), direct entertain-
ment expenses (against an agreed upon budget), and a car allowance
(either pay mileage or give them a fixed amount every month—don’t
lease a car in the company’s name in case the employee leaves).
I M PLE M E N TIN G THE P L AN

Putting a plan like this in place will be easier if the employee is just
starting. An existing employee will usually leave if you replace a base
salary with a commission structure. If you decide to do this anyway,
phase it in.
Except in unusual circumstances, it’s better to have the employee
work on site, not from their home.
Require that they log all significant prospect contacts (mail, phone,
meeting, email) in a centralized database, on-site, to which you have
random access. Obviously this should be backed up every day.
Funds due the employee should be paid as soon as possible (usually
the next payroll). This will keep their interest level high. These should
be tracked by the bookkeeping department or any other third party
that would be appropriate. Provide full disclosure to the sales
employee, on a regular basis.
To help you relax, outline specific expectations for their reporting
to you (in terms of frequency and format).
W H E N TH E Y LE AVE
Sales people leave, and when that happens you should only need to set
in motion a pre-defined exit plan.

There are basically four options for the additional compensation

they’ll be receiving.
• Option 1: They receive no funds that have not already been paid.
• Option 2: They are paid only on work invoiced to the client even
though the client hasn’t yet paid.
• Option 3: They are paid on proposals that have been accepted by
the client in writing, even though nothing has been invoiced or paid.
• Option 4: They are paid on any proposals in the works, even if
those proposals have not yet been accepted by the client.
Most plans lean toward option 2, with option 3 following closely

behind. It’s best to be conservative and then liberalize it as a negoti-
ating point. Of course, any amount due them would first be applied
to any outstanding draw they might have.
Keep in mind that even the best marketing plan might not show
results for six months. So be patient … and follow your instincts about
whether you have the right person in place at the same time.
BEF ORECAST
For the salesman, there is no rock bottom to the life. A salesman

has got to dream, boy. It comes with the territory.
—Arthur Miller, Death of a Salesman, 1949
People will always work harder if they’re getting well paid and if
they’re afraid of losing a job which they know will be hard to equal.
As is well known, if you pay peanuts, you get monkeys.
—Armand Hammer, Hammer, 1987
He that payeth beforehand shall have his work ill done.

—Thomas Fuller, M.D., Gnomologia, 1732

13
OPEN BOOK MANAGEMENT
This chapter examines the rationale for open book management. It

begins with a definition of open book management, discusses the vary-
ing degrees of it, and the theory behind an open environment as such,
followed by a look at the advantages and disadvantages of employ-
ing it in a small company setting. We then take the concept further by
highlighting the best reasons to implement it, and then exploring the
main reason not to do it. From there, we explore the components of an
effective environment, and then discuss the different degrees to which
you might implement this management practice. Finally, the chapter
provides suggestions on assembling your own system, with specific
suggestions on migrating to it.
The concepts behind open book management have been around for
quite some time, but as an identified management discipline it’s only
been with us for a few decades. It’s often abbreviated as OBM.
Nearly every one of you will be skeptical about this topic, and
that’s okay, because I am too. And I’m writing the chapter! I’ve had

Open Bo o k Management
many clients over the years inquire about it, but few who practiced it.
Those who did practice it didn’t do it well. Taken together these facts
have made it fairly easy to dismiss the movement out of hand without
much reflection.
Here’s the problem, though. The minority is often right. But even if
they aren’t, there are principles under the movement that are worth
incorporating into our management practices. As a discipline, OBM
overstates the benefits, but there are some excellent lessons from
which we should learn. This chapter is designed to explain the best
kinds of OBM and make it easier to move in that direction, however
far you deem wise. The first part will lay a foundation, and the second
will help you with examples and your own implementation.
W H AT I S O B M ?
OBM is not just opening your financial statements, though that
misconception would be common. It’s about much more than that,
which is partly what makes this topic so appealing.

Financial Information
First, it covers sharing financial information, obviously. Most of this
information is on financial statements, but much of it is not. For example,
you might talk about utilization, the cost of mistakes, or the profitabil-
ity of certain client segments. This ancillary data is based on financial
statements, but OBM goes further than the statements themselves by
explaining what the data means and how individual activity affects it.
Decision Making
OBM also involves giving some decision making authority to those
whose performance drives the numbers. In other words, OBM is not
just “opening the financial books” but “managing openly” so that it’s
less of a top-to-bottom arrangement.
Rewards
OBM also involves some degree of tying rewards to company, group,
and individual performance. This makes more sense in an OBM envi-
ronment because people understand where the company is and how
their individual actions affect that position. You can see this in a crude
way: if a salesperson is compensated on new business, they want to
see an accounting of all the new business they have brought in, and
they want to have some input in the marketing plan.
Understanding
We shouldn’t use information to intimidate, control, or manipulate
people, though unfortunately this happens quite frequently. We
should instead teach them how to work together to achieve common
goals and thereby gain control over their lives. At least to whatever
extent that is possible. They might do everything perfectly and still
get laid off, but at least it won’t come as a surprise if they are operating
within an OBM environment!
Nevertheless OBM is largely financial. There’s no way around this,

either. Whether you are comfortable with it or not, numbers are still

the language of business and the currency of success. If you make lots
of money, you won’t necessarily be happy. Good business people don’t
just make money—they make money without giving up happiness.
Frankly, I would welcome a return to more emphasis on numbers in
our management practices. With a few exceptions, there is too much
“rah rah” and too little emphasis on numbers. It’s okay to do white
water rafting for a weekend, climb simulated mountains on a local
wall, bring a yoga instructor into your office, or sponsor Friday after-
noon beer parties, but you can’t forget one thing. You can’t forget to
make money to stay in business. Emotions have a legitimate role, but
not at the expense of numbers, which are less likely to lie to you.
TO O B M O R N OT
OBM is clearly a fad. That doesn’t make it wrong, just suspect! Open
space layouts are also a fad, and time will tell how well they catch on,
though there’s already strong anecdotal evidence (if that’s possible)
that people jumped on the bandwagon and only later asked where it
was headed.
In my opinion OBM is a fad that will not catch on with the masses,
similar to the ESOP (employee stock ownership plan) movement.
But there are parts of this trend that definitely bear incorporating
into your management practices.
It’s not about whether you use OBM or not, either, but rather
to what degree you use it. We are all on a continuum. At one end
we might only disclose that we are “having a good (or bad) month.”
Further along we might talk about specific sales numbers. At the end
of the spectrum everyone will see the financials and be privy to com-
pensation arrangements.
If you implement OBM, you should do so because you think it fits
your style, not because you think it will bring better results. And just
to save you the trouble of looking it up, you’ll be hard pressed to find
published data that shows significant improvement in profitability in
OBM environments.

To dig a little deeper on that point, even one of the largest

proponents of OBM (the National Center for Employee Ownership)
is forced to admit that they only see a 1-2 percent increase in sales
(over the experience of non-OBM companies). They have more data
than any other organization, and their perspective is promotional,
so there you have it.
Think about the examples of large flops that were employee owned
and used OBM as a management tool (two things frequently found
together): United Airlines, Hertz, etc. These are not stellar examples
for us to emulate.
Of the hundreds of companies we have worked with through
ReCourses, Inc., only two have been very openly of the OBM ilk. One
did it for control. Both did it to avoid management. Neither performed
at a high level of profitability or morale. Fortunately, it’s a misnomer
to believe that it’s either OBM or not. It really is a matter of degree.
Even proponents of full OBM really don’t practice it fully, though
they will be loathe to admit this. One noted expert on OBM says that
compensation levels should be kept confidential. He cites pay scales
that are a jumble of seniority, skills, special deals, historical accidents,
favoritism, and bureaucracy. But isn’t that the point? That men and
women in the aisles will see this stuff and help root it out? After all,
compensation is typically at least 45 percent of your expenses, and
any serious attempt at controlling expenses must look at this area.
This just demonstrates that we all draw the line in different places.
Personally I cannot recommend that you publish compensation data.
When employees know what others make (except for direct manag-
ers), it usually means that we have a bad morale problem that has led
to this comparison. It also means that nothing good can come of it,
if only because we cannot easily separate assigning work value and
personal value.
Stepping back and looking at the landscape, it’s clear that com-
panies are doing better. They are providing better quality and better
service, all within better cost structures. Competition and technology
are powerful shaping forces.

But people aren’t doing as well. They are sometimes anxious and
frustrated. They are viewing employers with increasing mistrust and
misgiving. They are cynical, and their icon is Dilbert. Something must
be wrong, so let’s move to the theory behind OBM and see if you buy it.
T H EO RY B E H IN D O BM
Access to information is control. Control allows change. Change
allows happiness, only because we all want impact.
As you may have found, corporate reorganizations or deep work
with a management consultant are self-limiting because they do not
take place from the bottom up. Management consultants work from
outside, and reorganizations take
place from above.
You (as in “you” the manager)
can only accomplish so much
because there is only so much
you can control. Ultimately, I suppose you could fire everybody, but
there is a certain diminishing payout with that approach. Once you’ve
got your systems humming again, your mistakes low, and your quality
high, there’s just not much left to fix in a lasting way. And of course
your better competitors have already done pretty much the same
things that you have, to a greater or lesser degree.
Your performance may be as good as theirs, but it’s not likely to be
measurably better. From this point forward there are only a few things
left to boost performance over the long term, and one of those things
is to have employees work enthusiastically and effectively and to take
responsibility for their own work. Good procedures are indispensable.
But what makes the difference in the end is whether the employees
doing the job think about doing it just a little better and even care
whether they do or don’t do it better.
Having said this, somebody still needs to lead, and your employees
are probably not entrepreneurial leaders or they wouldn’t be working
for you. So let’s not fool ourselves and go too far. “Animal Farm” doesn’t
even work in a book.

But if you do want that edge, it just might be openness in your

management environment. While this might not be true in the
strictest sense, openness is ownership and I can promise you’ve
muttered the refrain: “I just wish they would think like owners.”
Openness really is ownership because we are talking about own-
ership of information, ownership of responsibility, and ownership of
results. An open environment provides all participants with an under-
standing of the intent of their organization. And it also provides them
with the capacity to comply with that intent, if they wish, and then be
accountable.
After all, when you understand, agree with, and have the capacity
to comply, it’s pretty hard to hang around and not embrace the organi-
zation’s intent.
A DVA N TAG E S
There are many advantages to a more open approach to management.
The specific ones will vary based on your circumstances, but these
three will probably be universal.
Less Taking for Granted

Most people don’t understand that 45 percent (or more) of gross profit
goes to salaries and that up to 40 percent of net goes to taxes (depend-
ing on your structure and compensation methods). Until they learn
otherwise, they might very well assume you are making lots more
money than you really are.
They also don’t know things like what retained earnings are or how
a company might be making money but still be cash poor temporarily.
They don’t necessarily appreciate how a mistake comes straight out of
profit and how thin margins really are. Did you understand that stuff
before you owned your own company? Did you ever complain about
things, “unhindered by data”?

Fewer Rumors
In the absence of real facts, people tend to fill the void with rumors about
all kinds of things. You can set the record straight easily and let employ-
ees concentrate on other things, like not filling out their timesheets.
Bigger Perspective
As you talk through the numbers and your plans to deal with them,
people will begin to see the connection between their activities and
the bottom line. You will also give them a sense of ownership because
they understand and have impact.
All this teaches them that to be a viable company we need profit.

Our survival and comfort depend on it. Sure, people are frequently
told what to do in an eight hour day, but they aren’t shown how that
activity fits into the bigger picture. For example, when is the last time
you walked through the time bid on a particular project and placed
that against the time actually spent?
D I SA DVA N TAG E S
On the other hand, there are three very significant fears
that keep most owners from employing a more open system.
My guess is that you’ve already thought of each of these
already. But let me lay them out and then provide a bit of
perspective on them. Here we are talking specifically about
the financial component of OBM, though obviously there
are other parts to a new, “open management” style.
Competitors Will Take Advantage

Once you print something out and give it to an employee, there is a
legitimate fear that a competitor will get it (often when the employee
becomes disgruntled or is talking with a friend who works with your
competitor). But what really happens when a competitor gets your
numbers? If they aren’t great, they’ll dismiss you. If they are great,
they’ll have the results, not the methods. And if they don’t adopt

your methods, it won’t matter. Our segment in the world of service

industries is uniquely insular. We should get over this.
Employees Will Start Their Own Company

Some owners are most afraid of their most competent employees,
certain they have taken the job only to leave and begin their own com-
pany with the new found knowledge you have provided. For one thing,
you can’t really prevent this. And a “close to the vest” style will likely
hasten their departure. For another, sharing honestly what it takes
to run the company might dissuade them from starting their own!
It’s a fact that many young entrepreneurs underestimate the capital,
energy, and wisdom required to turn opportunity into money.
Employees Will Apply Undue Pressure

As Jack Stack, the founder of OBM, points out, a lot of companies hide
their financials not because they’re afraid of their competitors, but
because they’re afraid of their employees. They don’t think people will
understand the numbers, and there’s some truth to that. If you don’t
show employees how to use financial information as a tool to help the
company, they might well use it as a weapon against the company. But
you might be better off in the long run being open with some financial
information. When the numbers are hidden, people make assumptions,
and they’re often crazy ones. Nine times out of ten, people think a com-
pany has a lot more money to spend on wages and salaries than it does.
Even with good education, some employees might pressure you
to spend money differently, like less money given to you and more to
them. But explain that money comes from work, ownership, and risk.
All three of those apply to you, and only one to them (work). Besides,
in most non-OBM companies, they still want more money, right? In
other words, everybody wants more money, but in a more open sys-
tem you’ll have an answer more likely to quell their restless hearts.
You can see that on their own these are not good reasons to dismiss
a more open environment out of hand.

W H Y H A R D TO D O
With these obvious advantages, and having answered at least part of
the objections, why is implementing OBM so difficult to do? I’ve noted
three reasons in working with various entrepreneurs. These are in
addition to the disadvantages noted above.
First, entrepreneurs don’t let go. They are control freaks, and
as long as they control information they can control the decisions.
Second, entrepreneurs crave independence. They don’t want to
“build consensus” and stop for obstacles. It’s easier to filter the data
and ask people to take statements at face value rather than pause to
give people a chance to digest and then approve. And what if they don’t
approve? Entrepreneurs would rather ask forgiveness than permission.
Third, it only looks more difficult in a small company. The only big
companies that disclose financials are the publicly held ones, and that
only because they are required to do so by the SEC. Of course they
are generally run by non-entrepreneurs, which makes it even easier
to comply.
S M A LL C O M PA N Y I SSU E S
Speaking of implementation issues unique to small companies,
here are three important guidelines.
Top Down
You must be excited about this. If another party, whether a group of
managers or a group of employees, is pushing you toward this, it will
fail. You can still be skeptical but you have to believe it’s the right thing
to do. If there are others with you in the management group, there
should be a clear consensus to do it.
Whole Company
You can’t do this just by department—it must be for the whole company.
One of the most frequent disputes is over how to allocate overhead
expenses, and there will be too many disagreements about who should
be charged with the conference room, the copy machine, and the new

server. Any open book system smaller than an entire company will
only work in very large companies with very clear divisions.
Maturity First
You need to make sure that your company is ready for the increased
scrutiny and that there is as little room as possible for confusion.
To do this, make sure you are receiving regular, accurate financials.
Those financials should reflect only company transactions, too. In
other words, don’t intertwine your personal life. Get those personal
cars and loans and expenses off the corporate books.
You’ll also want to spend some extra time making sure your man-
agers understand the new data at least as well (and hopefully better)
than the employees will.
And finally, make sure that the financial data you will be talking
through is forward looking. In other words, include not just historical
data, but also budgets, cash flow projections, and something about
your planning process.
YOUR MOTIVATIONS FOR IMPLEMENTING OBM

All this to say that you should think carefully about why you are doing
it. List the reasons for yourself, then ask yourself which ones are part
of a larger philosophical picture versus a more momentary need.
In other words, this is much easier to do when things are bad and you
need everybody’s help. But how will you feel when things are good and
the disparity between your compensation and theirs has widened again?
I M PLE M E N TATI O N
The first part of this chapter described the reasons for open book
management (OBM) and set a foundation for its implementation. The
second part walks you through the implementation of various degrees
of OBM at your firm.

OBM is not just opening your financial statements, though that

misconception would be common. It’s about much more than that,
which is partly what makes this topic so appealing.
For example, OBM is about sharing financial information in order
to get people involved in their work, particularly helping them see the
financial implications of their decisions.
It also moves decision making out “into the streets” as employees
are trusted to see the bigger picture as the environment takes on
characteristics of “managing openly” on a daily basis.
As this unfolds, it’s natural to find rewards that encourage employ-
ees to continue “thinking like owners,” as the saying goes. Some
variable compensation arrangements can further enforce these
with the appropriate rewards.
Finally, OBM is about under-
standing the work environment.
It teaches them how to work
together to achieve common
goals and thereby gain control
over their lives. At least to
whatever extent that is possible. They might do everything perfectly
and still get laid off, but at least it won’t come as a surprise if they are
operating within an OBM environment!
This is the thinking behind OBM. Individually they are a little unre-
alistic, but as a whole they present an outlook that is difficult to fault.
S PEC IF I C R E AS O NS TO D O I T
People have noticed these advantages, and have thus been moved to
implement some form of OBM. We’re going to talk about implemen-
tation in a minute, but we cannot in good conscience explore that
together without being absolutely clear about the good and the bad
reasons to do it.
There are typically four things that motivate such implementation.
After boiling down all the philosophy, the bottom line looks like this.
One of the reasons is bad—really bad—and the other three are good.

The first good reason to implement OBM is to clarify goals and

align interests. In other words, you are telling employees what you
expect, how to measure it, and what results will be achieved if these
goals are met.
The second good reason to implement OBM is to improve the bot-
tom line. After all, the primary form of measurement is financial, and
so the results should be obvious. And the new results should benefit
both management and employees.
The third good reason to implement OBM is to turn people loose
and let them flourish because they will see the results of their actions,
which is a basic human need.
A SPEC IF I C R E AS ON NOT TO
But there is one very dangerous reason to implement OBM, and it is
based on the belief that more information will create a “self-managed
environment.” This is precisely where OBM fails because it expects
results from a management system that can only issue from managers
(vs. systems). In other words, OBM is a system which helps managers
do a better job, not a system which lessens the need for management.
Management is more about making distinguishing decisions in an
environment not conducive to it than it is putting systems in place
that effectively “self-manage” people. If self-management were effec-
tive, every one of you would have such a system in place. Unless we
recognize our tendency to insulate ourselves from the down and dirty
side of management, we will waste precious effort on systems that are
doomed to fail from the start.
Many of our management practices—including OBM to one degree
or another—are meant to insulate us from the need to manage. They
are disguised as “good management” when in fact they are not. For
example, we create over-complicated employee manuals so that we
can point to a page when any question surfaces. Or we install a simple
formula for bonuses and invoke it once a year just before Christmas.

We don’t dare think of this as a great way to motivate people. Good

management should strive to create equal opportunities without set-
ting everyone on an equal plain.
“Distinguishing decisions” are the choices you make about how
well people are living up to their potential, and OBM will not relieve
you from the duty to keep making these decisions. If you are typical,
you have strong feelings about the extent to which this is true for each
employee under your care. But you are not trusting your instincts,
leading to inaction. Being fair and being even are different things. Make
distinguishing decisions and you’ll be as close as you should be to the
practice of management. On the other hand, without frequent use of
this management muscle, it will grow limp and increasingly ineffective.
So let’s agree that we aren’t trying to turn our people into rats who
will run the maze with a smile on their faces. Nor are we trying to avoid
the inevitable grayness otherwise called management. Instead, we
are trying to do the right thing, looking for ways to clarify our expec-
tations of people and to say thank you when they meet them. We are
also trying to give them the tools to take more personal control of their
environment. But OBM will not necessarily remove some of the need
to manage people.
A N E F F EC TIV E E NV I RONMENT
Now to the implementation of an OBM system. The place to start is
with an environment that complements the system instead of nullify-
ing any benefits it might bring.
This is important because unless there is a good environment
employees won’t believe the numbers, and unless they believe the num-
bers this won’t work. There is no amount of disclosure that will reassure
a skeptical employee if only because all of them are self-generated.
This skepticism is not unfounded in companies with difficult
management environments. For too long numbers have been used to
punish, supervise, intimidate, and control. In this case, though, we are
talking about education. To be more specific about what it means to
create an effective environment, here are three specific suggestions.

First, assess your company. Look it over from top to bottom,

assessing how effectively your company is poised to embark on some
change. Do this yourself or hire an outsider to take a look.
How’s the morale? What would you change about your company?
What would employees change? If you have to guess at their answer
to this last question, why is it that employees fear being forthright
with you?
How’s the infrastructure? Do people know who their single super-
visor is? Is that supervisor really managing people, or just providing
technical advice on how to do things? Do you see accurate, timely
numbers? Do you understand them and believe them yourself?
If I want to quickly assess the morale in a company, I typically just
ask about it in a confidential employee survey, and usually employees
are honest about it. But the best way to get at that information through
the back door is to ask how conflicts are handled. Poorly managed
environments sweep conflicts under the rug, or they are handled in
a manner that is not appropriate (too publicly, through the wrong
medium, etc.).
Second, have you gone
through some big changes
recently? These might include
the loss of a key employee
under less than stellar circumstances. Or a move into new
facilities that required far longer than you would have liked.
Or very poor results that fall far outside the norm. Or a divisive
employee retreat. Or a controversial new personnel policy.
In general OBM is best implemented from a stable platform. Not
only will your motives be clear, but employees will not be distracted.
Third, how good a job has your company done in the past at adapt-
ing to change? Sure, OBM requires more change on your part than on
theirs, but there is some adapting that needs to come from all quarters.
I would draw your attention to one very significant point: by definition
an entrepreneur’s tolerance to change is far greater than the tolerance
of an average employee.

Employees generally value stability. You probably place a higher

value on change and challenge. Step into their shoes and try to view
change on a grand scale from their perspective.
Working through these three questions will help you predict the
success of a more open environment. Where is your company right
now? What major events have you faced recently? How well do your
employees adapt to change? The main point is that you must be
willing to address the larger context in order to give OBM a fighting
chance to succeed.
D EG R E E S O F O B M
It may hearten you to know that OBM doesn’t mean going from your
current closed system to sharing everything! There are many degrees of
OBM, and there is no necessary correlation between “more open” and
“better environment.” There are two things to consider in this regard.
First, decide who will be involved. The choices are obvious: owners,
key managers, project managers, employees, clients, and competitors.
This answers the question of “who” will be involved.
Unbelievably, many owners—especially the ones who participate
less in managing the internal business affairs—know very little about
what goes on. This is unconscionable, and it’s the place to start for
a more open environment. After all, employees are likely to ask any
owner questions about what the data means, and any owner should
be able to answer those basic questions.
Key managers are those who regularly participate in steering the
firm. They are consulted on areas outside their immediate influence,

contributing to discussions about employee culture, facility usage,

marketing initiatives, and customer service standards, to name a few.
Project managers are those who track details or provide technical
expertise to lesser experienced employees. They shape projects more
than people. They function more like senior employees than managers.
Employees are comprised of the rest of the crew, though you might
also want to include full-time freelancers who for all practical purposes
function as employees.
Competitors are those other firms who hire your employees and
pump them for information, or who read the information you release
to the press (e.g., on your sales revenue), regardless of how true it is!
Second, decide what information you will divulge. While you could
obviously divulge all of it, few firms do. Instead, they pick and choose
elements that are appropriate for their situation. This list is organized
from “less risky” to “more risky” as generally perceived by principals.
Hourly Rate
This is first because it’s the first baby step on the continuum of
having a more open environment. Unbelievably, about 5% of firms
attempt to hide their hourly rate structure from employees. Not only
is this futile (how silly is it to keep something you reveal regularly to
prospects from the people you work with?), it is counterproductive.

The message it screams is paranoia. It also says “you aren’t smart

enough to know that an hourly rate assumes a certain amount of
overhead and corporate profit.”
Proposals
In the same vein, about 10% of firms don’t want employees to see
proposals, thinking they’ll be inspired to go out on their own and
“capture all that money.” They also fear that employees who could
otherwise get things done quickly, will “use up all the time if they
knew how much I allowed.” I would guess that employees are more
sophisticated than that.
AGI
This is an abbreviation for “agency gross income,” composed of your
fees and markup profit. It is also known as revenue, gross margin, or
gross profit. It is taken from your income statement, and is generally a
pretty “safe” number to reveal because in doing so you are not required
to reflect any compensation related data or net profit. (Note that total
revenue is not on this list. It’s a meaningless number since it might
include large amounts of pass through income that distort the picture.)
Income Statement
Your income statement shows all revenue, less all expenses, yielding
net profit, for a given period of time. Because it reveals compensation
levels—even if only in a large lump—and net profit, even principals
who conduct a more open environment draw the line here. In other
words, they reveal their hourly rate, proposals, and AGI levels, but
not their income statement data.
Balance Sheet
Your balance sheet describes what you own, what you owe, and
the difference between them (your equity). Many principals resist
showing this because they are afraid it will make them look “rich”
and because balance sheets are not easily understood by folks who

haven’t been around financial statements. A term like “retained earn-

ings” is inscrutable to the average employee.
Compensation
Sharing this information would typically mark the most aggressive
point on the continuum, and less than 1% of firms do it. No matter what
we want in people, they still tend to impute value based on compensa-
tion values. It is not helpful or healthy.
If all this seems overwhelming, here’s a simple suggestion. At a

minimum, share your hourly rate, proposals, and AGI with all employ-
ees. Share your income statement and balance sheet with key, trusted
managers. Obviously they will also know compensation of their direct
reports, which might be as far as you want to go in sharing that data.
ASS E M B LI N G YO U R OWN SYSTEM

We have just looked at the typical financial data that is shared. It’s a
place to start, but most people don’t understand financial data, and
they certainly don’t understand what it means and how their actions
impact it. For these reasons I would suggest that you develop your
very own dashboard.
The dashboard in your car is not designed for you specifically. If it
were, the gauges that mean the most to you would be positioned front
and center, and their relative size would complement their relative
importance. In much the same way, consider designing your own
financial dashboard. The key is to choose meaningful metrics and
then explain them carefully to employees.
What are these critical numbers? The answer depends on where
you are and what you are struggling with (which suggests that they will
change over time). These are the movements in your firm that are pre-
venting you from being successful or helping you keep the success that
you enjoy. And they can almost always be measured in financial terms.
See the earlier chapter on Benchmarking Your Financial
Performance for specific suggestions on what to measure, but three

simple ones that should make the list are these: your debt to asset
ratio, your billable efficiency (utilization), and the months of overhead
(cash cushion).
But of course these should be part of a larger plan so that you
don’t fixate on them. And what is that plan, by the way? What you
want to watch has everything to do with where you want to go. If you
are not interested in getting bigger, don’t talk all the time about gross
revenue; instead, concentrate on net profit.
Not only should you be strategic in your measurements (concen-
trating on what you want to see different), but you should also be
dynamic (watch it regularly) and holistic (what other plans will we
need because of these efforts?).
After you’ve decided what to measure, set
a benchmark or a goal for each number. You
might even want to establish a timeframe
within which you’d like to meet the goal.
Next, identify the operations that affect
this measurement. These are performance
drivers. To illustrate, if we want a higher
net profit, we’ll need a combination of these
things: higher estimates, fewer expenses,
fewer mistakes, less wasted time, etc. To
achieve a greater cash cushion, we’ll need
to take more cash in than we expend without
incurring long term obligations. That means
greater profitability and harder work.
Then after listing all the possible factors
that might affect the outcome you desire,
identify the best current opportunities and
weaknesses that could be exploited. These
will be the first places to concentrate as you chase the goal.
Next, track these metrics regularly. Report to the interested parties
with a simple cover summary, backed up by lots of detail for those
who are interested. Educate in the reporting, because financials will

not be useful unless they are understandable, timely, unbundled (by

department, if that applies to your situation), and with an element of
forward looking.
Meetings are generally the best places to disseminate this informa-
tion because they allow you to capture reactions and answer questions
in real time. But also use bulletin boards, big charts that make a single
point, intranets, handouts, newsletters, and emails. You are always
anticipating questions. What does this
mean? How will my actions affect the
bottom line?
As you open the books, so to speak, tell
them the stories behind the numbers. Let
the data serve as a discussion point about
what you really want to talk about.
Finally, after things have settled down
and people begin to learn this new language of open book management,
consider tying some compensation to financial metrics.
STA RT S AT H I R I NG
Whatever the extent to which you implement OBM, make sure you
begin the orientation to that system at the hiring stage. In other words,
tell people that “we do this here,” showing them what types of infor-
mation they’ll be privy to and how it might be interpreted.
If they are hired, provide extensive training during the orientation
process. Of course include a statement about non-disclosure in your
employee agreements.
T RA N S ITI O N I N G TO A GR E ATER
D EG R E E O F O B M
As illustrated above, OBM does not necessarily mean that you’ll open
your books to all employees. It’s more about a style of management
that is more inclusive and participatory.
If you aren’t interested in taking any big risks, get your feet wet
by first talking about the cost of health benefits. See how employees

react to the disclosure short-term, and then gauge if it affects their

behavior long-term.
If you want to take it a step further, you’ll find that OBM works
best if these things are true at your firm.
• First, everyone should understand what the company must
do to be successful.
• Second, make sure everyone is involved in the goal setting
process. This will help with the next point.
• Third, everyone should understand their individual role
in achieving the goals that define “success.”
• Fourth, problem solving and decision making should be done
at a level closest to the issues to be solved. This assumes,
of course, that the employees have the bigger picture.
The point is that OBM is not an “on” or “off” proposition. It’s just
a greater degree of openness.
FALL AC IE S
There are several things you’ll want to keep in mind, particularly if you
think OBM will solve everything. There are three things I’d urge you
not to assume.
• First, don’t assume that people will act smarter with information.
As I noted earlier, even trade groups (like the National Center for
Employee Ownership) can’t show more than a few percentage
point gain in profitability when employees know the numbers.
• Second, don’t assume that every employee will be fair. Some people
will misuse the information and you must be prepared for that.
• Third, don’t assume that people will not measure each other’s
value with financial criteria, whether that’s compensation data
(which you shouldn’t divulge) or sales or client conversion or
whatever else can be expressed in numbers.
Best wishes on your critical quest for a more satisfying management

experience, for you and others.

BEF ORECAST
The type of company we were going to invent would have total

involvement and empowerment. We had seen the immediate benefi-
cial effects of us humans interrelating and we knew we could unlock in
all of us some deep-seated honest values that would join us together
as an irrepressible force.
We talked of going back to the idea of a craftsman’s guild. A
community that was creatively driven. A collective whereby people
felt they had real ownership to direct themselves and find time and
respect for personal exploration.
The ideas we generated were fabulous. We would all buy houses in
the same street and live together like an artists’ commune. The office
would be a laboratory for experiments funded by just a handful of
select clients. We would only have a client for a year to demonstrate
that we could truly affect their business very quickly.
We wanted to be proud of our company, because so much of our-
selves was going to be in it. Therefore we wanted to produce work
we would be proud of. So much of advertising is thoughtless junk. We
didn’t want ‘Produced Thoughtless Junk’ on our headstones. We were
determined there and then to produce work that meant something,
something that had real effect and something that people would
enjoy and talk about.
We also wanted to right the wrongs of business. We wanted every-
one to be able to enjoy work without fear of coercion or the threat of
being fired for speaking out of turn.
—Andy Law, Creative Company, 1998

The power business has over our lives is awesome. It can promote us
or dump us. It can offer self-esteem or lack of dignity. It can frighten
and coerce us. It can stretch our imaginations. It can destroy families
and it can sponsor and build marriages. It can support evil govern-
ments and it can enliven economies. It can create unbearable stress
and it can invent wonderful new products and services. In short, it
can treat you as well or badly as it chooses, yet we devote our lives
unthinkingly to it and donate almost all of our knowledge and learning
and creativity and sweat without any regard to its true value. Most of
what we do in our working lives we do for others and their profit.
—Andy Law, Creative Company, 1998

14
E M P LOY E E I N C E N T I V E S
& R E WA R D S
This chapter examines the best ways to create incentives and awards for
employees by putting them in the context of communicating goals clearly
and then expressing appreciation when those goals are met. It explains
what employees are looking for in a healthy environment, how any par-
ticular plan should be designed, how you might measure results, and what
plans might help you and the employee work together in a better way.
What an interesting topic. Hopefully this will not be about manipu-

lation, or getting people to do what we want them to. In spite of the
surface coverings, that seems at the core of many treatises on the
subject. This is not about control cloaked in kindness.
Hopefully this is not about insulating yourself from management,
either (more on this below). Or installing “self-managing” systems
that move the inevitable grayness of management to a more comfort-
able black/white world.
This is more about creating an environment that communicates
your approval, and in the process helps employees see the connection

Em ployee Ince ntive s & Reward s
between their good work and the resulting environment that stems
from it. It’s about clarifying expectations and training through cause
and effect relationships.
Even beyond that, this chapter is meant to help you clarify your
own thinking on “doing the right thing” for your employees, along
with several suggestions that will make the implementation easier.
Don’t you hate it when an employee comes to you with news about
an offer? “I like my job here. The only reason I’m even considering this
is the package they put together for me. Is there anything we can do
with my current pay to make this less attractive?”
Your response is either a) Good riddance to you; b) I wish I could,
but we can’t afford to pay more and at this point I feel like your salary
is fair; or c) let me go back to the drawing board and I’ll let you know
in the morning.
Somewhere between “b” and “c” might be this voice that cannot
be quieted: “I’ve been thinking about raising her salary, why didn’t I
do it before she asked, not after?” Or, “I need an incentive plan around
here.” (One of the worst responses you could have is to offer equity to
keep their interest and loyalty high. There’s a move you’ll soon regret.)
W H E R E W E ’ V E B EEN
In the first half of the twentieth century, compensation models focused
on reserving the rewards of business success for the owners. In the
last half of that century, the rewards were shared with a larger pool of
managers. Now, however, there is a belief that every employee has an
impact on—and should benefit from—the company’s success. Part of
this stems from our desire to measure performance, but it is also driven
from the employee side. They want to be treated more like owners.
This would be easier if we could find ways to set goals that were
measurable. Financial yardsticks are only so useful. For example, they
aren’t as useful in measuring the value of a new process someone has
thought up for your production department, some continuing educa-
tion they have attended on your behalf, etc. Financial results tend to
lag effort by too great a margin, too.

Recognizing this, incentives are not new. Profit-sharing has been

around since the late 1880s. Gainsharing has been around since the
1930s. And specialized stock compensation plans abounded after
World War II. So this is a problem that still vexes managers.
D I STIN G U IS H I N G D ECI SI ONS

To this point regarding the perennial problem on our hands, let’s
look for a moment at the larger context. My perspective is that
management is more about making distinguishing decisions in an
environment not conducive to it than it is putting systems in place that
effectively “self-manage” people. If self-management were effective, a
lot of you would be less grumpy, and unless we recognize our tendency
to insulate ourselves from the down and dirty side of management, we
will waste precious effort on systems that are doomed to fail from the
start. And believe me, as the head of an agency or studio, you have less
propensity to manage people than the average business owner.
“Distinguishing decisions” are the choices you make about how
well people are living up to their potential. If you are typical, you have
strong feelings about the extent to which this is true for each employee
under your care. But you are not trusting your instincts, leading to
inaction. Being fair and being even are different things. Make dis-
tinguishing decisions and you’ll be as close as you should be to the
practice of management. We talked a lot about this in the last chapter.
T H E E N V I RO N M E NTAL CONTE XT
What kind of environment are employees looking for? There have
been so many studies of this that it should be enough to point to them.
Notable are the Gallup study from 1999 and our study, based on more
than 3,000 individual employee interviews at more than 400 firms like
yours (ad agencies, public relations firms, design studios, and interac-
tive shops). The results are published in Managing (Right) for the First
Time, released by RockBench Publishing Corp. in 2010. The big themes,
though, are these.

Recognition
Employees want individual and public recognition. What’s the dif-
ference between recognition and incentives? Recognition provides
after-the-fact reinforcement for specific performance or accom-
plishments and signals what the organization values. Incentives
focus employee efforts on the organization’s goals and often promise
specific rewards to those employees who offer significant help in
achieving them. Employees want both—pre-defined incentives to point
them in the right direction, and then recognition for goals achieved.
Security
Employees don’t expect a job guarantee, but they do expect, and
appreciate, your efforts to create a secure working environment. This
involves big picture things like ensuring client satisfaction, keeping
the client mix appropriate so that no single client controls your future,
putting money aside in good times to pad the bad times, etc. In the
more immediate sense, they want you to be honest about what’s in the
works so that they don’t worry. If you have a habit of telling them any-
thing they need to know, they don’t worry about what you haven’t told
them … because they assume that they don’t need to know it.
Opportunity
The employees you want to keep around don’t expect you to hand
them something, but they do appreciate the opportunity to learn new
things, expand their experience, rise to a higher position, and earn
your admiration.
Money
This is a good place to note that these are not in any particular order.
If they were, money would still not be at the top. To an employee,
compensation becomes central only after the other, more important,
reasons are not there (like some of the others in this list). Unfortunately,
we are far too quick to view money as the solution when we should be
doing cheaper, more effective, more appropriate things first.

Time
Employees want to work reasonable hours. If extra hours are going
to be required of them, they’d like a voice before commitments are
made on their behalf.
Flexibility
In a similar vein, they want flexibility in the hours that they work.
They can then handle an aging parent, young child, or just a hobby.
So you can see that this is not rocket science, otherwise known as
some complicated system to keep employees loyal and interested.
Essentially it’s about structure, communication, and impact. As
you have heard in so many venues, tell them what’s expected; give
them the tools; give them the freedom to find their own way to that
expectation; and recognize and encourage good behavior.
Money is a poor incentive. It’s more like cocaine. Having said
that, I’ll provide a few suggestions about how you can use it wisely
to “communicate” and then “confirm” behavior. But unless these
methods are part of something bigger, they will fail.

P R I N C I PLE S
Basics First
Any plan you arrive at should not replace regular, unprompted
performance reviews, salary increases wherever appropriate, and
sufficient structure to help the employee know their role and the
impact they can have.
Benefits Second
Examine your benefit package first. Employees can’t concentrate
unless their basic needs are met. The first basic need to address
is health insurance, or at least a major portion of health insurance.
Second, put a retirement plan in place, particularly one designed
more for them than you (i.e., avoid aggressive vesting schedules
or plans that pull lots of money out of the company under the guise
of a retirement plan for employees, like an ESOP plan). Aggressive
vesting plans save you money—they do not motivate employees to
stay. Neither are wrong, but we should be forthright.
Communication
Any plan you come up with should be in writing. This is about clear
communication, and the rules shouldn’t change mid-stream.
Cause and Effect

Over and over again, studies have shown that employees don’t change
their behavior unless there is a strong, short tie between action and
reward. In smaller companies, with an engaged owner, this is easier
to achieve. As an employee, I twist the steering wheel, and the car
moves. Wow. This is exactly where small companies like yours thrive:
individual members see the effects of their actions, and you can spend
whatever time it takes to help individuals see that connection.
When our puppy does something noteworthy (like peeing outside
instead of on the carpet), we give her a treat. We don’t just keep track
and give her all the treats every quarter or every year. She wouldn’t

see the connection. Shouldn’t we treat our employees even better

than that? The 20-year study of the workplace that Gallup concluded
in 1999 yielded a staggering finding: to be effective, rewards need to
occur within seven days of the action.
Extent
The next thing to think about is whether you want to reward individ-
uals or groups/teams as a whole. The theories of the day favor group
reward, but my experience has been that this is overplayed. As much
as we’d like people to play nicely together, your very best performers
will be frustrated by the common denominator otherwise known as a
group. Concentrate instead on individual plans.
Distinguishing Decisions
As noted above, don’t be afraid to single people out for your favor,
and to do so publicly. Frankly, unless this happens, those receiving
the “recognition” will not appreciate it and those not receiving it
will not learn. In fact, another study has shown that the most signifi-
cant influence on top performers (true of 81% of participants) is the
desire to maintain a good work reputation, and making the reward
public will enhance this. (In the same study, only 15% indicated that
financial reward was a significant factor in their performance.)
Supervisory Role
Make sure the decision, even if final approval stems from higher up, is
made by the immediate supervisor of the employee. That immediate
supervisor needs power in the relationship. Some of that comes from
who they are, and some of that comes from what they control. Unless
you control what people make (or at least have a major influence on
it), you aren’t really the manager.
Randomness
We are supremely individual, and as such we want to be treated differ-
ently when it comes to good things and not differently when it comes

to bad things. Recognition is a good thing, and we should be as random

as we can without seeming unpredictable or reactionary. Employees
would much rather know that they’ve moved you to action rather than
reminded you to trigger the inevitable policy within “human relations”
(often with little relations at all).
Non-Entitlement
Another reason to keep recognition random is to avoid the entitle-
ment trap. The first time you handed out that Christmas bonus, you
were Santa Claus incarnate. Next year, though, people are standing
around with open hands.
Target Simplicity
If you are going to tie recognition to specific things, have simple and
understandable goals. You engineering types, especially, are going to
need to stay away from your spreadsheets and dive into deeper waters.
So, incentives are good if they are there for the right purpose. This
means that they should not be a replacement for management and they
should be geared toward their good, too, and not just yours. Even if you
don’t see the results, consider whether or not it is the right thing and
just do it anyway.
Just as important, try to strike a balance between management
discretion (what is described as “distinguishing decisions” above)
and some link to a specific action.
ME AS U R E M E N T
Before pointing out some specific things you might do for employees,
let’s discuss measurement briefly. This will be important to the extent
that you want to measure performance before singling it out. In our
business, these are the things you’d measure.
• Sales: The total revenue that comes into the business, regardless of
the costs associated with it. Normally this is safe to use for public

relations, since there is very little pass through (otherwise known

as cost of goods sold or out of pocket expenses).
• Gross profit: This is known more properly as AGI, or agency gross
income. This is composed of your fees and markup profit. Also
known as revenue, gross margin, or gross profit.
• Net profit: This is the amount on your income statement that is
left after outside expenses and all overhead is paid. It is usually
calculated before income taxes.
• Costs: You might measure outside costs (what you resell to clients)
or inside costs (overhead). For more on financial measurement,
look at the earlier chapters in this manual.
• Growth: This can be expressed in terms of sales or gross profit
(see above). The former is not safe, and our recommendation
is to generally ignore sales.
• Timeliness: You can measure how soon phone calls are returned,
how soon a meeting report is generated, how frequently a weekly
report is faxed to the client on time, etc.
• Mistakes: You can track the hard (usually vendor-related) and soft
(usually internal time expended) costs required to fix mistakes.
• Attendance: You can measure days worked, sick days not taken,
or punctuality.
• Record compliance: You might want to measure how well
(and timely) employees are filling in timesheets or completing
project briefs.
• Client retention: You can measure client turnover by count
or percentage, adjusted for extenuating circumstances, like
a merger/acquisition or change in client contact.
• Client satisfaction: Even before a client leaves, you can measure
how well an account person is doing, specifically, or how satisfied
the client is with the firm, generally.

• Client acquisition: You can obviously measure new business

development effort, either by people charged with that task (sales
people) or those with an indirect impact on it (account people).
• Employee satisfaction: If you have a manager whose effectiveness
you want to measure, you can ask employees to complete a simple,
written survey periodically.
• New skill/training: You can measure how well employees take
advantage of related training and the acquisition of new skills.
OPTI O N S
So, armed with these means of measurement, what kind of programs
might you establish for incentives and/or reward? Here are just some
simple, obvious connections with the measurements suggested above.
• New business commission: See the earlier chapter for a full
treatment of this.
• Growth of account base: If you want to encourage an account
person to serve accounts well and look for new opportunities that
your firm might exploit, construct a plan that awards any growth
in an established client base.
• Cash for leads: All employees can listen to opportunities, and you
might want to give them a tangible “thank you” for any leads worth
pursuing through a first meeting.
• Mistake-free bonus pool: You might estimate the amount of hard/
soft expenses in mistakes over a period of time, and set that money
aside on paper. As mistakes are made, deduct the cost from the
pool. Anything left gets distributed to employees.
• Gainsharing: If you really want significant gains, in net profit, gross
profit, staff utilization, or anything else, draw a line to depict where
you are right now. Then offer to share a fixed percentage of the gain.
• Shadow stock: Also known as phantom stock or an incentive stock
plan, consider treating a key employee as a shareholder when
it comes to distributing profits. To make it even more attractive,
index your salary to some established benchmark so that the
employee doesn’t worry about the profit being manipulated lower.

• Individual/Group compliance: Having trouble getting everybody

on board, and wondering if a little friendly group pressure will
help? Have free pizza for everybody with five days of perfect
timesheet compliance, but none at all if one person messes up!
• Compensatory time off: Loosely track people’s time and give
them an appropriate amount of time off if they have worked
many extra hours.
• Billable time: Set billable time goals for each position and then
reward employees who meet them (assuming that you have
provided enough work to keep them busy).
• Non-qualified profit sharing: Distribute a percentage of the profits
quarterly, keeping some for yourself and some to reinvest.
• Cash: Having given you all kinds of ideas on spending cash, try to
avoid actually giving it away. Cash is not memorable, not personal,
and it is used to pay bills. And of course taxes should be withheld
from the payment if the award is considered a cash equivalent (i.e.,
it has a clear, monetary face value, or it gives the employee broad
choice in selecting the final item received).
• Ownership warrant: If a key employee begins to be nervous about
all the time he is spending building the value of the business, only
for it to be sold without any personal benefit to him, give him a
warrant that specifies that he receives a certain percentage of
the sale price if a majority of the stock is transferred while he
is an employee in good standing.
• Equity: Of course many principals jump to this too quickly, though
I think that equity should be shared as a last resort. If someone is
ownership material, chances are slim that they are working for you
already and just need an ownership stake to keep their interest
and loyalty high. There are exceptions, but they are few.
MO R E O N EQ U IT Y
Sometimes employees think they want equity, not knowing the down-
sides that come with it. So a long time ago I prepared a document with
eight reasons why equity may not be the answer. If you walk through

these with an employee, they will often be more open to a plan that
doesn’t involve actual equity. Here are those reasons:
First, where a lender (loan, lease, line of credit) requires a personal
guarantee, all partners must sign. The documents usually specify that
the ownership group is “jointly and severably liable,” which is fancy
talk for we’ll go after all of them personally until we get paid.
Second, there is fiduciary responsibility, even if there is no
involvement, in certain government-scrutinized events, like payroll
taxes, sales taxes, retirement funding (above a certain group size).
In other words, if there is a problem with taxes, the IRS is going to
look to owners to make that right. In fact—and this is a big rub—even
personal bankruptcy does not wipe out tax obligations for an individ-
ual or for an individual who owns part of a corporation.
Third, during slow times, there are no profit distributions to be made,
and partners are usually required to lower their own compensation.
Fourth, if that isn’t enough, partners are typically required to loan the
company money to get through a tough spot, as you’ve done yourself.
Fifth, employees should sign a non-compete that only protects
your clients and your employees, which allows them to start their
own firms, even across the street, as long as they don’t hire any of the
firm’s employees or accept work from any of the firm’s clients for a
period of time. But the non-compete an owner signs actually takes
that further and prohibits him/her from owning any part of a similar
firm for a period of time.
Sixth, the personal credit of each partner will be publicly discussed
among the other partners and will impact the firm’s relationship to
creditors.
Seventh, non-participating “significant others,” whether formally
married or not, will be required to sign a document that specifies how
the value of the firm will be calculated and how the payment terms will
be established in the event of a divorce or common-law separation.
Eighth, then the big one, of course: coming up with money to buy
the equity.

I M PLE M E N TIN G ONE

Decide what you want to reward, first. For example, if you don’t want
to grow, don’t put a gainsharing plan in place. If you want to encourage
teamwork, don’t primarily reward individuals.
Solicit feedback from the people it will impact.
Then stick with the plan for awhile. Incentive/reward plans that
change frequently are demotivating.
Every good plan is specific, meaningful, achievable, reliable,
and timely.
(For further reading, consult chapter sixteen of Rick Gould’s
The Comprehensive Guide to Public Relations Management.)
BEF ORECAST
There is a time to admire the grace and persuasive power of an

influential idea, and there is a time to fear its hold over us. The time
to worry is when the idea is so widely shared that we no longer even
notice it, when it is so deeply rooted that it feels to us like plain
common sense. At the point when objections are not answered
anymore, because they are no longer even raised, we are not in
control: we do not have an idea; it has us. The idea is that the best
way to get something done is to provide a reward to people when
they act the way we want them to.
—Alfie Kohn, Punished by Rewards, 1993
A high wage will not elicit effective work from those who feel them-
selves outcasts and slaves, nor a low wage preclude it from those
who feel themselves an integral part of a community of free men.
—D. H. Robertson, 1921

15
P O LI C I E S FO R E M PLOY E E
PA I D T I M E O F F
This chapter presents guidelines on handling paid time off for your
employees, including the philosophy behind offering time off, how
typical policies are structured, what holidays are observed, and how to
simplify your guidelines with a “Paid Time Off” policy. This is detailed
with specific reasons, suggestions about implementing the policy,
scheduling the days off as they occur, and handling special cases.
The chapter concludes with a brief overview of other types of time
off that need to be addressed in your policies.
Time off policies are quite an important component of your firm. Not
only are they central to attracting and retaining employees, but they
are also very expensive.
In any labor market, time off is core to employee satisfaction. We,
and our employees, live busier lives and both the time away, and the
flexibility we have in using it, help mitigate the craziness around us
and in us. In this environment, we don’t dare waste our approach to
time off. It must be harnessed to move the firm forward.

P olicie s f o r Employee Pai d Ti me Off
The expense alone warrants careful crafting of a time off policy. In

fact, you’ll typically spend one-half as much on paid time off as you do
on all of your facility expenses (monthly payment, utilities, cleaning,
etc.)! This expense must be managed well, and it must work for you.
Perhaps that’s why the amount of paid time off that businesses
offer has been level since the tough economic times of the late 1970s
(after World War II it increased every year until that point). Though
it hasn’t increased substantially in the last few decades, policies sur-
rounding it have been made more flexible to reflect busier lifestyles,
more frequent switching between jobs, and an employee-driven mar-
ketplace. This chapter is designed to help you take a holistic approach
to your time off policies, resulting in something that is good for you
and good for employees.
A NOTE A B O U T LO CALE
Some of the readers of this manual may not be in the US. The majority
are, though, and they may be surprised at policies outside the US,
which are nearly always more generous. In fact, many countries
mandate these policies. For example, some countries have no policy
on sick time, but require four weeks off for all employees, plus an
additional month’s worth of regular pay, either spread out equally
during the year or issued as a payment for the thirteenth month at
year’s end. Sort of a mandated Christmas bonus.
So this chapter is more for the US market, but most of the
principles will apply as you determine your company policies,
regardless of where you are.
P H I LO S O PH Y
The idea of “vacating” is at the root of “vacation.” It carries the notion
of “withdrawing” from a particular setting, and for many people that
is the long-term reward for hard work. The short-term reward would
be weekends. Each of these breaks is important. If we pace ourselves,
and our employees, the benefits are extraordinary.

First, we’ll be more effective because we will have rested (unless

we take our families along). Second, we’ll regain balance by placing
our work lives into proper perspective. Every deadline seems like a
life-changing event until you don’t even hear about them while away.
Third, spending too much time with the same people becomes annoy-
ing and you need to get away from people in order to appreciate them.
Fourth, when people take time off, those left behind can learn about
their contribution more accurately. You may hear yourself saying:
“Remind me again what that person does when they are here.” Or “I
had no idea how central they were to the operation.” Fifth, you’ll give
others a chance to step up to the plate and contribute in ways they
normally would not. Filling vacuums is the primary method for rec-
ognizing talent, similar to relief pitchers in baseball or second string
football players who step up when the starter is injured.
T Y PIC A L P O LI C IE S
The average small communications firm grants fifteen to twenty days
off, if you add together the days they grant for vacation, sick, and
personal time. The actual time off is structured differently between
firms, of course. Some firms separate the time into these three catego-
ries. Others just separate vacation and sick time. Others have no sick
policy at all. But for starting employees who are past any probation
period, this is the average.
Oddly enough, the principals of those same firms took off almost
exactly the same amount of time, though the range of actual time
taken varied more widely (from 0 to 35 days). So one advantage of
running your own business might not be taking more time off, though
it certainly should be!
But in another study, we did find one common refrain: “We like it
when the principal takes time off so that we can show him/her how
well we can do without them. Plus, they need the time off.” So quit
feeling guilty about taking time off.

HO LIDAYS
There is less disparity about which specific holidays are offered. While
mandated holidays are common in educational, banking, and govern-
mental institutions, no such requirement exists for business. Taking
certain days off with pay is widely practiced, but not a legal requirement.
The normal days everyone observes include:
• New Year’s Day
• Memorial Day
• Independence Day
• Labor Day
• Thanksgiving Day
• Christmas Day
The days that many firms also observe include:

• Good Friday
• Day after Thanksgiving
• Christmas Eve Day
• New Year’s Eve Day
Very occasionally firms will observe one or more of these days,

particularly if the day has more regional significance (like Columbus
Day in the northeast in the US):
• Martin Luther King’s Birthday
• Washington’s Birthday
• Lincoln’s Birthday
• President’s Day
• Columbus Day
• Veteran’s Day
• Employee’s birthday
• Various state holidays
Usually fixed date holidays (those holidays that fall on a specific

date instead of a specific day of the week, like Christmas) are

observed on the nearest week day. For example, if Independence Day

(July 4) falls on a Sunday, the paid day off is the next day, Monday.
T H R E E OTH E R TRAD I TI ONAL CATEG ORI E S

There may be little confusion about which holidays to observe, but
confusion abounds about other time off. Traditionally we have sep-
arated this time off into three categories: vacation days, personal
(sometimes called floating) days, and sick days. More recently firms
have begun to combine these three categories into “paid time off,”
eliminating the somewhat artificial distinctions between them.
They might have provided ten vacation days, two personal days,
and six sick days, and if the employee used all six sick days, they
would have had eighteen days off. In a new “paid time off” (hereafter
PTO) policy, the company might provide sixteen days to be used as
the employee wishes. If they only use two of those days as sick days,
they have fourteen days to enjoy as they wish. Under the old policy
they would have had only twelve days.
In a conversion from a traditional plan to a PTO plan, usually the
total days are slightly less than had been offered across all three cate-
gories. While that would not benefit someone who would typically use
all their sick days, it would benefit those who didn’t typically use them.
In fact, that is usually the sticking point when the conversion to a
PTO plan is made: “Why do we have fewer total days than before?” It
is true that firms make the conversion to limit abuse of sick time, but
this is not always so. Even if an employer doesn’t lessen the total days,
a PTO plan makes sense simply because of the added flexibility and
control afforded each employee.

W H Y C R E ATE A PTO P OLI CY

There are many good reasons to switch to a PTO policy, and it is some-
thing we would recommend. Here’s why.
First, a PTO plan will make better use of sick time. Employees
who are abusing it will be less likely to do so, since the days aren’t
“free” but will instead affect how much time off they have during the
rest of the year. There will be no incentive to lie, either, since you
will no longer be the “police” about the kind of day they are taking
(vacation, personal, or sick). In addition, as your employee population
ages, it won’t become an issue if a sick day is legitimately used for the
employee or the employee’s child (or elderly family member). After
all, does the employee need to be sick in order to qualify for the use
of a sick day? It really shouldn’t matter.
Second, employees will have greater flexibility, which translates
into more control, which yields better morale.
Third, tracking will be easier because you are only tracking one
category, not three.
Fourth, you’ll encourage healthier living, since what was previously
sick time can be used for any purpose at all if the sick days aren’t needed.
Fifth, new hires will earn some time off every month, giving them
time off to use earlier rather than later. It doesn’t make sense for
employees—especially senior ones—to wait an entire year before
they take time off.
I N STITU TIN G A PTO P OLI CY

A PTO policy (sometimes known as a “Paid Days Off” policy) is sim-
ply a means of combining vacation, personal, and sick time into one
category, and then letting that time off accrue every month. These
days are also typically used for doctor’s appointments, family illness,
religious holidays, marriage leave, funeral for a friend, personal emer-
gencies, inclement weather, and school conferences. A majority of
firms like yours are doing this.
First, decide if you want to reward seniority. In other words, should
employees be given more vacation as they build time with your firm?

The answer to that should probably be yes, though new employees

should have substantial vacation out of the gate.
Second, determine how many days will be accrued each month.
We suggest 1.0 days/month during the first year of employment;
1.25 days/month during years 2-5; then 1.50 days/month during years
6 and following. Or maybe ignore seniority entirely and just set it at
1.50 days/month.
Third, think about whether there should be an introductory period
during which no vacation is earned and/or no vacation can be taken.
While this has been standard practice in the past, it seems unnecessary.
Of course you wouldn’t want a new employee to take one or two weeks
of vacation early on, but that’s not possible with a PTO policy since
no big “chunks” of time are dumped in their account. Instead, time is
earned every month. The days of starting with a company out of school
and remaining there for a career are gone. Thus vacation “seniority”
needs to be portable, especially for senior employees who may be
reluctant to join you if they must start over in building time. Or in this
case, if they must wait for an entire year before taking some time off.
If you like having an introductory period, consider letting employ-
ees accrue time from the outset, and then letting them use the
time only after they’ve been on payroll for a three-month period.
Incidentally, in most service industries “exempt” employees are
not burdened with a waiting period for time off.
Fourth, set a limit on how many unused days can be accrued in a
“bank” account for each employee. This could be defined as a specific
number of days (e.g., fifteen), or it could be defined as a specific unit
(e.g., one year’s worth, which would vary depending on how much
they are accruing per month). Generally you want a specific num-
ber of days to make tracking easier, and the most common amount
is about one year’s worth. That usually amounts to the average days
that employees are accruing, which is typically fifteen. Beyond that,
no days are kept to be used later. The point is to limit your liability
when an employee leaves and to encourage employees to actually
take the time off, for their sake and yours.

Fifth, outline the policy, have an introductory meeting to explain it,

and ask for employee feedback before making anything final. The ben-
efit is largely for them, and they should have a role in defining it.
S C H E D U LI N G C O NSI D ERATI ONS

If you do implement a PTO policy, you’ll need to then clarify how
the days are scheduled. Here are some suggestions.
Ask employees to inform you when they plan to use more than
one day at the same time (i.e., when they are planning on using two
or more days back to back).
If you are a smaller firm, specify that normally not more than a
certain number of people should be gone at the same time. If there is
a conflict, decide how it will be settled. Will priority be given to who
asks first, or to who has the most seniority? This should not be an
issue with larger firms.
Indicate how much advance notice you would like before the sched-
uled days off are taken. Usually one month is considered sufficient.
Specify the proper channels for time off approval, including the
person responsible for granting approval and tracking the days
taken. Approval is usually sought from the person’s supervisor. The
tracking will obviously be done in the HR department if your firm is
large enough to have one. Otherwise it would be an individual in the
accounting department. Whoever tracks the days should provide a
written report to employees, at least quarterly (and probably monthly).
You might also want to limit the amount that can be taken at once
without special approval. For example, anything up to five days should
be considered routine.
Some firms also limit the time that can be taken in conjunction
with established holidays, and/or they list known busy periods during
which time off is limited.
All these scheduling considerations can be helpful, but you should
use as few as necessary, and then only to ensure adequate staffing.
Employees are interested in as much flexibility as possible. Where

there are expectations, though, they are equally appreciative of clear

communication in advance.
Q U E STIO N S/A N SWERS

Should employees with family obligations be given more time off?
Probably not. Family is a personal choice, and being more generous
with people who have more obligations engenders resentment with
those who don’t.
Should part-time employees earn vacation? Commonly they don’t.
If you choose to, just change the accrual rate to match the percentage
of full-time worked. For example, if the employee works three days/
week, let them earn 60% of the full-time rate.
Should we track time based on date of hire, or calendar year? The
answer to this depends on other issues, too, like when reviews are
given. Some firms make an adjustment the first year, and then put
everyone on a calendar year for vacation. Others keep track of PTO
based on hiring date. It doesn’t matter either way.
How do we handle small increments of time? One-half day is about
the smallest amount of time you will want to track. Any tracking unit
smaller than that will be cumbersome and may expose you to reclas-
sification of exempt employees to non-exempt (see below). To be fair,
any vacation policy should be coupled with an attendance policy.
Do we pay employees for unused vacation? No. The point of
vacation is not additional pay, but time off, for your sake and theirs.
Employees also have a reasonable expectation that you will protect
their ability to take that time off.
What happens when PTO is expended but an employee still needs
time off? The same thing that would happen with a traditional plan—
they would be given unpaid time off.
Will a PTO policy encourage people to come to work sick? It could
happen, though it’s unlikely. But this is a concern with PTO policies.
How do we handle an extended illness if there are no sick days to
accumulate? The best approach is to have an inexpensive short-term
disability policy.

Should we pay departing employees for unused PTO days? The

usual practice is to do so. If you choose not to, be sure to check appli-
cable laws. In some states (like California), terminating employees
requires a payout of all vacation time earned. And having a PTO policy
would require you to pay slightly more, since personal days and/or
sick days are lumped into the calculation.
L EGA L C AU TIO N S
Be sure to take all federal and state leave regulations into consideration.
There are several issues here.
Exempt vs. Non-Exempt

Some employees can be classified as “exempt” from earning over-
time pay (under the Fair Labor Standards Act). Most of the employees
who work for you would typically be classified as “exempt” because
of their professional status. But if you track the hours that such an
employee works, an argument can be made that you must pay them
overtime if they work more than forty hours per week. That’s because
professionals should be paid for their contribution, regardless of
when it happens or how long it takes. As this impacts a PTO policy,
don’t subtract time from the bank in hours. Instead, think in bigger
units (half days or whole days).
Comp Time
Generally, compensatory time off instead of overtime pay for non-
exempt employees is illegal under federal law (in all states). If the
employee works more than forty hours per week, they must be paid
for their overtime at time and one-half the normal rate. Employers
may give time off during the same week that the employee works
extra hours (e.g., ten on Monday, six on Tuesday), but as soon as
they cross the “more than forty hours in a week” threshold, they
are entitled to overtime pay.

Fair Medical Leave Act

In recent years, the legislatures of almost every state have considered
family leave legislation, and more than one-half have enacted some
policy. These laws allow employees to take unpaid leave for a birth,
adoption, or family illness, ranging from three to six months, after
which they can return to the same job. The law is only applicable to
firms of a certain size (that threshold varies between twenty-five and
one hundred employees, based on the state). Usually the person must
have been an employee for one full year, and you must usually allow
the employee to continue to participate in benefits (at their expense).
The federal version of this legislation only applies to firms with at
least fifty employees within a seventy-five mile radius.
ADA
If an employee is absent from work for legitimate medical reasons,
they may be covered under the Americans with Disabilities Act.
For example, an employee who needs regular kidney dialysis could
request reasonable accommodation to leave work on a regular basis.
OT H E R C ATEG O RI E S
Provision for these are generally not made in a core PTO policy
because they involve exceptional, non-recurring circumstances.
Jury Duty
Most employers grant (and in some states are required to grant)
time off for jury duty. In such cases, they usually pay the difference
between the employee’s normal salary and their remuneration as
a juror. State laws vary widely.
Bereavement Leave
Most employers allow up to five days of additional time off in the
event of a family death. This usually includes a spouse, parent, child,
or relative living in the same household. Any other blood relative
usually qualifies for one day off.

Military Leave
Laws sometimes require that employees be given time off for reserve
or National Guard duty, but there is usually no stipulation that the
time must be paid. Some employers, though, pay the difference
between their normal pay and what they earn when they are gone.
Voting
Many states require that employees be given time off to vote, though
usually there is no stipulation about the time being paid. Most
employers would encourage employees to vote, and would assume
that the time would be paid as normal.
Sabbatical
Not many firms provide for sabbaticals, though it is becoming more
common. Usually seven to ten years of continuous employment is
required, after which the employee is granted one to three months
of paid time off.
Leave of Absence
This is essentially time off without pay. There may or may not be the
presumption that the employee can return to the same position when
the leave is complete.
Being generous and being flexible are different things, but they are
both an important component of attracting and retaining employees.
And in helping them to be productive. Take a look at your own policies,
using this chapter as a guide, and consider making any changes you
feel might be appropriate.

BEF ORECAST
Rest is the sauce of labor.

—Plutarch, The Education of Children, Moralia, A.D. 100
It was Einstein who made the real trouble. He announced in 1905 that
there was no such thing as absolute rest. After that there never was.
—Stephen Leacock, The Boy I Left Behind Me, 1947
I haven’t been to sleep for over a year. That’s why I go to bed early.
One needs more rest if one doesn’t sleep.
—Evelyn Waugh, Decline and Fall, 1928

16
MANAGING A DOWNTURN
This chapter defines a downturn, and then examines the three different
kinds of causes (sudden, distracting, and insidious ones), highlighting
the ways to avoid a downturn in the first place. After explaining the
need for decisive action, we survey ten specific actions to take, ten
specific actions to avoid, and then alert you to what might happen if the
business fails entirely. After looking at a few alternatives, we then guide
you through selecting staff to dismiss based on performance, function,
seniority, and general attitude; discuss how deep the cuts should be;
and then suggest how to communicate your decision to departing
employees, remaining employees, vendors, competitors, and clients.
We then make specific suggestions about the announcement itself and
what benefits should accompany the dismissal. Finally, we’ll examine
the nine good things that come from lean times, as well as the three bad
things. We then discuss leading employees through lean times, highlight
the tactical errors that you might want to avoid, and conclude with three
important keys to thriving when times are lean.

Managing a D ow nturn
We have come to expect that life will be cyclical. Business, too. We

all experience times of unprecedented prosperity and near failure.
No amount of planning can eliminate all cyclical influences, but with
some big-picture thinking you can knock the rougher edges off these
cycles to create a more predictable business environment. Cycles
are good, but extremes are dangerous.
D E F I N ITI O N
We are defining a downturn (or a slowdown) as incurring results
that didn’t meet your expectations to the extent that scaling back
is necessary to preserve your firm’s health. The scaling back might
be severe enough to include employee layoffs (usually the most
significant effect of a downturn) to lesser consequences like putting
a facility plan on hold, deferring a significant “necessary” purchase,
or questioning a new initiative.
Downturns are caused by many forces, some in our control and
others not. But regardless of the extent to which you can control the
cause itself, you can—and must—control the environment around the
cause. In other words, everything is still your responsibility. It may
not be your fault, but it is still your responsibility. Your “ship” needs
to be ready for storms. And when you see a
storm coming, you should double check
your preparations and make any final
adjustments. Here are the most
likely storms that will toss your
ship around.
S U D D E N C AU S E S
Loss of Key Client

This is the most common cause of a downturn within a particular firm.
It is not usually caused by poor service on your part, but an acquisition
or change of personnel at the client level.

Loss of Key Employee

This is rare but too common to ignore. One or more key employees
leave and take a key client with them. The employee departure alone
is usually not a significant financial event, but if they take a source of
revenue (a client or two), it can be significant indeed.
Economy
The economy in the country where you live may stall. The businesses
that you serve will be affected to varying degrees, and this will ripple
through to the volume of work they require of you. Even a growing
economy can affect you negatively. For instance, it may create a worker
shortage and prompt you to overpay staff to get them or keep them.
Adjusting that pay back downward to more normal levels is painful.
Embezzling
As we will discuss in a later chapter, there is a 6 percent chance that
someone has embezzled from your current business or is embezzling
now. This is based on real data from firms like yours, and it only reflects
known embezzling. The actual percentage is probably higher. But obvi-
ously you could suddenly discover that your financial condition is not
as healthy as has been reported, and/or that you have unexpected debt
that must be addressed.
D I STRAC TI N G C AUSE S
Divorce
The public eruption of a divorce proceeding usually follows many
months of distraction, and when your attention is diverted you will

miss important signals and likely neglect the big picture, focusing only
on the small-picture demands of the moment.
Partnership Dispute
In the same vein, fighting with a partner can drain your energy and let
entropy have its way at your firm. It affects employee and client rela-
tionships and dissipates the good effects that multiple partners can
have when they are pulling in the same direction.
New Facility
Securing a new facility is often a watershed event. If managed well, it
propels your firm to a new level of recognition all around. If bungled,
it will strap you with unmanageable financial obligations and the
cumulative effect of ignoring more important issues during the pro-
cess (like staff morale, marketing, and managing client relationships).
I N SI D I O U S C AU S E S
Insufficient Financial Reporting

Financial data is a quantifiable indication of the combined effect your
decisions have had. But unless you know what that effect is, you won’t
fully grasp the implications of the decisions individually. A deteriorat-
ing condition might sneak up on you, particularly if you have carefully
trained yourself to embrace denial as a wonderful inducement to sleep!
Sporadic Marketing
You won’t notice it immediately when you put off proactive marketing
of your firm, but put it off repeatedly and the effects will sneak up on
you. It seems to hit many firms four to six years after they are founded,
usually because they can live off the early splash and/or the clients they
bring with them at the outset. Don’t put your marketing efforts on hold.

Poor Customer Service

If the culture of your firm doesn’t value customer service, you
may discover client relationships of increasingly shorter duration.
Specifically, clients who might normally overlook a particular gaff will
consider it as the final straw. As you cycle clients in the front door and
out the back, the effects will ripple through client acquisition costs,
employee morale, and even your ability to predict revenue levels.
Insufficient Cushion
It would seem that a thin financial cushion is the result of a downturn,
but often it can be the cause of one. A minor—or even major—downturn
that would not otherwise cripple a firm can bring it to its knees because
the landing is hard. Available cash is so scarce that more drastic
measures are taken, which further delays a recovery. These drastic
measures might include incurring debt, leases, or even flirting with
an investor relationship that cedes too much control.
R E AC TI O N TI M E S
Sometimes knowing what to do is not as agonizing as knowing when
to do it. There are legitimate, powerful reasons to wait as long as you
can, like your desire to limit disruption to employees. The important
thing is to recognize and then account for your tendency to react too
slowly. There are many instances of firms compounding their situa-
tion because of slow reaction times, and very few instances of firms
reacting too quickly.
Think of a ship headed in a straight line but off the prescribed
course. When the error is discovered, a course correction is made.
If it is discovered early, the correction is minimal and painless. If it is
late, the correction is severe. And getting back on course will require
a much longer period of time because of your slow reaction.
The tension is usually between having a team ready to go again
when work picks back up versus cutting expenses quickly and then
not having that team around when they are needed.

DAN G E RS O F R E ACTI NG SLOWLY
Permanent Damage
As noted above, reacting too slowly can cause damage much more
severe than would otherwise be the case.
Poor Morale
Though it may not be intuitive, bad morale is more likely to result from
your over-deliberation than from your quick action. The most frequent
cause of poor morale is not having enough to do. That’s when employ-
ees feel purposeless and begin to question every decision you make.
Early Departures
If you don’t make the tough choices and select among remaining staff,
your most employable ones—the ones that can find other work—will
depart on their own, leaving you with the less-useful employees. They
leave early because they don’t sense a plan but see a decision-maker
frozen in his or her tracks. Essentially your best people are filling the
decision-making vacuum and making choices that are in their own
best interest.
All this to say that the agony of tough decisions should not paralyze
you, or the indecision will make the problem much worse than it is.
Look back on the tough decisions you have made in life. Did you make
any of them too early? Probably not. As an entrepreneur, your person-
ality type is more likely to tend toward optimistic, not realistic.
So you are faced with a downturn and are committed to acting
appropriately. The next section will give you some guidelines about
how you can correct course to get back to a good place.
C UT STA F F
The truth is that laying staff off is generally required to fix a mistake
you have made. This might include, for example, bad hiring decisions
and/or timing, insufficient marketing, and poor customer service.

Even if the immediate triggering events are not your fault, the impact
they have had at your firm is your responsibility.
What remaining employees are looking for is honesty in that regard,
as well as a roadmap to get back on track. If you will provide disclosure
that is as prompt and complete as possible, you will enable them to
relax—especially if you appear confident, excited, and engaged.
D E F E R PAYA B LE S
The next most fruitful action will be extending payables. That does not
mean taking unilateral action and delaying payment without an appro-
priate explanation to your vendors. They, too, will work with you if
there is complete disclosure and honesty. If they don’t sense that you
are watching out for them, they will watch out for themselves.
Pay your small obligations and be done with them. Get rid of the
clutter and cut down on the inquiring phone calls. The big ones, though,
warrant special treatment. This is where treating them well over the
years will pay off. Sit down with them and walk through your financial
condition, showing them actual financial statements and explaining
how you got here and what your turnaround plan consists of.
Ask them to turn the total amount owed into a note (recognized
loan). It will not be secured (i.e., if you default there is nothing they
can “possess” in lieu of the payments), and it will not be guaranteed
(by you), but it will be more secure in this sense: When you turn it into
a note, there is no possibility of disputing the obligation.
As part of this process, ask them to grant you ninety days of deferral,
and then twelve monthly payments with interest. Promise to keep
them informed of your ongoing financial situation.
If you have treated your vendors well, they will gladly agree to this,
and you will have bought some maneuvering room in the process.
If you have waited too long in acting decisively, you will want to
further explain that the alternative is to go out of business and then
take their chances as an unsecured creditor.

S U B LE AS E S PAC E
If you are leasing space, it is likely that your agreement provides for
the ability to sublease your space to another party, usually requir-
ing you to seek specific permission which will “not unreasonably be
withheld.” So think big and determine how you can sublease a portion
of your space for twelve months or more. It may even be possible to
reconfigure the space so that a portion of it becomes self-contained,
with its own entrance. Even throwing up a temporary wall over a
weekend can enhance your chances of finding a tenant.
Consider offering a structured deal, too, in which the tenant has
the option of prepaying rent at a discount just to put cash in your hands.
C UT OTH E R E X PENSE S
This probably goes without saying, but cut every unnecessary expense.
Don’t bother cutting small subscriptions or free sodas for employees.
Doing so does more harm than good. But
do examine how much you are spending
on insurance, on dues, professional fees
(accountants, attorneys, consultants),
training, education, contributions,
entertainment, supplies, and travel.
You can defer maintenance, too.
It seems even more obvious that you
shouldn’t be purchasing any equipment
to speak of, but it seems like some prin-
cipals use the need to pull out of a dive
as the justification to purchase something they think will be necessary
to do it. It’s usually a subconscious death wish (“we are going down
anyway, and might as well do it in style”).
AC C E LE RATE R ECEI VABLE S

Be a little more aggressive in collecting receivables, not demanding
money before it is due, but being less lenient when your terms
are exceeded. This is not an area where you should concentrate

heavily because of the panic that can be telegraphed by your actions.

But it can make a small contribution to your positive cash flow.
I N VO IC E F R EQ U ENTLY
If you invoice every month, do it every two weeks. If it’s every two
weeks, invoice weekly on a temporary basis. The sooner you invoice,
the sooner the client pays.
R EQ U IR E D E P O S I T S
When starting projects, ask for a deposit up front. If you are already
doing so, ask for a larger one. This is standard practice anyway and
there is no better time to implement it. Obviously this will work better
with new clients whose expectations are not already set.
FI ND H I D D E N C AS H
Do you have a “permanent” life insurance product with a substantial
surrender value? Unless you are uninsurable now and can’t qualify for
a term product, it’s highly likely that you shouldn’t have it in the first
place. Make sure you qualify for something more appropriate, and
then consider cashing it in to help with cash flow.
U SE TRA D E - O U T S
If you have extra capacity, exchange some of it for something you need
but can’t pay cash for. For example, perform a service for your printer
in exchange for the production of marketing materials. Or go to your
information technology consultant and exchange consultation with
each other. It’s not a long-term solution, but it’s free money for now.
S E LL ASS ET S
Generally you will not have much in the way of marketable assets.
But selling used furniture brings cash, as does selling used computer
equipment through an online auction service. Don’t underestimate
the value that others place on hardware that you have discarded.

Even the license to unused software can often be transferred, as long

as you quit using it when payment is made.
W H AT N OT TO D O
All these means of saving money are fairly obvious. What is less obvious
are the actions that might get you into further trouble, or at least delay
your return to health. None of these are ironclad recommendations,
but you might think very, very carefully before violating any of them.
Don’t Borrow Money

It’s too easy to avoid the tough decisions when you borrow money.
But worse than deferring them, it will require a longer and more severe
correction down the road in order to return to where you should be.
It’s much better to force yourself to live within your means. If you do,
and if the recovery is not successful, at least you won’t be spending
years to clean things up because of the personal guarantee that almost
certainly accompanies such debt. So draw a line in the sand and force
yourself to make whatever adjustments are necessary to be viable
moving forward. See the earlier chapter on funding sources.
Don’t Sign Leases

In a similar vein, don’t incur leases. This is even worse than borrowing
money because of two things: you can’t avoid additional fees by pay-
ing them off early and because you can’t sell the equipment to recoup
a bit of your money.
Don’t Sign Personal Guarantees

No matter what. These are usually attached to a facility lease, equip-
ment lease, line of credit, or conventional loan. You probably already
have some in place, but don’t incur additional ones.
Don’t Factor Your Receivables

There are factoring companies that will essentially give you an
advance against your receivables. The cost is high, though, in terms

of the percentage that they keep as the fee. In addition, your clients
will be asked to pay the factoring company directly, which sends a
clear signal that “this company doing my work is in trouble, and I’d
better find another one.”
Don’t Miss Any Tax Payments

If you miss a tax deadline, you’ll incur a hefty penalty. If it progresses
to the point where a lien is filed, this will show up on your credit report,
even if you pay it off. Most importantly, in a business failure your tax
obligations will still be fully owed by all business partners, and your
taxing authority will go after each of you until one of you pays. Even
bankruptcy generally has no affect on these obligations. They still exist.
Don’t Make Rash Promises

It is understandably easy to overpromise when dealing with employ-
ees who have stuck it out. Just pause a moment before uttering those
promises, though, and be sure that you can live with them (without
resentment) when the danger has passed.
Don’t Water Down Your Marketing Focus

Most firms have worked for years to carefully stake out their position,
turning down work that doesn’t fit, looking only for work which they
can do competently, and using their “focus” as a primary selling tool.
Those firms should resist the panic and now declare that they do
“anything,” thereby losing their most compelling edge: specialization.
Don’t Lower Prices

In a similar vein, be careful about lowering prices just to land more
work. Clients assign value primarily on price, so don’t set pricing lower
than you can comfortably live with into the indefinite future. Or at least
recognize that you may never get paid appropriately again from any
client who samples your lower pricing. In that sense you may elect to
“waste” a client or two, but just recognize that this is what you’re doing.

Don’t Jump Too Quickly to Investors

No smart investor is going to give you money without expecting signifi-
cant control. These investors may also take advantage of your weakened
situation. You are not in a position of strength, and anybody who would
consider a passive investment in your firm (i.e., without being personally
involved in management) will have expectations that could cripple
you later. Of course, if you can find a foolish, rich investor, go for it!
In fact, do you already have some minority partners that have not
turned out to be a good fit for you? This is often the best time to con-
sider buying them out. There are two reasons for this. First, the price
you have to pay will never be less than it is now. Second, partners
usually command the highest salaries, and you can realize substantial
savings in salary load by letting a partner move on.
Don’t Look Rich

Get rid of your nice car. Cancel your island vacation. Show some signif-
icant personal restraint. Mixed signals can really grate on employees
being asked to sacrifice. And don’t worry about whether it makes fiscal
sense to get rid of them—pay more attention to appearances.
I M PLIC ATI O N S O F BANK RU P TCY

Very few firms will actually file bankruptcy as a corporation. There
is usually no point. Just let the obligations sit there. But getting the
assets out can be dicey, and you’ll need to consult with a bankruptcy
expert to avoid doing anything illegal or reversible. For instance, the
law allows for money paid out in the last ninety days can be recovered
and distributed by the court. In other words, you will not be able to
favor vendors you are particularly attached to—they might have to
return the money to the court. Even more restrictive is the require-
ment that any money paid to insiders (such as officers) in the last
twelve months can be reversed. These laws vary widely by state.
You even have to be careful about angering creditors, since any
three (and sometime one, if you owe them enough) can force you

into an involuntary bankruptcy. It is a very simple procedure with

a minimum of paperwork, so treat them openly and with respect.
Finally, take solace in knowing you’ve done all you can. That’s all
there is. If it’s a really bad situation, you’ll find out who your friends
are. You’ll also find out what you are made of and will learn lessons
you’ll benefit from the rest of your life.
D I S M ISS I N G STA F F
Now let’s take a more in depth look at dismissing staff.
Why is this issue so integral to recovering from a down-
turn? First, the potential impact on the bottom line is
enormous. Typically you will spend more on employee
compensation than on all overhead expenses combined.
This is even more likely if you are overstaffed. Second, no other
“adjustment” to your overhead is as painful as eliminating staff.
Eliminating staff is referred to variously as firing, downsizing,
rightsizing, involuntarily separating, terminating, restructuring, laying
off, dismissing, or reducing. Regardless of the terminology, you—and
the employees directly affected—will be sobered and saddened.
Incidentally, this chapter does not address “firing” an employee
due to poor performance. That is a different issue altogether.
Here we are talking about incurring results that didn’t meet your
expectations to the extent that scaling back is necessary to preserve
your firm’s health. And we are presuming that you’ve done all the
other little things that you can before relying on steps this drastic.
And speaking of drastic, your salary load should be about 45 percent
of your agency gross income (AGI). If you have already tried to hold out
on tough staffing decisions, chances are that you are quite a bit over
this. You might want to trim to—or beyond—that level, based on what
your cash flow projection is indicating. Also factor in anybody who is
known to be leaving the firm, the solidity of your client relationships,
the amount of cushion you have in the firm (or available personally to
loan back to the firm), and where you think the economy is headed.

OPTI O N S B E S ID E S D I SMI SSAL

There are some other staff-related options you can consider before
“surgery.” If you implement them early enough they might have some
effect. Otherwise they’ll just delay the inevitable and require much
more serious surgery than would otherwise have been necessary.
You can ask employees to take their unused vacation now, while
things are slow. That won’t have any immediate effect at all on your
cash position, but it will ensure that the slow time is not wasted with
employees sitting around. There is very little downside to this, espe-
cially if employees recognize that a severe downturn is just around
the corner. At this point you have more time than money, and coming
up with the cash for unused vacation can be debilitating later.
Another option is some sort of company-wide reduction, either
in hours (everybody chooses one day each week to take off without
pay) or money (everybody’s salary is reduced by a fixed percentage).
Neither of these variations typically work better than giving everyone
two-thirds of a parachute and shoving them out the back of the plane.
Very few employees have the personal cushion to make an adjustment
significant enough to help your firm.
More importantly, it avoids the tough decisions. Your employees,
in fact, can usually come up with a “cut” suggestion in their own mind,
and they don’t understand why you can’t, either.
Most importantly, your best, most employable people may not
sense enough leadership from you and will leave while things are
relatively intact. (The only rats still on the ship when it goes down
are those that can’t swim.) If you have a small, very dedicated group
of employees, this might work, provided that you take a cut equal to
about double the percentage of their cut.
S E LEC TI N G A M O NG STAF F
Performance
As a downturn intensifies, you will typically make any necessary cuts
due to performance. Any hesitations you have about underperforming

employees quickly dissipate in the bright light of no cash. But in select-

ing from the remaining, largely productive staff, performance certainly
will impact your decision. And should, even if there are no glaring issues.
Function
An employee’s particular function should be the next issue to con-
sider. This is counterintuitive, too. Generally keep your administrative
staff intact and cut your “production” staff. The former impact clients
more, control more information, and are the most difficult to replace.
They almost always need to work full-time to be effective, which is not
true of your “producers,” who can also be hired on a freelance basis.
Of course this is the time to figure out what functions you can elim-
inate entirely. Why pay someone to answer the phone when there are
very acceptable auto-attendant systems that most firms use now? If
they are configured correctly, they are not a client issue. Someone will
still need to answer any caller who presses “zero” for assistance, but it’s
a waste of human capital to have each incoming call answered in person.
Some of your systems, too, might be redundant or overly
involved. Think about how you can eliminate doing some
things altogether rather than how
to do them smarter.
Seniority
Some union contracts require LIFO
(last in first out) layoff decisions.
Unless such a mandate applies to
you, dismiss it from your consid-
erations. Your situation is more
like getting under an NFL salary cap. Think about position strength,
chemistry, and return on (compensation) investment.
Challengers
Every firm has one or more. These are the folks who are always
questioning your decisions, prodding you for evidence, and taking

a different view. It’s tempting to eliminate the source of your frus-

tration, but often they have been a good antidote to your views and
should not be dismissed out of hand. If they are ornery and never
satisfied, certainly consider that in your decision. But if they are hard-
working and loyal, don’t cut them simply because they are more vocal
or opinionated. (Who knows—maybe you wouldn’t be in this mess if
you had listened more carefully.)
FI NA LIZ I N G TH E D ECI SI ON
One Deep or Many Small Cuts

A boss of mine used to say: “Dammit, Baker, you are always cutting
my legs off one inch at a time.” After realizing that this was not a
compliment, it occurred to
me that he wanted all the
bad news at once and not
dribbled in so that he was
always wondering what
was coming next.
Determine as best you
can how deep the cuts will
need to be, and just make
them. Rip that bandage off
and gasp for air just once. Don’t cut someone tomorrow, someone else
a week later, and then two people four weeks later. The staff can never
relax and dig in for the long haul ahead.
Aim Now and Fire Later

If you aren’t sure how deep to cut the staff, lay out a bigger plan and
implement the first stage immediately. Then set targets for the next
stage(s) and simply pull the trigger when the target comes into view.
For example, if you don’t get a set amount of signed proposals accepted
by a specific date, these particular two people will be dismissed. Make
the emotional decisions now, and then just interpret the data later.

The emotional toll on you (and them) is the difficult part, and
simply executing a predefined decision is less traumatic than deter-
mining what your response should be.
If you have the time and money, you might even engage an indepen-
dent third party (typically a management consultant with expertise in
your field) to make a recommendation free of personal entanglements
and bias. You can always make the consultant the bad guy, too.
A F F EC TE D PA RTI E S
Departing Employees
Inform employees being cut in person, not via email, not on their
voicemail, and not with an impersonal note. You might want to follow
up in writing, but you’ll probably want to avoid email altogether. The
advantage of a later follow-up note is to give them something for
reference after the emotions have settled a bit, and based on their
emotional response they might not hear you entirely well. Having
something to refer to will make it more likely that the full story will
be heard. A spouse (or significant other) is more likely to capture
your tone and spirit directly than through the filtering of someone
who has been let go.
Remaining Employees
Those not being cut should be the next group to know. They will worry
about their own status otherwise, and if they have any lingering doubts
about your will to act, this will put them at ease. By the time you have
agonized through the decision-making process, it is unlikely that your
verdict will be a shock. In fact, you’d be surprised how comfortable
remaining employees will be, knowing that there is a decisive leader
willing to make tough decisions. So tell them right away.
Vendors
Only your major vendors need to know what has transpired. Since
they will find out anyway, it’s best that it comes from you. Just inform

them by phone and reassure them that you are trying to manage
the situation well.
Competitors
You might even tell your competitors. Nothing disarms them like a
little forthrightness. Besides, you have an interest in helping your
displaced employees find a new home, and contacting competitors
will smooth the way for that to happen.
Clients
It would be nice if you could keep the news from clients. If the cuts
are minor and don’t affect them directly, it’s best to not say anything
to them (or to vendors or competitors). But if the news is significant
enough to travel through the underground, or if they are affected
directly, be proactive and let them know. Ideally the departing
employee can have a hand in this so that the client will feel like they
are benefiting from complete disclosure. If in your circumstances it
is better to leave the departing employee out of the equation, be sure
to give the client at least the illusion of choice in their new contact.
You will obviously have a specific new client contact in mind, but you
can say to the client: “I think you and Jerry have developed a good
working relationship, and I’m hoping that Janet will do just as well for
you. Would you let her take you to lunch and see how you think it will
work, and then get back to me? She has our confidence, and we’d like
her to have yours.” Just by giving the client a choice they are likely
to endorse your decision. But if you foist Janet on the client, they’ll
dig in just because they don’t want someone making the decision
for them, not because they don’t like Janet.
Advance Notice
The Worker Adjustment and Retraining Notification Act (known as
WARN) requires sixty days advance notice to your employees if you
have one hundred or more of them and a substantial part of your work-
force will be affected. So be sure that you comply with all applicable laws.

MA K I N G TH E A N NO U NCEMENT
Day of the Week

Don’t use the conventional “hit and run” approach of telling an
employee in the late afternoon, especially if it’s toward the end of the
week. Monday, Tuesday, or Wednesday are the best days. There are
two reasons for this. First, it will give you time to notify all the parties
involved in the same day. Second, it will give those parties time to
adjust to the news while you are available for questions.
Time of the Day

Do it in the morning. The same reasons apply as described in the
previous point, and research shows that we are freshest and most
adaptable in the morning.
Time of the Year

There are definitely times of the year when it is easiest to find work
(January is the easiest; early summer is the hardest), but you will not
have the luxury of waiting. Just ignore the time of the year and do
what you need to. On the other hand, if an affected employee is sched-
uled to go on vacation, it is usually better to wait until just after her
return than telling her just before she leaves. But, if waiting means
that you keep others on the payroll who will also be dismissed, go
ahead and notify all employees sooner rather than later.
Where
Try to use a neutral area, like your conference room or a vacant office,
rather than your own office. It’s more human and puts you on a more
common level.
Transition Period
How much longer should an employee stay? Generally they should stay
no longer than is absolutely required to pass the baton for any projects
they are working on (a few days is usually enough). But the specific

period will depend on the attitude of the affected employee. If he or she

is antagonistic and bitter, help them leave right then. But asking them to
turn in their key and escorting them to the door should be a last resort.
That would be an extreme measure reserved for the most disrespectful
employee. It strips them of their remaining dignity and communicates
very loudly that they are not to be trusted. (In those cases you can pack
their personal belongings for them and ship or deliver them, or you can
arrange to meet them back at the office after closing time.)
Pre-Notices
Employees at a management level should be notified first. There may
be circumstances when you’ll want to tell a few key employees first,
too, if you will need specific reactions from them in order to make this
work (like taking over an account, changing roles, etc.), and you need
to know where they stand.
Witness
It is generally not necessary to have a third party witness the
dismissal. We are not dealing primarily with performance-related
dismissals, and there is little cause for dispute. Inserting a witness,
too, makes it unnecessarily adversarial.
Tone
Try to avoid anger, excessive sorrow, or indifference. Legitimate
sadness couched in willing leadership is good, though. The key is
to be brief, clear, and final.
P O ST B E N E F I T S
Vacation
In most cases you will not legally be required to compensate the depart-
ing employee for unused vacation. It is, however, customary to do so. If
you have a choice, your financial situation will dictate your response.

Severance
The same applies here in that severance pay would only be required if it
has been specified contractually. It is common, however, to provide sev-
erance. Of course if you’ve waited too long to act, you will have no money
to provide severance and employees can be hurt more significantly than
they otherwise would be. If you can’t afford to provide severance pay,
don’t do it. If you have acted early enough to be able to afford it, consider
one week of severance pay for each year of employment. Some firms
also vary the severance payment based on the employee’s age, since sta-
tistically age has a direct relationship with how difficult it is to find work
again (and their financial situation is less flexible). Whatever you do
should be couched as an intention, not a guarantee. In fact, it is better to
not provide a lump sum but rather to keep the employee on payroll, just
in case something happens that would require further adjustment (this
also delays unemployment claims).
Health Insurance
If you can afford it, offer to pay for health insurance during the sev-
erance period. Under COBRA requirements, you will generally need
to give the employee the option of continuing their coverage past
anything that you might provide, but you don’t need to pay for that
coverage—just make it available at their own expense.
Retirement
The Employee Retirement Income Security Act (ERISA) provides
very specific guidelines for handling retirement benefits, and your
plan (whether “qualified” or not) must be followed. Generally nothing
needs to be done when the employee leaves. Eventually you’ll need to
send a final statement of benefits and cooperate with any request for
an IRA-rollover transfer.

Office Space
If the employee’s presence after dismissal will not be disruptive, con-
sider providing office space from which the employee can prepare
résumés and make calls.
Leased Car
If a particular key employee has a car that is leased in the company’s
name, have him turn it in once the severance payments end. Hopefully
you’ve not leased a car anyway, but instead handled it with a car allow-
ance so that you don’t end up being a car dealer in disguise.
Unemployment
Employees who are dismissed because of an economic downturn
can file for unemployment compensation (after their severance
payments expire). If they have not been dismissed for cause (i.e.,
poor performance), they will collect and your unemployment
insurance rate will rise at the next audit or renewal. Frankly, very few
employees file for unemployment since the benefits are so minimal
and disappear to the extent that the employee earns money in any
other manner (like freelancing for you or someone else).
ASS I STIN G D I S M ISSED EMP LOYEE S

One thing you can do is to help them find new jobs by calling competi-
tors and introducing them or preparing a helpful reference letter.
The obvious choice, too, is to use them on a freelance basis as you
transition out of full-time reliance on each person. Their freelance
rate is likely to be much higher, though, so this will not make economic
sense for long.

OT H E R TRA N S ITI ON D ETAI LS
Training Materials
Your policy should specify that any materials from training you have
paid for belong to the company. If the training materials are valuable,
be sure they stay behind.
Portfolio Pieces
You may feel nervous about letting employees show the work they have
done in your employ, but it is a reasonable thing for them to expect.
Employees as a matter of course should receive several copies of any-
thing they’ve worked on (as long as it is not confidential). It will be up to
them to be ethical in describing what role they played in developing it.
Things to Collect
Obviously you’ll want to collect keys, parking passes, company credit
cards, and any equipment they might have been using at home (like
a laptop).
If the departing employee shows signs of retribution, be sure
to change the locks and security codes and passwords.
Speaking of passwords, make it policy at your firm to have a central
repository for all passwords, to which you have ready access. Asking
for these after you have dismissed someone is not great timing.
N O N - C O M PETE ISSU E S
If departing employees already have a non-compete, provide them
with an executed copy for their files.
If they do not have one, you can make severance pay contingent
on signing one. It’s awkward to do so, but it is reasonable and prudent.
This non-compete should only prevent them from seeking or accept-
ing work from your clients (and perhaps hiring your employees).
Otherwise, it should not prevent them from working for your com
petitor or even starting their own competing firm across the hall.

T H E B I G PI C TU R E
People survive these things. Both the people being dismissed and the
people doing the dismissing.
After listening to all kinds of advice, including what you’ve read
here, just do what you think is right. That’s all there is. In fact, you may
even discover some new things about yourself and how leanness can
be gratifying. Let’s talk more about that before closing this chapter.
THRI V I NG LE AN
At the beginning of the “lean” cycle,
nothing feels good. Assurances that
“good will come of this” sound like
silly 99¢ Hallmark cards. At times
like these, when the firm needs
you the most, you are least likely
to want to lead it.
If your staff count has decreased,
you’ve experienced the struggles that come with lower morale, lost
trust, and uncertainty about the future. At that very point in the cycle,
things will get worse before they get better. You are charged with work-
ing harder, smarter, longer, and leaner—all with less motivation than
you might like.
So why is this section titled “Thriving Lean” instead of “Surviving
Lean”? Silly platitudes are just that—silly—but your firm, if it survives,
will be stronger for having squeezed through a lean period. So many
things that you should be doing would never happen unless they were
forced on you in a lean period. Let’s look at what those are.
Remember, too, that we are not talking about “lean” as a business
strategy, but rather an enforced leanness to get through a tough time,
caused by internal or external circumstances. The most common
causes are a downturn in the economy as a whole, the loss of a client
that represented too much of your business in the first place, or a
partnership dispute.

T H E G O O D TH AT COME S F ROM LE ANNE SS

As noted above, sometimes it’s only the inevitability of your situation
that provides the courage to make those tough choices. When you
look back on the decisions you make now, you might realize that this
“lean” period was a watershed that set you on a path of great prosper-
ity. The vast majority of our clients have found that to be the case.
Not to get too philosophical here, but in my own experience the
things I am most confident about now are the things that I struggled
about earlier. Failing in the trenches has taught me invaluable lessons.
In fact, I tend to coast when things are going well. It’s pleasant and
relaxing when there is no financial pressure, but my life does not
typically improve any more than incrementally when that is the case.
In your case, these good things that emerge from leanness might
help you thrive … eventually.
Better Client Base

Your first tendency in a lean environment is to take any work you can
get. You then might compound that first mistake by making another:
keeping staff in order to lose money servicing clients who aren’t a
good match.
Even though it seems counterintuitive, don’t ignore profitability just
for the sake of cash flow. That fallacy is partly how you got here in the
first place. You’ve got to be choosier, and there is no better time to start.
If you must cut staff, too, just for cash reasons alone, you will soon face
capacity issues as your frantic marketing efforts pay off. When that
happens, pare your client base back even further before adding staff.
Better Employee Base

You probably grew up hearing the notion that last hired equals first
fired. That might be integral to some union contracts, but it’s not a
good way to do business in a lean environment. Dismiss people purely
on the basis of what you need and how suited they are to meet that
need, and in so doing you will raise the average competency level of
your staff. In an environment with lots of work, you tend to overlook

performance issues because you are struggling with getting the work
done in the first place. Not so when things are lean.
Build Teamwork
Want to find out what people are made of? Go through tougher times
when the difference between selfish and unselfish choices is more
apparent. Some people will surprise you and some won’t, but there
will be no mystery about who is fair, hardworking, and committed
for the long haul.
Better Prospective Employee Pool

When it does come time to replace an employee, either through attri-
tion or from your renewed growth, there will be more good choices than
during a time of economic strength. Salaries will not be as high, “atti-
tudes” will be less prevalent, and great candidates will be more common.
Comprehensible Financial Data

During leaner times you will no longer be able to ignore financial data.
You will not tolerate late statements. Mistakes or misclassifications will
annoy you. You’ll want the data crunched any number of ways. You’ll
be amazed at the kinds of decisions that other people are making with
your money. All of these changes are good, and you will never under-
stand the financial pulse of your firm more than during lean times.
Trimmer Operations
You’ll understand the difference between what you need and what
you want. You’ll quit subscribing to publications that you don’t read,
you’ll ask employees to share in the cost of continuing education,
you’ll finally do something with all the extra space in your facility,
and you’ll force that issue with your ISP.
Fewer Competitors
Many of your competitors will not make it, thinning out the competition
and raising the likelihood of your landing any given project.

Greater Shareholder Control

Are you stuck under a burdensome partnership agreement? Are some
partners less interested than others in fighting through the mess? If
you have a variable valuation formula, now’s the time to apply it and
return to a smaller management group. The more owners there are, the
more your decision making will avoid risks and become unremarkable.
Even if you don’t have a partnership agreement, the present circum-
stances will tend to play into the hands of those who want to continue.
Renewed Personal Commitment

As opposed to letting momentum define your commitment to the firm,
lean times force you to reexamine your role, how you can contribute,
and how much you really care. You’ll emerge with a much clearer
perspective on what the business provides to you and what you need
to do to enhance its ability to keep providing that. It’s like signing that
five-year lease again for your facility, forcing you to examine the depth
of your commitment.
Why even talk about these things? Two reasons. First, you need to
balance any negative pressure you feel about the leanness you are
working through with the knowledge that good things are happening,
too. In addition, you need to embrace the opportunities that leanness
provides. They are good.
T H E BA D TH AT C OME S F ROM LE ANNE SS

But they aren’t all good. Some of them are bad, so let’s not live in denial.
Here are the three major ones that relate to roles. I’m leaving off the
rather obvious financial implications, since those are covered earlier
in this chapter.
Employees with Survivor Remorse

Survivors suffer as much as those laid off. They feel guilty for their
“luck” in not getting dismissed. They feel badly for their colleagues
that are gone.

When you dismiss employees, make sure you don’t provide them
with more support than you are providing those that stay. Sadly
enough, those that remain may feel trapped in a codependent rela-
tionship with an uncertain partner that they might not trust.
Conflicted Managers
Managers in lean situations are charged with unusually conflicted
roles. They must act as the “tough guys” and also as the people
responsible for promoting healing and raising morale. Their empathy
with employees (and even coworkers) can make it difficult to carry
out the turnaround mandate.
As Delorese Ambrose has noted in her work on surviving lean
times, managers are to wield a cost-cutting axe and be a trusted coach.
They are not allowed to fail but they must take risks. They may have to
shrink the workforce but still grow profits. They must maintain stabil-
ity but still be visionaries for change. All this can be agonizing.
Paralyzed Owners
It is difficult to focus on long-term goals if the short-term future is in
doubt. Long-term stuff is taxing and requires a unique commitment,
and if your motivation is dimmed at all, it will be difficult to concen-
trate. In a somewhat related fashion, the entire decision-making
process in a lean environment is difficult.
“I’ve never needed marketing more than I do now, but should
I spend the money?”
“My new business development person has been marginally effective.
Do I stick with her or start from scratch? If she isn’t going to work out,
the sooner I change, the sooner we’ll be back to speed. But if she does
work out soon, and I switch her prematurely, I’ve wasted five months
of ramp-up time!” You get the point. These questions never stop.
But most of the tension and confusion relates to handling employ-
ees (particularly if their fellow employees are cut), so let’s look at
these in particular.

GU I D I N G E M PLOYEE S THRO U GH LE AN TI ME S
Any employees who are dismissed lose friends and income. Those
who are not dismissed lose friends and stability. But even if dismissals
are not part of your lean times, there are changes afoot and employ-
ees look to you with renewed interest as you respond to the events
unfolding around you and them together.
We could talk about the steps that employees go through during
lean times as they process the changes occurring in their environ-
ment, but the most important critical step is that you face reality.
Listen to Delorese Ambrose’s admonition.
“The most critical step in the healing process is facing the reality
of the situation at hand. Yet this is also the most difficult step to take.
Human nature dictates that, faced with the shock of an affront to
our security, we first turn to denial. In this state of disbelief, we find
a momentary, and necessary, safe harbor. Our denial inoculates us
against the dis-ease of our losses, giving us a chance to maintain our
bearing and perhaps maintain our sanity. Our denial holds the prom-
ise that perhaps things will return to normal; perhaps the situation
in which we find ourselves is a temporary aberration that will right
itself under the pressure of our protest. Such is the case with today’s
employees and their employers, faced with the challenge of a dra-
matically changed workplace in which old promises and cherished
premises no longer hold true.”
So rather than talking about all the stages that employees go through,
let me talk about what they are looking for from you. This comes from
years of experience in helping firms like yours walk through lean times,
either helping directly, on-site, or from afar, over the telephone.
During this certain disruption, employees need to know that they
can relax. They can only relax if they think that the ship is in good
hands. And they’ll believe that it is in good hands if they have satisfac-
tory answers to the questions that follow.
“Are these people competent?” Employees don’t need you to be
totally competent, but they do insist on a basic level of competence.
They understand that there is some information that they do not have,

and so a certain amount of trust is involved. But they know that you
have all the information, and they are (hopefully) comfortable that
you will make a competent choice.
“Have they largely made competent choices?” Chances are that
you have, and thus employees will give you the benefit of the doubt.
If this is not the case, then they are probably being influenced by your
spending decisions, growth decisions, hiring decisions, and position-
ing decisions. In brief, they assume that your competency before the
“leanness” will carry over into the present.
“Do they care about the impact it has on us?” They understand that
you must make tough decisions. They don’t want to be in your shoes
because they don’t even know what they would decide if they were,
despite claims otherwise. They don’t even mind if you make decisions
that have negative consequences for them, as long as you have care-
fully weighed the impact such decisions will have. In other words, they
want to matter. They want to know for sure that their best interests
played a role in the considerations.
“Are they acting in a consistently honest, principled way?” They
have some control (how hard they work, whether or not they stay), but
employees realize that you are holding most of the cards. Furthermore,
lean times call for sacrifice and tough choices. As you make those
choices, will you do the right thing? And they are wondering about
more than just the right thing as it relates to them. They care about
how you treat vendors, employees, competitors, etc.
This is a tough balancing act, frankly. There might be waves of
layoffs, some of your actions might not look like you care, and not
being able to share everything with them seems to point to a lack of
integrity on your part. All the more reason to just do the right thing
without worrying too much about the consequences.
So how do you navigate these waters? Here are some errors you
can avoid in implementing changes during lean periods.

C O M M O N TAC TI CAL ERRORS

Frankly, following your instincts is more important than following pre-
scribed advice, but it might be helpful to at least catalog the mistakes
that seem to be common so that you can run through them quickly as
you navigate the leanness.
Denial at the Top

The higher up you are in the organization, the more likely you are to
be in denial, even despite the additional information you have, regard-
ing morale, utilization, and the likelihood of sales coming through.
Check your instincts with outsiders and key employees.
Poor Communication
When significant announcements are made, don’t let communication
filter through managers to employees. The timing and substance will
vary substantially. Address the entire company at once, in person,
with concurrent handouts that can be referenced later.
More Work with Less Help

Though there might not be much that you can do about it, at least
be aware of the pressures that employees are facing. You are asking
more of them, and often they must accept this task with less support
staff. Be sensitive to their needs.
Failure to Manage Cultural Clash

There is an inevitable tension between the old way of doing things and
the new way, made necessary by leanness. On the one hand it’s easy
to hang onto the things that have contributed to your success. But as
useful as those things were, they are not appropriate now, and you
cannot condone activities to hang onto them.
Culture can become a proven survival tool over time, and values,
norms, and behavior become ingrained in the unconscious belief sys-
tem. This is “the way things are done around here.”

Unfortunately, the culture itself, unless managed carefully, can

become a restraining force against change long after the current
situation is screaming for a new solution.
Promising in Exchange for Loyalty

Don’t panic. Yes, things are tough, but in expressing your gratitude
for the loyalty and hard work that employees are exhibiting, you can
easily overpromise. Don’t be too caught up in the moment and sacri-
fice your long-term future.
For example, don’t give someone a title and/or promotion without
thinking far ahead. Picture your firm beyond its lean stage and ask
yourself if this will still seem like a good idea.
If you promote someone inappropriately, not only will you regret
it, but the person you promoted will easily feel chained with responsi-
bilities for which they are not prepared.
This is particularly true in offering ownership to employees.
Thinking Employees are Shareholders

You cannot expect employees to act like shareholders, as welcome
as that would be! They don’t have as much at stake—they only have
a job, while you have financial obligations that go beyond that. They
also don’t have much to gain once the leanness is past—at least not
as much to gain as you do.
Pay them fairly and expect them to earn that money, but don’t
expect more.
Convenient Open-Book Management

As we discussed in an earlier chapter, a few firms—a very few firms—use
open-book management (OBM). That is, they are open about the finan-
cial results of the firm, and they do this on principle. They think it’s the
right thing to do and they think it will improve company performance.
That’s one thing, but it’s quite another to use OBM only when it’s
convenient, like when things aren’t going well.
The point is to use OBM when it’s good and bad, or not at all.

T H R IV I N G W E LL
Finally, let me make a few parting suggestions for thriving lean.
Be an Inspirational Leader
Everything has changed. People might have new bosses.
There is almost certainly a flatter structure with less
certainty about where people fit and how they
contribute. Confusion abounds.
It’s difficult to imagine a time when the firm
needs your inspirational leadership more
than it does now. Step up to the plate—
it’s part of what it means to be a leader.
Be Honest About Now and Hopeful About Tomorrow

It would seem like there is an inherent contradiction in being honest
about the present and being hopeful about the future.
Listen up, here. Unless you believe that positive change is possible,
maybe someone else should be leading.
Going through intense, severe doubts on a cyclical basis is part of
what comes with leadership, but when you are getting ready to lead a
charge, your words should not ring hollow to yourself.
There is nothing like honesty to set the stage for hope.
Listen to how one manager addressed the employees who remained
after some tough times and a few layoffs. He said that he was excited
about working with them, and acknowledged that the restructuring
had allowed him to handpick everyone in that room. And he was proud,
he added, of the team that was left. Here is what he said:
With no reservations, I’m betting my career on you. Working

together, we’re going to do great work; achieve great things.
We all have something to look forward to here. It’s our future.
We can’t be entirely certain of exactly how it will unfold, but
we certainly can make the most of it. Because we can’t do
things the way we’ve always done them, we have an

opportunity to do things in ways we’ve never done them

before. That offers each of us an exciting opportunity to grow,
to try new things and develop new skills and competencies to
enhance our careers.
This is a great example of honesty and hope combined, while at the

same time avoiding dangerous promises that you might regret later.
Become Comfortable with Discomfort

Finally, don’t put your life on hold. Work hard, but concentrate on
doing the right things, not getting rid of the discomfort. Which leads to
this important point: Lean times are uncomfortable, and it’s healthier
to try to live with a measure of discomfort than do stupid things out of
desperation in order to ease the discomfort. Work, wait, hope, be clear,
and keep a good perspective.
Lean times are just part of the new paradigm. Fast ups. Fast downs.
Less job security. Always learning and thriving.
Unless you are comfortable with discomfort, life in your organi-
zation will look too much like spinning plates with one hand while
putting out fires with the other.
Managed well, leanness and disruption are very useful things.

BEF ORECAST
When you are down and out, something always turns up—
and it is usually the noses of your friends.
—Orson Welles, The New York Times, April 1, 1962
The termination meeting should last no more than five to 10 minutes.

The downsized employee should clearly understand that he or she
is being fired and that this will be his or her last day of work.
Have Kleenex available.
Both men and women are capable of overreacting to news of their
termination. For terminated people who begin to cry after hearing
the news, have a glass of water handy.
—Termination guidelines compiled from internal memos
of downsizing companies, as reported by Michael Moore,
Downsize This, 1997
On
the mean side
of “leaner and meaner”
we huddle fearfully waiting for the next cut,
dreading the next blow to fragile psyches worn thin
by broken promises. Trust betrayed. Love of work lost.
Hopes for a secure future dashed against the hard cold reality
of mergers, acquisitions, cutbacks, and layoffs.
—Scrawled by an employee in a post-downsizing meeting,
and handed to Delorese Ambrose, Healing the Downsized
Organization, 1996
Always “lead by example.” Let’s say you’re trying to reduce costs in

the company. You can set an example by ordering your chauffeur to
get his hair cut at Super Cuts. This is the kind of personal sacrifice
that inspires the employees.
—Scott Adams, Dogbert’s Top Secret Management Handbook, 1996

17
FORMALIZING CLIENT
R E L AT I O N S H I P S
Client relationships must be developed very carefully to ensure that the

working relationship—which often consists of programs and projects—
is enjoyable, effective, and profitable. This chapter examines the nature
of a client relationship and how many relationships your firm should
seek, avoiding the dangers of too many or too few. We then look at why
it is so important to define these relationships, and then identify the
elements in a typical agreement.
D EG R E E S O F R E L ATI ONSHI P D EF I NI TI ON
The degree to which client relationships have been formalized is so
important that for decades it has been used as an indicator of how
strategic the relationship is. And so you will hear that a certain design
firm is “project-based.” Never mind that the design projects from that
client all go to that same design firm, and that the relationship has
existed for years. “Project-based,” in this context, is being used to den-
igrate the relationship as more tactical than strategic. They’ve wanted
to be more strategic but have not had a convenient mechanism to

F ormalizing Clie nt Rel at i on s hip s
capture the billable time necessary to do the overall planning. And

they’ve been downstream of where the larger decisions are made.
Advertising agencies have generally worked only under the
umbrella of an exclusive, lead relationship called “agency of record.”
They are either handling everything or they aren’t. When they get
fired another agency publicly takes their place, and the strategy
and implementation generally change at the same time. A monthly
retainer covers planning and account service, but projects are still
billed as they arise. And out-of-pockets (or pass through expenses)
like media have generally defined the compensation.
Public relations firms have long defined their relationships
with monthly retainers. But there is a strong movement away from
retainers, not just because retainers can be a lightning rod when the
relationship goes sour, but because the retainers they have used have
been poorly structured, forcing the firm to absorb excess time spent
on behalf of the client.
Digital agencies are sometimes project based if only because the
projects are large enough and defined enough to easily allow a strong
planning component without necessitating a retainer.
This chapter is about formalizing client relationships regardless of
how you approach the retainer issue. More specific information about
retainers is included in the next chapter.
R EL ATIO N S H I P C APACI T Y
Most relationships consist of projects, but the focus should be on the
relationship from which defined projects flow, no matter the type of
firm you are. While a relationship must start with a project, projects
don’t necessarily lead to relationships.
This is a very important point, and it’s why we recommend “dating
only people you are willing to marry” in the marketing process. Every
relationship will be a series of projects, but unless those projects
are identified as part of a relationship, you’ll be a vendor instead of
a partner. Keep in mind, too, that the “relationship” component does
not depend necessarily on having a retainer in place.

Most of the definition work should be done on the front end of the
relationship (the dating) to ensure that the on-going relationship (the
marriage) is enjoyable and long-lasting.
AVO I D I N G C LIE N T CONCENTRATI ON

As you design a marketing and retention plan, aim for as few relation-
ships as possible without creating a client concentration problem.
A client concentration problem is defined as concentrating too
much of your business in one relationship, putting you at risk if the
relationship disintegrates. The rule of thumb is to begin to see yellow
warning lights when any single source represents more than 25% of
your fee base, and then to see a red alarm light when that relationship
represents more than 35% of your fee base.
Be sure you are intellectually honest, too, by seeing any related work
(even from different departments/divisions) as coming from the same
source. It’s true that there is no necessary connection between getting
fired by one division while still staying in favor at another, but that’s not
how “gorilla client” relationships are usually lost. More typically there
is either a merger/acquisition that catches you off guard, or there is an
enterprise-wide audit to consolidate suppliers to a preferred vendor list.
Either one will leave you in limbo long enough to put the entire business
at risk. The point is not to turn work down from a fast-growing gorilla,
but rather to look intentionally for manageable animals from the start.

T H E ID E A L M I X O F R EL ATI ONSHI P S
Obviously, then, single relationships can be too large. But they can
also be too small, as is more often the case in smaller firms who have
not managed to snag lead relationship arrangements with their clients.
The ideal world doesn’t exist in real life, but if it did, the typical
creative service provider would have eight to ten clients, the top
three of which would represent 25% each of the fee base, leaving
the remaining five to seven to make up the final one-fourth of their
business. Each of these feeder clients could easily move up in the
standings, essentially sliding from the back burner to the front one.
In this scenario, you would look for two to three new relationships
per year. That will replace the one-third of your client base that cycles.
Remember that some client cycling is good, provided that it’s for
the right reasons. For example, if your capabilities have been changing,
many existing clients will not let you step out of the box in which they
have placed you. Another important advantage of client cycling is to
find clients who do not expect the same level of principal involvement
if you are trying to extricate yourself from relationship management
so that you can properly concentrate on managing your firm. So the
fact that the average client relationship lasts about three years is gen-
erally a good thing. It allows you to start with some fresh perceptions.
To fill this gap as clients depart, you should pitch two new
relationships per quarter (about eight per year), landing one-fourth
to one-third of the relationships pitched (or two to three per year).
This will provide client options more than sufficient to keep you in
the driver’s seat as you manage existing ones. Incidentally, if you snag
more than one-fourth to one-third of the relationships pitched, it is
more likely that your pricing is too low than that your sales abilities
are stellar. Be choosier and set the bar higher.
I M P O RTA N C E O F R EL ATI ONSHI P S

But back to relationship management. Why are steady client relation-
ships critical? There are several reasons, all of which highlight the
importance of “formalizing client relationships.”

First, you will be able to work more effectively if the work is done
in the context of an on-going relationship. There will be mechanisms
for discovering and contributing to strategic direction which would
otherwise not be possible.
Second, you’ll work more efficiently since the major learning curve
(see previous point) is behind you, providing even more time to take
the larger plan and seed it throughout individual initiatives. In other
words, more time will be spent on activities that will see results.
Third, you will be positioned more as a consultative partner than
a transactional vendor, since tactics are properly informed by strat-
egy, which falls more naturally within a larger relationship than
isolated projects.
Fourth, steady relationships will bring more stability to your
workflow and thus your cash flow.
I M P O RTA N C E O F D EF I NI NG R EL ATI ONSHI P S

Having agreed that relationships are important to your professional
practice, why would you take the next step to actually define them?
First, the very “definition” process itself is more important than
any document that might be formulated as a result of the process.
That process will surface issues before they arise. In fact, think of any
written agreement as a discussion outline to help both parties address
their perspectives on key points.
Second, if a relationship is dismantled, something is wrong and
now is not the time to determine an exit strategy. That time is at the
outset of the relationship, before undisclosed hurt and silly posturing
rule the day. A written agreement should spell out how the relation-
ship will end so that any decision to sever the relationship—by either
side—will be merely implementing a plan that has been devised.
Third, a written agreement won’t suffer from memory lapses,
making it more useful as a reference tool when questions arise.
While memories can vary, written agreements are static records.
Fourth, a written agreement can serve as a marketing tool as much
as a management tool, since it positions you in relation to the client.

They will understand how you can be effective and thus what is import-
ant to you in any relationship.
Fifth, they provide important protection should there be a change
of contact at the client level and no written record of an oral agree-
ment exists. This has happened countless times, when suddenly a
great relationship evaporates into desperate explanations that don’t
even sound plausible to you!
E X PEC TIN G TO O MU CH F ROM

A N AG R E E M E N T
Having argued strongly that you should fashion agreements with your
clients, keep your expectations in check. No agreement will really pro-
tect you. Even the tightest legal document is not impregnable. That’s the
nature of professional service work, and even attorneys cannot create
iron clad agreements with their clients. That should tell us something.
So relinquish that notion and expect other things from the pro-
cess. But it is the one and only time you’ll be in control, similar to the
serve in racquetball, the pitch in baseball, or the penalty kick in soccer.
These are cherished times that are not to be wasted.
To be even more specific, formalizing client relationships is a
balancing act. You should apply just enough definition to create
communication and respect, but not so much as to be protective
and pedantic. If you define the relationship in too much detail, it will
become adversarial at the outset. Nothing confirms bad client relation-
ships or paranoia in your past than tight agreements in the present.
Your agreements should not be one-sided, either. All of us crave con-
trol, but control must be distributed to both sides of an arrangement or
one party gets nervous and the other gets sloppy. Here are some of the
elements in the typical agreement to help you achieve that balance.
E L E M E N T S O F A T Y P I CAL AGR EEMENT

We are only going to look at the typical elements in an agreement,
not a typical agreement itself. For one thing, this is not an appropriate
forum for advice better suited to a qualified legal advisor. But more

importantly, any agreement template needs to be humanized and

authentic, which by definition requires it to originate from you.
The end result should resemble more a letter of agreement than a
contract. This is because a contract offers marginally more protection,
and that is not usually a good trade-off for the increased
intimidation that accompanies such a document.
These initial elements are used to describe major
projects. With some modification and addition, they
can also form the basis for retainer agreements (see
below). Usually deliverables are described more
broadly, and project schedules are eliminated entirely.
Here are the elements you’ll want to include as you
fashion an agreement that describes the relationships
you value.
Need
Your need is fair profit and the opportunity to apply expertise and
mission, both of which should be described clearly in your marketing
materials. In fact, never hesitate to be clear that you are looking for
clients who are comfortable with your making a fair profit. Money
is the commercial language of respect, and it should not be treated
as an afterthought.
Their need will be even more obvious, but should be stated obliquely
in terms of their need for a provider like you. The fact that both of you
have a need translates into mutual consent as you forge this arrange-
ment. Each of you has to have something that the other wants.
Objectives
State clearly what we are trying to accomplish in the engagement.
Measurement
Note how these objectives will be measured, if at all. Asking about
measurement is more important than the measurement itself, since it
indicates that measurement (and accountability) are important to you.

Methodology
The methodology is really the project itself (what we will be doing)
and the services necessary to do it (how we will be doing it), includ-
ing coordination of outside services. This is the means whereby the
objective will be met.
Scope
You will want to define the parameters of the project, by describing the
elements and/or the maximum hours to be devoted to the entire proj-
ect. Lean toward the former, of course, since you want to use program
or package pricing wherever possible. Defining scope provides a clear
boundary beyond which change orders apply.
Access
Identify the access and information you’ll need from the client. This
might be the place to highlight the degree to which promptness on
their part will ensure that deadlines are met. It might also be wise to
specify the single contact point that will facilitate decision making.
In this same section pledge your best efforts and cooperation with
their other providers, noting frequent, proactive updates on your
progress to keep them informed.
Partnership
Clarify that while your firm is exceptionally qualified to bridge their
product or service with a marketplace, you will depend heavily on
their particular knowledge and experience of their niche, and will be
grateful for a cooperative exchange that brings both worlds together.
Deliverables
Take the methodology further by describing the activities and product
that will come from those deliverables. But don’t emphasize the latter
over the former, especially if a consultative relationship makes you
nervous enough to hide behind implementation (i.e., products). You
are, ultimately, a consultant who happens to do [fill in the blank].

Ownership
Spell out who will own the intellectual property rights to your work
(once it is paid for, of course).
Schedule
Identify the key schedule points to be met. Your internal schedule will
expand this, but that amount of detail is not necessary in this document.
Direct Expenses
Also known as “cost of goods sold” (and abbreviated COGS), these are
the items sold back to clients. Be clear about how these will be handled
in terms of quality control, liability for payment, and markup policy.
Pricing
In contract terms, pricing is the means of setting valid consideration
in exchange for something of value. This is predicated on need, as
described above. Your goal should be to position your work as con-
sultative, not transactional. To accomplish this, consider: grouping
services into one price rather than breaking them out; using round
numbers ($80,000) instead of artificially contrived specifics that
appear more thoughtful than they are ($79,380); highlight process,
results, and management activities, downplaying tactile deliverables;
and employing terminology more respectful of what you do (like
“client consultation” instead of “meeting time”).
Hourly rates should be listed only as necessary, and should never
be listed as part of the agreement that would require you to notify
them when they change. Rather, refer to “prevailing pricing” and
attach the current pricing schedule. Even change orders should be
specified as a total cost, not so much per each hour spent.
Terms
Whether you charge it or not, tell clients that 12% interest will apply
to balances past forty-five days old. It is also appropriate to note that
work will be suspended if any balance is more than sixty days old.

If you will be working for a small, struggling, or quickly growing cor-

poration, consider asking for a personal guarantee from the principal.
And regardless of the size of the client, separate the total cost into
estimated payments, the first of which is due at the outset. If the client
needs justification for this practice, explain that payment issues tend
to moderate strong advice and that it is in their best interest as well.
Tax
Be sure to check with your local taxing authorities about sales tax on
fees, particularly when they contribute to a finished product of any
type. Many states in the US are becoming so aggressive that creative
service providers are erring on the side of collecting it just to be sure.
Cancellation
Make it clear that any project can be cancelled at any time for any
reason, but that time and materials expended to date will be invoiced
to the client.
Disagreement
Note that arbitration will be used for all disputes, with each side
paying their own legal fees.
Confidentiality
Clarify that all information received from the client, that is not
otherwise public, will be kept confidential. Offer to sign a lengthier
agreement that they provide.
Indemnification
Disclaim any responsibility for unintentional misuse of trademarks or
copyrighted material, and insist on indemnification for that as well as
errors and omissions in the work itself (if the client has approved it).

Feedback
Seek their permission in advance to be in the loop about the results
of the work you are doing on the client’s behalf.
W H AT N OT TO INCLUD E
Conflicts of Interest
You shouldn’t accept conflicts of interest, but neither should you let
the client define these for you, since they will have incentive to define
them broadly.
Approval
Don’t promise that nothing will be released without their approval.
That is easy grounds to not pay you. Seek approval, but recognize
that there will be exceptions.
That’s it. It’s usually best to set up an MSA-style (master service

agreement) arrangement with your clients at the outset, and then
just formalize individual projects that follow on from there.
BEF ORECAST
Judging from inquiries that come in these days, agencies still find
it difficult to turn down small accounts, or, taking them, to charge
enough for their services. Accounts are definitely divided into two
categories: those on which you make money, and those on which you
lose. It requires great firmness, and considerable ability in analysis,
to establish which accounts belong in each classification.
—Kenneth Groesbeck, The Advertising Agency Business, 1964

18
CONSTRUCTING
A P P R O P R I AT E R E TA I N E R
R E L AT I O N S H I P S
This chapter begins by defining the four kinds of retainers and then
contrasts retainers with media commissions and agency of record
agreements. Next we look at why retainers are good for clients, good
for you, bad for clients, and bad for you. Finally we look at five ways
to mess up a retainer and four ways to construct a good one.
A “retainer” is either a removable orthodontic appliance or a long-term

client agreement. Both are painful as well as easy to lose at a restaurant,
either because you’ve hidden it under a napkin or because the client
dismissed you over a power lunch.
The fact that we are willing to use retainers—in spite of that pain—
is a testament to how desperately we want to wrest back some of that
control over our destiny. Though this hope is too broad, formalizing
client relationships is an invaluable corollary to bringing a profession-
alism to your practice.
Business relationships are measured in many different ways,
including longevity, access, frequency of contact, and level of

Con stru cting A ppro priat e Retain er Re l at i on s hip s
influence. But money is and should be the most accurate measure of

value. As we noted last chapter, money is the currency of (business)
respect. It’s not a comfortable thought but it is an accurate one.
How does it work? At a simple level, you do something and they
pay you. But how the “do” and “pay” are measured or even aggregated
is a question that bears further exploration. You can do the work, bill
the client, and then wait to get paid. You might even ask for a deposit
just to weed out the tire kickers and/or to help with your cash flow.
That’s not unlike going to a gas station and paying for the gas as you
pump it, perhaps even paying up front if you look scruffy and the
business owner isn’t real sure you won’t run off without paying.
But say you go to the gas station frequently and over time have
developed a relationship of trust and predictability and you decide
that there’s a simpler way to do things—especially if it enhances the
relationship. How that hypothetical relationship is defined in terms
of money requires some deeper thinking. Should you get a discount
because you buy so much, even if the station owner’s costs are not
significantly less? Should you prepay? Should you expect to have other
services included? Will the nature of the relationship change as the
expectations become more fixed? Will you take each other for granted?
All these questions are legitimate ones when considering whether
or not to establish a retainer relationship with a client.
W H AT I S A R ETA I NER?
A retainer is a more defined relationship between your firm and a
client, often with more specific expectations in terms of what you
will do for them, how long you will do it for them, and how you will be
compensated. Its very essence serves to heighten those three aspects
of your relationship. You expect to work at a more strategic level; you
expect to do it on an ongoing basis; and you expect to be compensated
in a more predictable way.
At the opposite end of a strong retainer relationship is a relationship
that is based on projects. They need one, you agree to do it, and the
client pays a fixed amount. You expect to have a strategic, long-

standing relationship during which you will be paid fairly, but such
expectations have not necessarily been discussed, and they certainly
haven’t been put to paper.
Retainer relationships come in many forms, too. At the outset
you should realize that in the context of creative service firms, the
“retainer” word is not used like a law firm would use it. In the latter
case, a “retainer” is merely a deposit against which they will bill for
their time. This puts legs to the idea that you want them to repre-
sent you, and it eliminates any risk that you won’t pay the bill. While
a retainer can mean different things in the creative services field, it
does not mean a deposit. Here are some options.
Global Retainer
A retainer can cover everything you do for a client. Typically this
arrangement takes effect after you’ve worked with the client enough
to know what they generally require. From there, usually frustration
on the part of the client or you prompts the suggestion to look at a
retainer because “it’ll make things simpler.” You look at all the work
that you’ve done, make a projection based on what changes might be
in the works, divide by twelve, and thus arrive at a monthly retainer.
In this arrangement cost of goods sold is extra. Costs of goods sold
(COGS) is calculated as anything you purchase on the outside, spe-
cifically for this client, whether or not you mark it up (see earlier
chapters for a discussion of this). You get the same amount of money
for doing whatever the client needs, whether it’s more or less than
the retainer would normally cover. Usually it’s more, and later in this
chapter we’ll talk more about handling this.
Monthly Balanced Retainer

This approach is similar to the “Everything” approach above, except
that time is tracked and any unused time is held as a credit for later
use by the client. Your firm might or might not charge the client for
any overages, and it’s common to see the client charged if they exceed
the retainer by a set percentage (like 10%). In other words, you would

absorb any 1-10% fee overages. This approach is better than the first
but still lacking.
Partial Task Retainer

This approach isolates certain functions that you perform on behalf
of clients, letting a retainer cover only those functions. Generally this
would include things like account planning, travel, account service,
keeping up on the client’s industry, attending trade shows, etc. This
approach can be very effective if the fee matches the retainer and is
balanced appropriately.
Minimum Monthly Fee (MMF)

This approach estimates the total client need (similar to the global
retainer), and then fashions a MMF, often just below that number. Time
is still tracked and any overages are billed to the client, but unused time
is not credited to the client for future use. All expenses under COGS are
billed separately. This is the best approach—if a retainer is a good fit in
the first place—and it’s what we’ll detail further in this chapter.
R ETA IN E R VS. M ED I A COMMI SSI ON

Those of you who are functioning more like ad agencies will wonder
how a retainer works in relation to a media commission. The 15% media
commission has historically included creative and account service,
but with the decades of pressure to lower that commission, it’s more
common to unbundle every aspect of compensation, especially if
you are placing large amounts of media. In such a case, you would

generally charge the client separately for media planning and then
charge them for media placement and management together. Creative
fees would be estimated and billed separately, as would COGS or out
of pocket (OOP) expenses. The media commission itself would be sub-
stantially lower than 15% and would compensate you for risk alone.
If you are billing for business-to-business media or not billing
much media at all, the client usually allows the historic 15% com-
mission, assuming it will cover media planning (there’s very little
planning involved) as well as media placement and management
combined. Creative fees and COGS would be billed separately.
R ETA IN E R VS. AGENCY OF R ECOR D

Before we examine retainers more specifically, let’s look briefly at the
correlation between having an “agency of record” (AOR) relationship
with a client and having a retainer relationship with a client. There
is no necessary connection between the two, though being an AOR
makes it slightly more likely that you will have a retainer relationship
with said client.
Being an AOR means primarily that you are the exclusive—or at
least primary—advisor and implementer of marketing activities for
a specific client, buttressed by a written agreement to that effect. It
used to mean more than it does now, implying that you could incur
obligations on the client’s behalf (like large media purchases) or were
empowered to speak for the client to the media (in a public relations
capacity). That has been watered down in such a way that being an
AOR really just means that you are the official agency, whether or
not you place media or provide public relations services.
An AOR relationship would also imply a strong partnership. The
client regularly relies on you for high-level advice, letting you look
far ahead with them in product planning and branding, doing so at
the highest levels of the organization.
Should you seek an AOR relationship with your clients? If you do
indeed meet the criteria outlined above, there is no disadvantage in
doing so. In fact it’s a good thing for you. The problem is that clients

are not as monogamous as they used to be, and thus they are less will-
ing to tie the knot publicly.
Do keep in mind that an AOR relationship can be with the client as
a whole, a division, or even just a single brand. On this note, where are
we most likely to find retainer agreements?
W H O U S E S R ETA I NERS?
Public relations firms utilize retainers to a higher degree than any
other type of creative services firm. In part this is driven by the
nature of the work—there are fewer defined projects. Instead, public
relations firms are tasked with big goals that require lots of time and
energy. The destination is grand, but the mileage posts are few and far
between, and having a retainer agreement establishes a more stable
relationship. Actually, even if the relationship is not any more stable,
arranging a retainer forces the client to address exactly what they
are looking for in advance, making it easier for you to achieve results
while still meeting their expectations. An added reason for a retainer
at public relations firms: they need to be on call for quick help.
Advertising agencies are the next most likely to employ retainer
arrangements with their clients. As with each of these categories,
the larger the relationship, the more likely the relationship is defined
by a retainer. More is at stake, there’s more work to do, and the nature
of the relationship is more critical to delineate.
Design firms and digital firms are far more project oriented and far
less likely to have a retainer relationship with clients. Having said that,
there are very good reasons to consider one.
In fact, let’s look at the good and bad reasons from both vantage
points: the client and your firm. This will help you decide whether you
should pursue one, and it will also help you evaluate the opportunities
that arise, usually prompted by an inquiry from an existing client.
As you probe, you’ll easily determine if they want a retainer for the
right reasons.

W H Y R ETA IN E RS ARE G O OD F OR CLI ENT S

First, retainers are good for clients because such an arrangement is
a means of securing capacity. There’s a clear understanding of how
much work to do, and there’s every expectation that you’ll gear up for
it, protect that capacity, and ensure a good working relationship with
(presumably) one of your best clients.
Second, retainers are good for clients because you will provide
more strategic leadership, for two reasons. On the one hand, you will be
operating in a relationship defined as such because they have told you
in writing that they want your strategic guidance. On the other hand,
the retainer will be a mechanism to compensate you for such work. If
you are working on a purely project basis, how do you charge the client
when you put your feet up and do some good thinking? Do you allocate
it between active projects? What do you call it? A retainer says, in part:
“Here, think on my behalf and be sure that you are getting paid for it.”
Third, retainers are good for clients
because they are formally protected
against conflicts of interest. This con-
cern is more applicable with a vertical
specialization, but the larger your firm,
the more likely you are to have retain-
ers, and the more likely you are to be
specialized vertically.
Very few clients you are working for
on a project basis would expect you to
refuse any work that would be a conflict
of interest. But if you have a primary
relationship with the client—whether
or not it’s defined by an AOR agreement—a retainer can formalize
this protection. It can simply eliminate any work in that niche, or it
can give them the right to approve work for related clients, or it can
eliminate a client relationship with a small number of their identified
competitors.

Fourth, retainers are good for clients because they can get help
quicker when something important arises. This explains why they are
so prevalent among the public relations community. Just like firemen
need to be on call even if they are fighting fires only 5% of the time,
they have a defined compensation package so that they are available
almost immediately. Someone has to pay for that access.
W H Y R ETA IN E RS ARE G O OD F OR YO U
First, retainers are good for you because, to a point, they provide a
more predictable cash flow. We all know that you can get fired at any
point, notwithstanding any written agreement in place. We’ve seen
companies claim that their agencies have been guilty of gross neg-
ligence, withhold payment, or just threaten something so that it’s
obvious that ending the relationship early is in everybody’s best inter-
est. But those cases are very rare, and in general a retainer helps you
anticipate cash flow with some expectation that you’ll have at least a
few months of advance notice should the relationship come to an end.
Second, retainers are good for you because they establish your
firm as one with a strong strategic bent. We are speaking here pri-
marily of how you are viewed by the client, not how you are viewed
by other prospects who know of your retainer arrangement. But the
client clearly values your “partnership” enough to formalize it, and
even in the process of formalizing it you will speak openly of how this
will enhance your strategic leadership opportunities because you will
be compensated for them.
Third, retainers are good for you because you will get paid for this
strategic thinking. I put this as a separate point because you can pro-
vide strategic leadership without getting paid for it. They are separate,
though related, points. Unfortunately too many firms give away their
best work. They rely on implementation for their bread and butter
income and give away the strategic thinking as a loss leader for “all
this other money.” In essence they are like portrait photographers who
charge $50 for a sitting fee and $300 for a 16x20 color print instead of
$500 for a sitting fee and a modest markup on all product. Where do

you give away this work? Usually it’s upfront when you are trying to
snag the project. Instead of charging a separate “Account Planning”
fee, you make the recommendations right in the 30-page proposal.
Welcome to the world of $50 sitting fees.
Fourth, retainers are good for you because they will enable you to
leverage an existing client relationship into a larger one in exchange
for promising exclusivity as you avoid conflicts of interest on the
client’s behalf. This must be handled gingerly, of course, or it’ll look
like you are holding them hostage. But it’s just common sense that if
you limit your opportunities by agreeing to not work with a client’s
competitors, you must be guaranteed a certain level of work.
Fifth, retainers are good for you because they’ll provide more oppor-
tunities for good public relations about your firm, which will result in
greater marketing opportunities. In other words, landing a retainer or
AOR relationship is more newsworthy than simply landing a client.
W H Y R ETA IN E RS ARE BAD F OR CLI ENT S

First, retainers are bad for clients because they might make you relax,
and in the process you might provide less leadership than you should.
Heck, you might even quit being as nice! Do you bring as many flowers
to your spouse now as you did when dating? You get the idea. There’s
a certain level of presumption that creeps into a retainer arrange-
ment—a certain taking for granted of the relationship.
Second, retainers are bad for clients because a retainer raises their
expectations and they might become dissatisfied quicker. The drop
off in their satisfaction levels will be more severe. Instead of gradually
slipping in their eyes, they’ll begin to see you milking an entitlement.
Even though it won’t likely be a fair assessment, it will nevertheless
sour the relationship more quickly than it otherwise would and they
will not have the benefit of your good work.
W H Y R ETA IN E RS ARE BAD F OR YO U

First, retainers are bad for you because they serve as a lightening rod.
As just described above, this happens because people argue about

money when other things are gone in the relationship. When your
employees start arguing about how much they make, the relation-
ship will never be good again. Same with clients. The problem with a
retainer relationship is that the downward progress happens quicker
than it otherwise would, and with fewer warnings along the way. Bam.
All of a sudden the repressed dissatisfaction they’ve had will surface
and explode. Why is this bad for you? Because you will have less
advance notice in fixing it.
Second, retainers are bad for you because they might prompt you
to ease up on your own marketing efforts. Most firms misunderstand
marketing in the first place and believe that their own marketing/
sales efforts should be undertaken solely to find work. So when they
don’t need work—because they have a strong, busy retainer relation-
ship—they don’t look for work. Makes sense, right? The only problem
is that marketing your services is about controlling your client base by
keeping prices at acceptably high levels, being particular about who
you work with and what you do for them, etc. So slowly your client
base decays because you relax and neglect to go to those dentist
appointments (regular marketing) until you have a toothache (the
gorilla client jilts you).
Third, retainers are bad for you because they actually require more
administrative work! Think about it for a minute. Sure, you can send
the client a big invoice with the retainer amount, but you still have to
track all your time, verify the profitability of each project (to ensure
accurate estimating), and process any charges for work done outside
the original scope of the project. Here’s a very important point: if a
retainer is less work for you, than you are doing it wrong and almost
certainly subsidizing the client relationship.
ME SS IN G U P A R ETAI NER
There are several ways in which you can really mess up a retainer, or
in fact let a retainer mess you up. Let’s go over those quickly and then
detail how to get it right.

Include Everything
Establish a set amount of money and then do whatever the client
happens to need. Don’t worry about whether the monthly fees
actually cover the work for that month—assume it’ll all work out.
Ignore Timekeeping
Want to lose money quickly? Relax your timekeeping routines and just
assume it’ll wash in the end. More firms lose money than make money
in retainer relationships, and this is the reason why (coupled with the
“Include Everything” note above).
Give a Discount
While this is often at the forefront of reasons to establish a retainer
relationship, it’s a mistake. Your cost structure does not change, and
the only money you give back to the client comes from profit. Actually,
your marketing costs might go down, but they shouldn’t, and you
don’t want to do anything that encourages you to rely on this retainer
relationship. Do not give a discount for a retainer relationship. If that’s
the client’s motivation, the relationship will fail.
Relax
Assume that you don’t have to work as hard now that you’ve got the
client relationship into a more predictable place. Assume that they
won’t look longingly at opportunities with other firms since they are
now married to you.
Underreport
Don’t worry about good communication with the client on the retainer
status. Assume they’ll let you know if they have any questions. After
all, you are probably doing far more work than the retainer covers,
and they ought to know that!
There you have it—several easy ways to mess up a retainer!

C O N STRU C TI N G A G O OD RETAI NER

These are the key points in establishing a good retainer relationship
with a client. Follow them and you’ll make more money, keep the client
longer, and lose less hair.
Right Reasons
Before you even agree to pursue it seriously, look at the good reasons
(above) for clients wanting a retainer. If they apply, proceed. If they
don’t, explain your reasoning and craft a better plan.
What it Covers
If it’s a partial retainer, make sure everyone knows what it covers and
what it doesn’t. If it’s a MMF, make sure the client knows that they
won’t get a refund if the usage is less, but they will get a bill if the usage
is greater. A MMF retainer is designed to guarantee capacity, access,
leadership, and no conflicts of interest. Any other reason is a recipe
for failure.
Clear Billing
Detail billing procedures clearly. That includes an advance payment
for the MMF and quick payment for any overages above the MMF
and out of pocket expenses.
Client Size
Never contract a MMF with a client who is too small anyway (less than
10% of your fee billings, or perhaps 5% in unusual circumstances).
MO D I F Y I N G TH E RETAI NER
While you will obviously do your best to establish a perfect retainer,
the relationship will change and the retainer must change with it.
On a monthly basis, be sure to bill for any time spent above the MMF
(see above). On a quarterly basis adjust the MMF up or down based
on usage trends.

Be sure to include the retainer client in your regular efforts to

assess client satisfaction. And also be careful that you don’t establish
retainer relationships with clients that are too small for your firm.
There should be no end to the retainer relationship. It should exist
for an initial period (six to thirty-six months), and then automatically
renew for fixed periods (six to twelve months) or simply require
so many months of advance notice for their cancellation (three
to six months).
Ultimately the client should decide if a retainer makes sense. If they
think it does, and if it’s constructed properly, you have a good thing.
BEF ORECAST
So when you’re sure you have the right agency on board, how should
you manage your relationship? Clients always get the agency service
that they deserve. If you make yourself available, if you give clear
instructions, if you pay compliments when someone on the team
has worked specially hard, your agency will go the extra mile for you.
If you treat them like suppliers, they will eventually lose heart and
treat you like a customer.
—Adrian Wheeler, GrowingBusinessMag.co.uk, 2004

19
THE ROLE OF LEGAL

I N YO U R AG E N C Y ’ S
FINANCIAL WELLNESS
By Sharon Toerek
This chapter concentrates on the most common areas where legal

disputes arise, covering copyright, trademark, social media, client
contracts, and employment and HR issues.
Taking a proactive approach to legal affairs is a key step toward achiev-

ing financial wellness in your agency.
The investment in strong legal controls and processes is usually
regarded as an operational “cost” to be merely tolerated in the business;
but it’s more accurate to say that healthy legal operations are a profit
center for your agency.
Let’s review the revenue-saving and revenue-enhancing opportu-
nities agency leaders can create with their legal operations.
Sharon Toerek is an intellectual property and marketing law attorney,

with Toerek Law, a national firm based in Cleveland, OH. Her practice is
devoted to helping creative professionals protect, enforce and monetize
their creative assets. Visit Toerek Law at www.legalandcreative.com.

The Ro le o f Legal in Yo ur Age n cy ’s F i n a n cial We lln e ss
STRO N G C O N TRACT S AR E A P ROF I T CENTER

F O R YO U R AG E N CY
The role of well drafted contracts in your agency is both risk reduction
and profit enhancement.
Both of these goals are achieved by having the right contract for
the relationship or business opportunity at hand—trying to shoehorn
a business transaction into the last contract the agency signed for
what felt like a similar situation is a shortcut that feels efficient in
the short term but creates unnecessary risk later for the agency.
The other advantages to having proactively developed your agen-
cy’s agreements are meaningful as well. The first of these is that it’s
likely to get you through a contract negotiation more quickly when
you’ve thought through, in advance, your benchmarks and expectations
for the transaction. Next, it sets the table differently for the discussion
when the agency has expressed the value it places on its work upfront
in the agreement terms—agencies frequently have more leverage in
the conversation when they present their proposed terms first.
How do you accomplish this for your agency without reinventing
the wheel every time a new opportunity requires a contract? Start
with a solid contract toolkit.
Essential Contracts Every Agency Should Have

While every agency has a different specialty, focus, or set of service
offering, there are common recurring transactions for most agencies.
These present opportunities to create, standardize and centralize a
library of contract templates that are evergreen and can be consis-
tently adopted for the agency’s day to day business, lowering risk
and maximizing profit opportunities.
TH E M UTUAL NONDI SC LO SU R E AG R E E ME NT
A lot of conversations with prospective clients, vendors or venture
partners occur before a transaction is finalized, during which confiden-
tial information is exchanged. The most meaningful risk for the agency
in this regard is the sharing of concepts, strategies, or sample work

with prospective clients without the assurance of closing the busi-

ness. A Mutual NDA reduces risk for the agency of having its IP used
without compensation (or at least acknowledgment). While many
agencies are reluctant to ask a prospective new client to enter into a
NDA—which protects both parties to the conversation—keep in mind
that most prospective clients are well-acquainted with the request and
that they usually have no hesitation asking your agency to sign their
version of the NDA, which is less likely to protect all parties.
TH E M ASTE R SE RVI CE AGR E E ME NT

The ideal provisions and terms of the Master Service Agreement are
well documented elsewhere in this volume. Add to those recent hot
button issues that we now regularly observe agencies and clients
debate during the contract negotiation process, including: exclusiv-
ity of the agency to the client, limited promotional or publicity rights
for the agency to display work samples or client names for business
development purposes, and protracted billing or work approval
language that delays the receipt of payment from the client.
The additional factor to consider about the MSA is whether your
agency actually needs its own standard MSA. It does. Some agencies
don’t feel a compelling reason to have their contract terms self-defined
where their business is in large part with enterprises, governments or
clients which have a robust procurement process, and who therefore
expect the parties to document their relationship with the client’s con-
tract. However, the value of bringing the agency’s contract first to the
table, and of having its own terms against which to benchmark, can’t
be understated—simply, we see repeatedly that the financial impact of
this on agencies is positive, and the liabilities assumed are lesser, even
if the agency’s contract is only used to inform the negotiations.
TH E I N DE PE NDE NT CON TR ACTO R AG R E E ME NT

Nearly every agency augments its employed team at some point
with freelance or contract help, whether to provide a skill set where
the agency’s talent bandwidth is low, or to meet production needs

temporarily where the volume of work is speculative. There are two

critical reasons to document these relationships with an Independent
Contractor Agreement—to enhance compliance with
the IRS factors for classifying talent as employee vs.
contractor, and to ensure that the agency properly
owns the intellectual property rights to the work
the contractor creates. The most necessary
points to be addressed in the agreement are:
intellectual property rights transfer of the work
(remember this is not automatic unless it’s in writ-
ing per the U.S. copyright laws, even if the agency
has paid for the work), non-solicitation of clients
and employees by the contractor, and work display
rights, which should require the agency’s permission.
TH E AG E NCY STR ATEG I C A LLIA NCE

AGRE E M E N T
Agencies are increasingly seeing the benefits of collaborating to serve
the needs of a common client where they have complementary spe-
cialties or niches. There are a number of potential legal implications
of these types of strategic “partnerships” or alliances that should be
documented before the collaboration begins. A Strategic Alliance
Agreement is an opportunity to define the relationship for the parties’
mutual benefit. The important issues to address in this agency-to-
agency contract are: the roles and responsibilities of each agency as
to the work itself, and as to the interactions with the client (Who will
communicate with and bill the client? Is the collaboration disclosed to
the client or is it a white label relationship?), intellectual property own-
ership of the work product, indemnifications and liability assignments,
and fair competition (confidentiality and non-solicitation covenants).
TH E E M PLOYE E BUSI N ESS PROTECTIO N AG R E E ME NT

An agreement with many potential titles, this agreement includes
provisions that might also appear in your agency’s employee

handbook or employment contracts. The key is that these provisions

should appear somewhere in your employee documentation to pro-
tect the agency from unfair competition from its employees. The key
terms to address in the contract include confidentiality about the
agency’s and client’s business, a reminder that the agency owns the
intellectual property in employee-created works, work and portfolio
display rights for the employee, non-solicitation of your clients and
other employees, and, in the few remaining jurisdictions where it is
enforceable and makes business sense given your particular competi-
tive landscape, a non-competition covenant.
Additional Contracts Many Agencies Should Have

Some agencies will also need to expand their contract toolkit to account
for specific types of work or opportunities they encounter. These are
additional opportunities to reduce risk and safeguard profit. For these
agencies, the following standardized agreements should be considered.
TH E DATA PRI VACY AG REE ME NT

Agencies that create direct response marketing campaigns, targeted
social media campaigns (paid or organic), or lead generation or com-
munity building campaigns will inevitably come into possession of
large amounts of customer information and data. Your agency will
need an agreement that establishes the legal responsibilities of the
parties about complying with quickly evolving data privacy regula-
tions that protect that data. Having a standard, agency-provided Data
Privacy Agreement increases the likelihood that your agency avoids
legal liability for this compliance or, at a minimum, divides the respon-
sibility of compliance more fairly.
WEBSI TE DEVE LOPM E NT/ M A INTE NA NCE/ H O STING

M A NAG E M E N T AG RE E M E NTS
If your agency develops online presence for its clients, there are both
upfront and ongoing matters unique to building and maintaining web-
sites that should be addressed in a specific agreement (or in a written

Addendum to your MSA or Statement of Work) regarding ongoing

debugging, maintenance, updating of content and appearance, and
management of hosting issues. Frequently there are technical details
about service levels or escalation practices of the agency that should
also be documented here so that expectations are set correctly with
the client.
TH E I N F LUE NCE R AG RE EME NT

Influence Marketing is a fast-evolving discipline that raises a com-
bination of legal compliance issues including intellectual property
rights in influencer-created content, brand usage, truth in adver-
tising principles, and the FTC’s requirements around transparency
and disclosure. Your client will have expectations around the agen-
cy’s management of these issues, especially if the agency is directly
managing the influencer or influencer network. Those expectations
should be translated into an Influencer Agreement between agency
and influencer that describes the obligations of the influencer to
comply with these expectations and gives the agency to take fast
action where the influencer is noncompliant or is not acting in the
agency’s or client’s best interests. And as influencer marketing
matures as a strategy, expect that you will increasingly be negotiat-
ing these agreements with professional management on behalf of the
influencer rather than the influencers themselves—making them feel
a bit more like talent agreements in some cases.
You Need Insurance Too

The interplay between well-drafted contracts and appropriate insur-
ance coverage can’t be understated. Contracts set expectations and
create an agreed roadmap for remedies if something unexpectedly
doesn’t work as planned. However, adequate insurance coverage is a
necessary risk mitigation and profit preservation investment for your
agency too. And in many cases, the insurance is a requirement of the
contract, and the formula for determining the agency’s liability lim-
its is contractually linked to the insurance coverage your agency has

in place. The types of insurance every agency should have in place

alongside its contract library are:
GENE R AL LI ABI LI T Y I N SUR A NCE

This is overall coverage for unexpected events every type of business
can experience that will cause financial harm (from slip-and-fall, to
climate-induced damage, to fraud losses). Many general liability pol-
icies also include an advertising injury provision that might provide
coverage for some mistakes in the work itself.
ER RORS AND OM I SSI ON S INSUR A NCE

This is professional liability coverage for negligence and mistakes,
or other damage caused by the agency to another party (usually its
client) in the course of performing its professional services. A general
liability policy will not provide the coverage your agency will usually
need for issues arising out of the work itself.
CY B E R I NSUR ANCE
The work of agencies is all digital today, regardless of whether the
agency considers itself a digital specialist agency. Most agencies need
to consider adding cyber coverage to general liability and errors and
omissions coverage to provide security against data breaches, cyber
attacks, or data privacy mistakes.
Work with an insurance carrier or broker to determine the right

blend of coverage for your agency.
I P PROTEC TI O N AND LI CENSI NG I S A

P RO F I T C E N TE R F OR YO U R AGENCY
Aside from its talent, an agency’s most significant asset is the intellec-
tual property it develops.
And for agencies that specialize in a particular discipline or indus-
try niche, there are exciting opportunities to spot patterns, develop
insights based upon those patterns, then turn those insights into

one-to-many solutions that can create new and separate revenue

streams for the agency to ride alongside its customized client work.
To do this, you need a framework for spotting, organizing, and
protecting your intellectual property to turn it into a potential profit
powerhouse.
A Simple Framework for Identifying and Protecting Agency IP

Working with hundreds of agencies to spot and protect their intellec-
tual property has allowed us to spot a frequent pattern in the types of
IP agencies create and can leverage for themselves. Put simply, the IP
generally belongs in one of these three categories:
• Brand—the words, pictures, logos, sounds and other visual or
auditory elements of your brand presentation that can be owned
and protectable by trademark laws. These can be trademarks that
brand the agency overall, or that brand a particular productized
service or package of services separately from the agency’s identity.
• Content—the work or works that express the value of the agency’s
offering—such as a presentation deck, digital course, model cam-
paign, content library, mobile app, or software—that are owned and
protectable by copyright laws. In other words, the actual output
that manifests from the agency’s knowledge and solutions.
• Transactions—the agreed business arrangements around owner-
ship of or use rights for the intellectual property. Inbound, this can
include an assignment of rights from an independent contractor
or vendor to your agency. Outbound, it can include a license agree-
ment or end user terms creating permissions for use of the IP.
Your agency is already developing this type of IP every day for the
benefit of clients, and in many cases all parties intend that the client
will own rights to the IP on completion of the work.
Identifying Your Intellectual Property

But what about the proprietary insights your agency develops by
developing the knowledge it needs to serve and help these clients?

Start here by identifying the patterns you see and the solutions
you have created that might be productized to help multiple clients,
creating a continuous and separate stream of income.
And what about the agency brand or brands you have created,
and the value they convey to the marketplace of potential clients?
Investing some internal bandwidth into identifying the agency’s
IP assets (and potential IP assets) frequently brings a high ROI to the
agency, even to the agency that initially assumes that the work it cre-
ates always ends up in the client’s hands. A professional advisor can
assist the agency in performing an IP audit of your assets so that you
can make some decisions about where the opportunities lie, or where
your agency remains vulnerable and unprotected.
Protecting Your Intellectual Property

Once the agency has identified its intellectual property assets, there
are a number of protection options to consider depending upon the
type of asset.
Deciding upon a protection strategy is as much a business decision
as it is a matter of legal due diligence. Your evaluation should include
a consideration of whether a particular asset has potential financial
benefit for the agency—do you intend to market the asset as a saleable
product or service—or the harm a lack of protection might create for
the agency if another party were to misappropriate the asset.
TR ADE M ARK SEARCHI NG A ND R EG ISTR ATIO N

Trademark protection begins with appropriate trademark searching
(beyond a simple search engine and domain name availability search—
although certainly start there) to determine availability and risk of
the brand name or marks. It might be helpful to note that the top two
reasons trademarks are refused registration by the U.S. Trademark
Office is that they are either deemed too descriptive of the product or
service they identify, or they are found to cause a likelihood of confu-
sion with another existing trademark. Once a full trademark search

reveals no known conflicts, the next step is applying for trademark

registration with the U.S. Trademark Office.
COP Y R IG H T R EG ISTR ATIO N

Copyright registration is a statutory require-
ment for filing a copyright infringement case,
or for collecting statutory damages from a
party infringing on your work. It is not tech-
nically required to establish the agency’s
ownership position in the work—if the agency
created or has acquired the rights to a work in
writing, it owns copyright in the work. The best approach for works
that your agency intends to productize and then sell or license is to
register copyright, and to also put appropriate copyright notices and
ownership language on the works themselves.
L IC E NSE AGRE E M E N TS A ND E ND U SE R TE R M S
IP assets that an agency creates as “works for hire” for the client’s own-
ership are normally dealt with in the client Master Service Agreement,
where they should transfer to the client once the agency has been paid.
All other IP assets that the agency creates and owns, whether they are
incorporated into client work product or are stand-alone assets that
might be made available independently by the agency in addition to
shared with service clients, are licensed to their final user. This license
is normally documented in a License Agreement, a License Addendum
to the Master Services Agreement, or (in the case of a technology asset
like an app, software, or online tool) End User Terms. The License or
User Terms will define the relationship, use permissions for the work,
and sometimes the compensation for the license.
Putting IP Monetization into Context

It’s helpful to share some examples of IP monetization we have actu-
ally seen agencies implement to create new revenue streams aside
their main agency businesses:

• Mobile apps
• Online calculators
• Content libraries licensed for e-newsletters, email marketing
and direct response marketing
• Online courses on entry level fundamentals for in-house marketers
• Marketing campaigns “in a box” for clients in non-competing regions
• Virtual summits highlighting experts in the agency’s client vertical
with access sold per seat
• Private podcasts
• Rich research studies in “pay per download” white papers
• Graphics and visual presentation template libraries
• Video clip libraries for social media posts
The possibilities are exciting and limited only by the agency’s band-
width to package and protect these IP assets.
MA R K ETIN G R EG U L ATI ON COMP LI ANCE

I S A PRO F I T C E N TER F OR YO U R AGENCY
Many times, the best method of preserving profit for your agency is
avoiding or mitigating risk up front. There are some common market-
ing campaign-focused risks, mostly regulatory, of which every agency
should be aware so that address them proactively.
Copyright Infringement Risk

Creative work is a collaborative effort, which usually means that the
work, or its elements, can come from a number of sources—agency,
client, freelancer, vendor, stock photography service, or software
vendors, to name a few. A further complication is that the concept
of “fair use” in copyright law won’t help your agency avoid responsi-
bility for a misuse or infringement, as it doesn’t apply to commercial
use of another’s work (remember—marketing use is commercial use).
Minimize your risk of misuse of a third party’s work by taking the
following proactive steps:

• For client-provided elements (photos, logos), address rights to

include these in the work in the Master Service Agreement with
a license from the client to the agency.
• For freelancer or vendor-provided works, make sure there is an
independent contractor agreement or vendor agreement that
addresses the agency (and client) right to use the works in the
final product.
• For stock photography or software, review stock service license
terms and software end-user terms to ensure that the planned
use is permitted by the type of license in place.
Trademark Unavailability or Infringement Risk

The risk mitigation steps of searching and clearing a trademark are
mentioned earlier in this Chapter. In addition to those steps, it’s
appropriate to put the responsibility and risks associated with brand
adoption for the client on to their plate, not the agency’s. Include lan-
guage in your Master Service Agreement that disclaims responsibility
for final trademark review and approval, including legal review of the
trademark due diligence done prior to the client adopting the new
name or logo.
Data Privacy Regulation Compliance

Increasingly, clients are seeking to hold agencies responsible for
primary compliance with data privacy regulations when running
marketing campaigns. Your risk reduction strategy for this area of
potential exposure has several components:
• Address and minimize where possible the agency’s responsi
bilities for compliance in the Master Service Agreement or Data
Privacy Addendum.
• Contract with third party vendors that are knowledgeable about
data privacy compliance and negotiate the responsibility for
compliance to your favor in the agency’s contracts with them.

• Ask pointed questions about the sources of the customer personal

data the client is providing the agency with which to operate
campaigns. If the client cannot establish a privacy regulation-
compliant method for having obtained the information, move
forward with caution, and revisit the liability language in
your MSA on this point before proceeding.
FTC Regulatory Compliance for Social and Influence

Campaigns and Ad Copy
The FTC’s regulatory work around truthfulness and non-deception in
marketing has not shown signs of waning, and the FTC is particularly
concerned as of the time of this publication with updating the regu-
lations around influencer marketing disclosure and transparency, as
well as careful scrutiny around marketing messaging directed toward
vulnerable audiences such as children, elderly consumers, or individ-
uals with cognitive or physical challenges. Remember that regardless
of the tactic the agency is using, your work is, at its heart, advertising.
Consider these steps before releasing your next campaign:
• Include a summary of relevant FTC disclosure and testimonial
rules in your Influencer Agreements, and vet the Influencer for
their understanding of the rules.
• Talk with your client before including product performance claims
in campaign materials—ask whether they have testing or other
information to support the product claims made.
• Ensure that the copy used in the campaign is not only truthful,
but that it is not misleading (there’s a difference between false
and misleading ad copy, especially for vulnerable audiences).
Your agency is working hard to earn money and preserve profit.

Don’t miss the opportunity to put proactive legal processes and
documentation in place to preserve the benefits of that hard work.

BEF ORECAST
So today, with the scarcity of jobs the number of unpaid internships

has climbed. Companies can hire unpaid internships year-round,
following some government criteria, which in most cases we know
are not observed. This is unfair to those who can’t afford to spend a
summer working for free, and to those who have graduated and are
trying to start their career. How much worse could it be? Free labor
has always been associated with slavery. Today, working for free is
unheard of, especially in capitalist America. Ironically, it looks like
that is what capitalists are looking for now.
—Vasilka Atanasova, Unpaid Interns—the Slaves of the 21st Century

20
PREVENTING
FINANCIAL FR AUD
This chapter starts by describing the scope of financial fraud at firms like
yours, then paints the profile of a typical embezzler. After explaining
what motivates this, we detail the most common methods of stealing
from you, followed by specific steps you can take to prevent it. Finally, we
offer specific suggestions on implementing a plan to prevent embezzling,
as well as what to do if you discover it.
This is not a fun topic. Just the notion that somebody might be cheat-
ing—or will do so in the future—is not a comforting thing to consider.
It falls in the same category as drafting a prenuptial agreement, filling
out your living will before surgery, or making your parents sign a note
before loaning them money.
If it helps, think about your honest employees, clients, and vendors.
For that matter, think about those close to you who depend on your
livelihood. You might be willing to operate entirely on trust (as if that
is antithetical to safeties), but you may not have the right to make that

P re venting F inancial F rau d
decision for the other affected parties. In other words, by not instituting
antifraud policies, you are hurting more than just yourself.
Later in this chapter, we’ll look at ways to implement better controls
in an existing situation. For now, do yourself a favor and read through
this with an open mind instead of setting it aside and believing that you
are the exception.
After seeing so much heartache over
the years, I’ve recommended many of
these procedures in consulting settings.
In most cases the principal’s response
is this: “That would never happen. I
really trust [person’s name].” You know
what? The only people who can steal
from you in a small service business
setting are those you trust. And in
every case—without exception—
the person embezzling was still
trusted until he or she was caught,
and almost always accidentally. As you’ll learn below, when they are dis-
covered, it will statistically be the fifth employer they have stolen from.
In many cases, the offending employee (or partner, believe it or not)
has been with the company for many years and is considered trust-
worthy and loyal. In fact, many times the relationship was stronger
than just an employer/employee bond, often involving some element
of family or friendship—which of course makes it more difficult to
implement any policy that smacks of distrust.
S C O PE
Financial fraud can be simple fraud, like fudging an expense report,
stealing equipment from your office, personal use of a long-distance
telephone account, making photocopies without reimbursement, or
doing private work on your color printers. And we aren’t even going
to address accepting personal favors in exchange for preferential
treatment, or having vendors doing work for individuals but billing

the company. These are petty and usually discovered quickly. Instead,
we are looking at more aggressive fraud, like embezzling.
Embezzling is defined as the wrongful appropriation of money or
property that has come into someone’s possession or control lawfully.
This is different from larceny, where the latter part of the definition
doesn’t apply. In embezzling situations, the employee was expected
to have access to the money but misused the privilege. In larceny, the
person was never intended to have access. It’s the difference between
misusing the credit card you have loaned me versus pick pocketing it
in the first place.
It may surprise you to learn that the primary victims of embezzle-
ment are companies with less than one hundred employees. That’s
likely because they don’t have fraud policies in place, operating instead
on trust and instinct. It might also be due to overworked owners who are
eager for all the help they can get without asking too many questions!
In the United States alone, the cost of embezzlement is estimated
to be $400 billion per year. This is a crime that is rarely prosecuted,
rarely provides for jail sentences when the criminal is convicted, and
rarely results in the repayment of the full amount taken from you.
According to the FBI, embezzlement accounts for the majority
of all business crimes investigated by local, state, and federal law
enforcement agencies. That is a staggering statistic. And remember
that your cost is much greater than the actual dollar amount taken.
You also have to account for the time spent finding and prosecuting
the culprit and then training a replacement.
Our own statistics, after surveying approximately 350 firms, is that
21 of them have discovered embezzling at their firm (their anonymous
stories are scattered through this chapter). That much we can verify.
But it’s also fair to extrapolate those numbers based on the assump-
tion that people have usually embezzled at four other jobs before they
are caught. So at least 6 percent have been victims…and the number
could run as high as 10 percent.

P RO F I LE
You’d be surprised at the profile of the typical embezzler, too. Of
course, all people who have these characteristics don’t embezzle,
but these “good” characteristics explain why you don’t suspect
embezzling until it stares you in the face.
The typical embezzler is very competent, works hard while maintain-
ing long work hours, has at least completed college, and is neat, precise,
and attentive to detail. Embezzlers also exhibit signs of being control
freaks, resist asking for help, and won’t put procedures in writing.
So that describes the employee you want, right? You might
value the above characteristics normally, but there are some subtle
clues, too, that begin to put a twist on it. Embezzlers are not usually
upwardly mobile at the firm, content to keep working the system. They
also refuse to take a vacation, or insist that no one steps into their role
while they are gone. This makes accidental discovery less likely.
There are more obvious clues, too. Often their lifestyles don’t
match their income, leaving you wondering if they have inherited
money recently. They might also be taking calls from creditors at work,
or even have a wage garnishment order that you must contend with.
It’s possible that they are borrowing from employees or requesting
early paychecks from you. We have even seen bookkeepers writing

early payroll checks to themselves without permission, justifying it

because they needed it. In extreme cases they might receive strange
visits at work (subtle manipulation from someone who knows, like a
drug or gambling source).
You might also be aware of actual gambling or frequent references
to gambling. Or other personal problems that spill over into the work
environment, like domestic disputes. Look, too, for a business on the
side that might be struggling, perhaps involving a spouse. This person
will not see himself or herself as a criminal and they will not be moti-
vated to turn themselves in because of guilt.
There is one important point to keep in mind: people embezzle to
meet growing obligations, not to get rich. They do not set out to put
money aside. They usually do it out of pressure that comes from else-
where. (Occasionally it is done by a thrill seeker who is bored, but this
is rare.)
Finally, if the person embezzling is a staff employee, that person is
more frequently female. If the person is an officer, that person is more
frequently male.
W H Y I T H A PPE N S
As intimated above, embezzling flows from a combination of things.
The most common reason is to support a lifestyle, either illegal or not.
It might be anything as simple as “wanting nicer things” to a more
destructive chemical dependence. Others are involved in an extra-
marital affair and want an anonymous source of funds. It might even
be as noble as having an ill loved one. Regardless, it usually starts with
a short-term need for cash, which they might express as “borrowing”
but then cannot pay back. Even generally nice people may discover
the hole in your systems and slowly talk themselves into exploiting
it for “good” reasons.
The second most common reason for embezzling is to extract
revenge because of some real or perceived wrong. This might be
related to actual or threatened downsizing, either for the employee in
question or someone she is close friends with. She might also feel like

she is underpaid or treated less than fairly. This is more common when
there is a large differential between either her pay and the pay of oth-
ers whose payroll she processes, or a large differential between her pay
and yours. This is yet one more reason (in a small company without
adequate controls) to keep salaries confidential from the bookkeeper,
using a payroll company instead and dealing with them yourself.
Just like a fire requires fuel, oxygen, and an ignition source, so too
embezzlement requires need (see above), opportunity (poor controls),
and rationalization (how I’ve been treated). This is known as the “tri-
angle of fraud,” and it’s what an investigator or auditor will look for.
HOW IT ’S D O N E
There are simple patterns to how embezzlement takes place. Here are
the more common schemes, written from the first-person perspective.
Missing Check to Fictitious Vendor

I write a check to a vendor that I’ve made up, like a fictitious printer
or media outlet. I then endorse the check with a stamp I’ve purchased
at office supply source. There’s no need to incorporate this entity—
a DBA (doing business as) is sufficient. If I have signature authority on
your checking account, I just sign the original check myself. Or I’ll use
your signature stamp. If I don’t have authority to sign checks and can’t
find a signature stamp, I’ll forge your signature, knowing that the bank
will not likely catch it.
Incidentally, banks quit looking at every signature years ago. It is
now considered the cost of doing business for some to slip through,
even though they are still liable if it happens. Just for fun, leave your
signature off or have someone else sign a check and see if they notice.
Back to the story. Sometime after I deposit the check, it will appear
in the monthly batch of cancelled checks sent with the statement. I’ll
open them right away, locate the check that I’d written to the fictitious
vendor, and throw it away.

Credit Card Statement Going to P.O. Box

I notice all these credit card solicitations coming to the office. Just for
fun (or maybe with a plan), I fill out the simple application, listing the
real officers of the corporation but then adding myself as an autho-
rized user. The credit cards come to work, and I immediately notify
the company that “we have just moved. Please send the statements
to this P.O. Box,” which I have opened just for this purpose.
I use the card for personal expenses, collecting the statement once
a month from the P.O. Box and paying the bill with a company check
made out to American Express, Visa, or MasterCard—something you
aren’t likely to notice.
Using Legitimate Company Card for Personal Expenses

I use the card you have given me access to, simply ordering something
from an online source and taking it home when it arrives, whether it’s
hardware or software.
Even if you ask for backup before signing a check to Visa, the pur-
chases will look like legitimate business expenses.
Intercepting Client Payments

A client pays and I intercept the check instead of crediting the client’s
account and depositing it. Or I credit the client but then deposit it in
my own account, endorsing it as if the client has written the wrong
payee on the check.
Other
Occasionally we’ll see other minor attempts, like paying yourself
for extra vacation or sick or personal days. Or crediting a personal
credit card with bogus refunds (assuming, of course, that the business
accepts credit cards).
There is one interesting thing about embezzling: It usually escalates.

We have never discovered embezzling that had already stopped. The
person either moves to another victim employer or is caught.

P R E V E N TIO N
So how do we prevent this? The good news is that it is very simple.
You’re not likely to need expensive audits, detailed policies, or redun-
dant personnel. A few simple things will suffice. We’ll lay them out here,
and then in the next section give you some specific guidance about how
to implement these suggestions without throwing people off balance.
Culture
It may seem like an odd place to start, but be sure that you don’t give
tempted employees any unnecessary justification to cheat you by
cheating clients yourself. Not only would it be smart to have a strong
written policy denouncing theft (and declaring your intention to
pursue any and all fraud), but treat clients like you want to be treated.
Refund overpayments, don’t pad bills, use a consistent markup, and
don’t fudge on travel expenses. Nothing screams “it’s OK to embezzle”
more than unfair treatment of clients. In the same vein, of course,
treat employees fairly and give them scant justification for retaliating.
Payroll Privacy
To keep your bookkeeper from having to know the salary levels of
staff, simply have the payroll service contact you every two weeks
to briefly see if there have been any changes. From there the payroll
service works with him or her, communicating what the total payroll
obligation will be (without disclosing the individual components in
the large figure). Then he or she transfers that exact amount into a
separate payroll checking account that is subsequently drawn back
down to a zero balance (your bookkeeper should have authority only
on that account). This works in smaller firms where payroll isn’t that
complicated. In larger firms, the CFO would manage the relationship
with the payroll company. In the largest firms, a payroll clerk would.
All of this is designed to lessen compensation envy, which is a fre-
quent motivation for embezzlement. (On a side note, you will also
tend to overpay employees who know what their peers make.)

Address for Cancelled Checks/Statement

To protect you and your bookkeeper, it is important that your bank
send the cancelled checks and statement to an address other than the
office, where you can flip through the checks quickly, looking for any
suspicious vendors, amounts, or endorsements. Ideally this will be to
your home. (Don’t frustrate him or her by keeping them in a pile!) This
is the simplest and most effective way to prevent embezzling. Please
do it! And if there are partners at your firm, have the cancelled checks
and monthly statement sent to the partner with the least financial
involvement. If your bank doesn’t return cancelled checks, randomly
or regularly ask for a hard copy so that you can scan them. Note that it
is not sufficient to simply ask that the envelope be given to you at work,
unopened. Many banks use resealable envelopes, and even if they don’t,
the envelopes are easy to open and reseal without your knowledge.
Backup for Credit Card Bills

Require that any checks written to credit card providers have a receipt
for each bill (or at least a credit card statement) attached to the check
requisition. This will make it more likely that the cards will be used
only for legitimate business expenses.
Signature Authorization
You shouldn’t usually be signing every check or even approving ven-
dor payments. But it would be wise to require a partner signature on
any check over a certain amount (the amount will vary based on the
size of your business). That might not prevent embezzling, but it will
allow you to make a claim for unauthorized funds from the bank that
let the checks slip by without the extra signature or with a forged one.
Separate Duties
In larger firms, separate duties so that the same employee does not
process payables and also reconcile the bank accounts, or does not
prepare billings and also record receivables. If the duties cannot
easily be separated, consider rotating them (that will be good

preparation for vacation planning, anyway). Or bring in a part-time

outside bookkeeper to handle a key check-and-balance duty, like
reconciling the bank account.
Vacations
Require them, not allowing employees to get ahead in their duties so
that no one has to step in while they are gone, but actually expecting
someone else to step into that role. Not only will you have an extra
set of eyes to keep everybody honest, but you’ll force a little bit more
institutionalization from the bookkeeper and accounting types who
are bad at letting go anyway.
Scan Mail
On one random day every month, get all the mail yourself and
open it. You aren’t likely to find something that particular day, but
the open knowledge that you might do that any given day will be a
strong deterrent. Look for clients who complain about their checks
not getting credited, credit card statements, etc. Plus, you might be
amazed at what you learn about other things!
Lockbox Payments
Though this would only make sense for the largest firms, you always
have the option of directing clients (right on the invoices) to send
their payments straight to a lockbox. Not only will this improve your
cash flow (because the deposits are automatic), but it will be very
difficult to intercept a client payment. The downside is that you can’t
defer deposits at certain points of the year, and getting reports on who
has paid is a bit more cumbersome.
Voided Checks
Require that all checks be accounted for. If a check is written and later
voided, insist that it be kept and then inserted in numerical sequence
so that you can quickly scan for missing ones.

Bond Employees
You can often purchase this with a standard business liability policy. The
coverage will not be extensive, though, in which case you can consider
bonding any employee individually who has ready access to money.
Accurate, Timely Financial Statements

This should go without saying, but it’s amazing how many firms don’t
have statements within a few weeks of the previous month. It’s easier to
embezzle when the data is not expected to be current. And if an embez-
zling employee leaves with the financial statements in that condition,
it will be very difficult to know whether or not anything is missing.
Outside Audit
This would be used as a last resort, and is usually not necessary if you
have appropriate safeties in place. It is a very expensive, laborious
process, and statistically an outside audit will only detect 5 percent
of actual embezzlement. It’s better to prevent it in the first place.
I M PLE M E N TATI O N
First, decide which of these safeties you would like to implement.
Second, gather other things that can all be implemented at the
same time, like an employee handbook, certain employee benefits,
standards for financial statement reporting, expense reporting, new
timekeeping procedures, etc.
Third, solicit feedback from the parties who will be affected, noting
that these will be put into effect in a month or two (pick a specific date).
Fourth, if you can’t bring yourself to superimpose these financial
checks and balances on a bookkeeper who has been with you forever,
at least do it with any new person you hire.
I F YO U D I S C OV E R I T
Be careful about due process. Those who are caught sometimes
retaliate, claiming discrimination or sexual harassment.

Make sure you are correct before confronting the person. Have
a CPA come in late one evening to confirm your suspicions.
Contact the authorities. Find out how long you will have to prose-
cute the offender. Then decide if you wish to involve them. Some firms
have the authorities waiting at the office when the offender shows
up for work. Others promise to do nothing if everything is paid in full
(which means that they will likely embezzle again).
Confront the employee with witnesses. If you can, have him sign a
confession and personally guarantee a repayment plan with a signifi-
cant amount of money up front. Explain that if he misses one payment
(based on your decision above), you will prosecute immediately.
(If that happens, the IRS may treat it as a tax avoidance issue. This is
a good threat to keep in your pocket, but the IRS has more clout and
might siphon off payments to cover back taxes before the money has
a chance to reach you.)
And of course remember an employee’s right to due process and
privacy. This isn’t the time to lash out from the sense of personal
violation you have every right to feel.
BEF ORECAST
And what makes robbers bold but too much leniency?

—William Shakespeare, King Henry VI, Pt. II, vi, 22, 1564-1616

21
TRANSITION OPTIONS
F O R P R I N C I PA L S
This chapter begins by listing four reasons why we ignore transition

options, four times when we are more likely to consider our own transi-
tion, and the four goals we need to consider during the planning. Then we
look at timing issues, four big things to watch out for, and then the eight
common options to choose from when transitioning out of your firm.
It’s strange to note when people think about this issue. They can go for
years without any serious consideration of what will happen next, and
then some event triggers a reflective journey on what the future holds.
Just like certain parts of the world where “peace breaks out,” so too our
normal routines occasionally yield to some thought about the future.
Since I get many such questions in our consulting practice, and
because so many of you have asked that this topic be covered, it seems
even more appropriate to end this manual with a timely topic: what
are your transition options?

Transitio n Op tio ns f o r Pri n cipa ls
W H Y W E I G N O R E THI S
As mentioned above, it’s actually quite rare to get people to think
much about the next stage in their lives. In working with hundreds of
principals, we’ve found a mix of the following four traits that seem to
encourage a “heads down” approach to the future.
• I’ll live forever. Why do I need to worry about that right now? I feel
great, business is good, and most importantly, I can’t imagine doing
anything else.
• I’m great at winging it. I’m an entrepreneur, right? I’ll figure it out,
because so far I have. And if I run out of good ideas, hard work
solves everything.
• I’m too busy. Yes, I really should think about this stuff. But if I don’t
put out this fire, we’ll lose the client and I won’t have a future to worry
about. For now I’ll do great work. I’ll worry about the future later.
• I’m an optimist. How bad could it be? I’ve always landed on my feet,
and I don’t have any reason to believe that things will be different
when I’m ready to do something else.
Besides these four things, they might also be telling themselves

a fifth lie: “I’ll sell it some day. Yes, I know I’m not setting aside all I
should, but if I keep doing good work it’ll pay off.” As a teenage boy
might say, “Right.”
W H E N W E FAC E T HI S
Just as there are patterns to why we ignore this, there are also pat-
terns to when we face it. Significantly obese patients aren’t going to
take weight loss seriously unless something happens, and it usually
takes something out of the ordinary to help you look up and out.
Tough Times
You can still be optimistic in tough times, but it’s tougher to be blindly
optimistic. For one thing, it’s tougher to believe that more of the same
will get you somewhere. For another, it’s more obvious that you
shouldn’t count on selling your firm.

Lease Boundaries
There’s nothing like a major five- or ten-year commitment to give
you pause. There is no other commitment related to your business
that locks you in like a long-term lease. Employees can be dismissed,
equipment can be sold, and accounts can be won and lost. But a lease—
especially if you guarantee it personally—forces the issue. See the
earlier chapter on this topic.
Exhaustion
If your firm isn’t structured properly, you’ll be solving the same prob-
lems every morning. It’ll be like running a business for eleven years,
for example, but repeating that first year eleven times. At some point
you might realize that you aren’t making the kind of progress that you
could and you wonder where all this is leading.
Awakenings
If you are subsidizing clients or employees, you’ll eventually tire of it.
Yes, you need to put the child’s oxygen mask on, as they instruct you
in the airline safety talks, but you have to put your own on, too, and
you have to do it first. Are you making more money than anyone else
at your firm? Are clients eating into your personal time? Maybe some
things need to be fixed. Maybe you’ll never get chocolate cake if you
keep using a vanilla cake recipe.
You need more than a job. You need an investment that pays off,
because every month you spend working for yourself could easily
represent a month down the road when what you did now makes
an enormous difference.
W H AT D O YO U WANT ?
Before we talk about the eight options you have, you need to be honest
with yourself and decide what you want. Only then will you be able
to make good choices about the transition options that might meet
those goals.

Cash Out
Do you want to settle up and move on? There are quick ways to cash
out (close the business) and ways to maximize the process (sell to a
larger entity), but in the end, is the cash really what you want, if only
because it’ll help you pay for what you want to do next? Be very hon-
est with yourself, even if it’s not politically correct.
Leave a Legacy
Do you want your firm to outlast you, preferably with your name still
part of the company? It seems a little difficult to reconcile this with the
realities of running a small service business, but it can be a legitimate
goal, however elusive it may be.
Care for Employees

Do you feel a responsibility to your employees after you scale back
your involvement at the firm? Sometimes this is expressed through
the purchase of a large insurance policy, the proceeds of which will be
used to fund ongoing operations (albeit without a leader, which does
not bode well for the long-term viability of your firm). Sometimes this
desire to care for your employees is little more than the extension
of the mothering they’ve been showered with during their tenure
as employees, when in fact they are quite capable of finding work
on their own. Or should be, anyway.
Avoid Perceptions of Failure

Nobody wants to see a statue of themselves taken down, and many
of us run our business like they are statues. We name them after our-
selves, take the most prominent position at the firm, and orient the
roles in a way that feeds what we want from a business. In some cases
that desire to erect a monument is so strong that the principal cannot
easily face the prospect of “closing” a business, even if it’s for very
appropriate reasons.

T I M IN G
Above we talked about what triggers internal discussions of your
options. But when should you begin thinking about them?
In some cases the timing is out of your hands. An example of this
might be an offer from a larger firm, which obviously might get you
thinking about a transition that otherwise would not have surfaced
on its own.
In other cases the timing is entirely up to you. Transitioning owner-
ship of your firm to a key employee is far more in your control, and it’s
these situations where timing is critical. On the one hand you cannot
start so early that the incoming majority owner does not get a chance
to spread his or her own wings because you are lingering at the helm.
On the other hand, you cannot wait so long that you don’t have the
energy to be a contributing owner during any necessary transition.
And some transition is surely necessary.
All this means that it takes about three months to close down a firm,
about four to nine months to effect an acquisition, and about two to
three years to transition a firm to an internal ownership group. We’ll
walk through the options more specifically below.
BI G ISS U E S
So let’s assume that you are going to pursue one of these options.
Having been involved in guiding clients through every one of these,
let me just mention a few things you’ll want to look out for. These are
a little out of place in that we haven’t even looked at the options, but
they are that important.
Getting Paid and Options if You Don’t

If the deal involves future payment of some sort, make sure there is
both protection and recourse if the payment isn’t made. The protec-
tion might involve a mix of a personal guarantee, access to financials
on a regular basis, etc. The recourse might involve the release from
your non-compete or the option to reverse the deal in some manner.

Distractions
Be careful about the distractions that come with exploring transition
options. Statistically any given pursuit is not likely to be consummated,
but meanwhile you’ve lost some time and energy (and perhaps cost) in
playing out the steps that accompany such a pursuit. Your marketing
efforts might provide just one example. It’s hard to continue fishing
for business if someone is dangling a big offer to buy your boat.
Cultural Clashes
This is the big unknown, obviously, especially if the party to whom you
are ceding control is largely untested. What will change? How much
of your entrepreneurial control will be lost? How will the experience
change for the employees who work with you? The biggest issue is
a loss of control, because at heart, every principal is a control freak—
some are just better at admitting it!
Bad Advisors
There are many advisors out there. I think experience in managing
these transitions is more important than experience with creative
service firms, and of course that will open up the pool of candidates
to help you. Next, they should have experience with smaller firms.
Finally, make sure they are compensated in a way that does not
encourage them to be less than honest with you about any particu-
lar opportunity. More specifically, their compensation should not be
dependent on “doing the deal” or they might be reticent to raise their
hand and slow down the process, or even kill it.
T H E E IG H T P O SS IBI LI TI E S
As mentioned at the beginning of this chapter, we’ll only look briefly
at eight of the obvious options.
These options are listed in descending order of likelihood. This
means that in general statistical terms, the first option is the most
likely to occur and the last option is the least likely to occur.

#1: Walk Away

Sad to say, this is the most likely outcome when you are ready to move
on, and the reasons are legion. First, your firm might not be institu-
tionalized sufficiently to manage a transition where you are phased
out. Second, the only time you are willing to consider a transition
might be in more difficult times, which is also when you have fewer
options and less leverage in negotiating them. Third, very few parties
buy smaller service firms like yours as an investment, particularly
given the low barriers to entry. If they have the capability to do the
work that your firm is in the business of doing, they just assume that
they can start their own firm. If they can’t do that work, they aren’t
interested in buying a firm that does it.
More than 90% of you will walk away from your firms, but that’s
not necessarily bad. Many of you will be well prepared for the next
stage because you’ve done two things well: paid yourself handsomely
in order to put money aside and run your business with sufficient
profit to provide respectable distributions.
Have you ever read a real exit speech? Here is one from a firm
in Palo Alto, CA:

Dear Colleagues, Clients, and Friends,
After more than a decade of service and collaboration, Artemis

will be closing on June 30, 2003.
Over the next month, our team will be available to complete
all work that is in progress and to take on any new projects that
can be completed by our closing date. Throughout this time,
we will be happy to discuss with you our recommendations for
meeting your needs after that date.
The decision to close is due in part to challenging conditions
in our industry over the past two years. But, it also reflects my
own desire for a transition at this time of my life that allows for
more flexibility.
I have truly enjoyed the fascinating work we’ve had the
privilege to be a part of over the past 13 years. And even more
importantly, it’s been a pleasure to have shared the creative
process with so many extraordinarily talented people.
And here’s one from the departing principal (of a two-principal firm)
on the other side of the US:
It is with a mixture of great sadness and yet some relief that

I tell you that, after nearly 18 years, I will be leaving the firm.
This may come as a bit of a shock to you, so I’d like to talk
through my thinking on this and, more importantly, give you
an idea of what the future holds for the agency I leave behind.
As you know, Janet and I have been partners for a long, long
time. For much of this time it has been a strong, healthy and
productive partnership. Over time, as people sometimes do,
we have diverged some in our thinking and this has sometimes
produced a strain between us. A strain never more evident than
a couple of years ago. I’m pleased to say that we managed to
overcome that and we have continued on to build the com-
pany back to a much healthier state. Not only is it on a more

financially sound footing, but it is more of one mind than it ever

has been in our entire history.
In order to accomplish some of the goals we have set for
ourselves, the agency needs strong, clear direction. It does not
need two people at the helm steering divergent courses. And
the time has come in the agency’s life where it doesn’t make
sense to have me rushing around plugging dikes. It’s not helping
to have me trying to rescue situations and people. That’s just
confusing and ultimately, destructive. What we do need is more
role clarity and more clearly defined expectations overall. This
is a good thing. It’s good for me, good for Janet, and good for you.
The possibilities are exciting and I’ll tell you a little more about
that in a minute.
But first, as long as we’re on a confession binge here, I will
tell you in hushed tones that, besides being an inveterate res-
cuer, I have one other fatal flaw. I don’t just absolutely love
advertising. But I have come a long way. I’ve gone from pretty
much loathing it to finding it quite interesting and fascinating.
This is in large part your fault. Through your interest and enthu-
siasm you have shown me the depth and variety of the media
function, the nuances of concept and strategy, the delights of
copy and design. You’ve made it fun. But still, for a vice presi-
dent of an ambitious agency to be ambivalent in any way about
advertising is a detriment to growth. It’s been hard for me to
go out and proselytize to the community, hard to embrace the
work with the fervor it needs and hard to maintain constant
enthusiasm for an end I ultimately question. It will be far, far
better for the agency to stick with leadership that wholeheart-
edly embraces the goals and benefits of advertising.
Behind each of these stories (and there are many others in the files)
is a long process that led up to the final decision. That process involved
neglect, courage, action, and honesty. And many times there was no

payoff. So let’s make sure there is in your case, and I’ll have two sug-
gestions for you at the end of this chapter.
Does it seem unlikely that you would walk away from your business?
Probably not, right now, but you must remember that “walking away”
frequently follows a period of difficulty, which might not be true of
your firm right now.
Another important point: you really never have to walk away. At a
minimum, you can sell the accounts to another firm who will pay you
a percentage of the AGI volume over a period of time. This provides
no risk to them and a potential payout to you.
#2: Sale to Key Employee(s)

The next most likely scenario is to sell your firm to a key employee or
group of employees. This is only slightly better than walking away from
your firm because, first, the buyer won’t bring any significant money
to the table, and second, you might very well squander your equity.
They’ll need that equity as working capital, which will put it at risk.
Ask yourself two questions before you do this. First, are you
willing to publicly identify an employee as your successor, or do
you feel like you’d like to keep that from people for now? Second,
are you completely comfortable opening the books to this employee,
including your own compensation levels? Unless you are willing to
do both, the timing isn’t right.
If you do have an entrepreneur working for you, they might already
be running their own firm. That’s not foolproof, though, because every-
one starts somewhere. But if they had a lot of money, they’d definitely
be running their own firm rather than buying yours!
If you do transfer ownership to an inside party, keep the group very
small, make one the lead buyer, make sure they have some skin (i.e.,
money) in the game, and take little steps toward this. Putting one of
these deals together is more complicated than an outright acquisition
from the outside.

#3: Sale to Remaining Partner(s)

If there are two or more partners, you essentially have a built-in
transition plan. This assumes that the buy-sell agreement and bylaws
address all the important issues.
The remaining partners are usually competent and the firm does
well after the one partner leaves. What happens to the final partner,
however, is another issue. But even there the news is usually good:
firms that make it through one ownership transition can usually make
it through multiple transitions, though the transactional value of each
is usually low.
Keep in mind that this option assumes that the purchasing part-
ner(s) are already installed at your firm. Otherwise it seldom works.
#4: Business Combination

Is there something you are really good at, but something you also
struggle with? Perhaps you can find another local firm whose
strengths match your weaknesses, and so on. Maybe you are really
good at managing the financial side and keeping clients happy, while
another principal is good at finding new clients.
The best partnerships are built on mutual respect and mutual need.
#5: Acquisition by Larger Firm

If you can make this happen, it’s usually your best hope of a large
payout. They have the money, they understand your business, and
they have the support system in place that allows you to typically
concentrate on managing staff, bringing in new business, and guiding
accounts strategically.
They are typically stable enough, too, making it more likely that
you’ll get paid.
#6: Absorption by Large Client

If you don’t have a client concentration problem, defined as any single
source of work that represents more than 35% of your AGI, you are
probably fine. But occasionally a client gets in the 75-90% range,

and as anyone who’s been there knows, you are practically owned
by the client. So you might as well formalize it!
Seriously, we’ve helped with a number of these transactions,
where each party is so dependent on the other that an “absorption”
makes sense. Obviously you are in a far better bargaining position
if they approach you first about being their “in-house department.”
#7: Roll-Up and IPO

A roll-up is a rapid aggregation of a number of businesses in the same
industry, through individual acquisitions, in order to achieve econ-
omies of scale. The purpose, besides efficiencies, is to create a large
enough revenue stream to raise public financing through a private
placement or even a public stock offering.
These offers are very common, very boilerplate, and usually come
in the mail or fax machine with no personal introduction. They sel-
dom amount to anything, and you’ll find that you have very little
ongoing control over the performance of the group. And since a large
portion of the payment is stock in the holding company, you’ll never
get paid unless the roll-up is successful.
#8: ESOP
An “Employee Stock Ownership Plan” is usually something suggested
by your public accountant or a well-meaning but misguided friend.
In essence you create a separate entity (the ESOP), to which you sell
a portion of your stock. The ESOP borrows money from a bank, using
the stock as collateral, and pays you for the shares you sold.
The short-term advantages are that employees feel empowered
because now it’s an “employee-owned” company and you get an
infusion of quick cash (though it’s usually not a lot, since only a small
portion of your stock is part of the transaction).
Long-term, though, it’s just short of a disaster. First, I’ve never seen
an ESOP-owned firm thrive. Ownership does not really encourage
employees to think like owners. If you doubt that, consult the results
from those companies who’ve tried it. Second, it’s very difficult to

disentangle your firm from an ESOP. This limits your options because
seldom will any other entity want to purchase a firm already involved
in one. Third, the decision making process can easily become ponder-
ous and unremarkable.
Don’t do an ESOP. (Or the more common worker cooperative that’s
cropping up these days.)
FI NA LLY
I promised to suggest that you do two things as you plan for the future.
Sure, you will face one of the eight options above, but that might be
quite some time off. The best thing you could do now is to prepare for
the future without chasing it.
First, manage your firm as if you are going to sell it to a larger firm
(Option #5). Even if it never happens you’ll enjoy the fruits of owning
a well-managed firm with lots of money. Better yet, you’ll be less likely
to encounter difficult times and walk away from it (Option #1) or face
the less desirable choices.
Second, don’t count on such a sale financially. Rather, assume
you’ll get nothing for your firm and put the pressure on yourself to
take enough money out so that you won’t require a sale. The path
to getting rich along the way is the extra money the firm throws off.
Concentrate on that and it takes the pressure off a transition.
BEF ORECAST
Why do most exit strategies fail to produce the anticipated and

desired results? Why is it that successful entrepreneurs, who created
the world’s greatest wealth, fail the final exam?
—Don S. Matso, Most Exit Strategies Fail: How to Avoid Becoming
Part of the Statistics of Failure, 2007

BA L A N C E SHEET
Current Assets
Petty Cash $ 1,000
Checking 180,001
Savings 135,588
Investments 187,554
Prepaid Expenses 5,125
Accounts Receivable 1,514,841
Less Allowance for Doubtful Accounts –16,874
Work in Progress 212,000
Total Current Assets 2,219,235
Fixed Assets
Computers and Equipment 145,214
Less Accumulated Depreciation –78,445
Furniture/Fixtures 89,871
Leasehold Improvements 125,879
Total Fixed Assets 239,791
Equals Total Assets 2,459,026
Current Liabilities
Accounts Payable 951,782
Taxes Payable 45,433
Line of Credit 0
Current Portion of Long Term Liabilities 62,212
Accrued Retirement Liabilities 28,383
Total Current Liabilities 1,087,810
Long-Term Liabilities
Notes Payable 57,855
Less Current Portion –20,249
Equipment Leases Payable 137,334
Less Current Portion –41,963
Total Long-Term Liabilities 132,977
Equals Total Liabilities 1,220,787
Equity
Paid in Capital 20,000
Shareholder Draw –142,793
Beginning Equity 739,242
Net Income Year to Date 621,790
Equals Liabilities and Equity 1,238,239

I N C O M E STATEMENT
Sales
Fees $ 1,945,331
Resale of Media 6,587,413
Resale of Printing 3,515,547
Total Revenue 12,048,291
Cost of Goods Sold

Media 5,599,161
Printing 2,905,411
Independent Contractors (Project Related) 69,852
Other Resold Expenses 112,284
Less Total Direct Expenses 8,686,708
Equals Agency Gross Income 3,361,583
Overhead Expenses
Compensation 1,781,639
Independent Contractors (Admin Related) 62,548
Facility 184,887
Delivery/Shipping/Postage 32,541
Communication/Connectivity 22,200
Depreciation 100,847
Lease Payments 45,778
Amortization 27,454
Interest 8,799
Fees/Penalties 1,147
Insurance 36,977
Professional Fees 26,988
Dues 17,747
Subscriptions 3,228
Training/Education 20,946
Promotion/Marketing 65,465
Contributions 5,973
Gifts/Entertainment 17,452
Repairs/Maintenance 26,893
Supplies 28,751
Travel 117,655
Miscellaneous 98,754
Less Total Overhead Expenses 2,734,670
Equals Profit from Operations 626,913
Less Other Expense –13,111

Plus Other Income 7,988
Equals Net Profit before Income Taxes 621,790

U T I LI ZATIO N
One of the simplest ways to see how effectively your firm converts
time into money is to do a quick calculation like this. I’ll use example
numbers, but you’d need to adjust them to your specific circumstances:
• The number of FTE (full-time equivalent) people at your firm,
including the billable and unbillable people, all together. If you
have 15 full-timers and 2 half-timers, that equals 16.
• The number of weeks you work, after subtracting PTO and holidays.
• The target percentage of the group.
• The number of hours full-timers regularly work (not bill, but work).
• The internal hourly rate you use when putting proposals together.
Use the average, weighted one, even if it’s just internal and your
client never sees it.
This might look like this, in the same order:

• 16
• 46
• 60%
• 42.5
• $180
Multiply all of those together and you get a potential AGI

of $3,380,000. In our sample firm, they are actually generating
$2,700,000, or just 48% instead of 60%. Assuming that everyone
is generally busy with work to do, that means that there’s some
degree of underpricing and over-servicing. (See an example
from a spreadsheet I use on the following page.)

A B O UT THE AUTHOR
David C. Baker is an author, speaker, and advisor

to entrepreneurial experts. His work has been
discussed in the NYT, Forbes, WSJ, USA Today,
BusinessWeek, CBS, Fast Company, and Inc.
He co-hosts 2 Bobs, the most popular podcast
for entrepreneurial creatives, worldwide. He grew
up in San Miguel Acatán, Guatemala, with a tribe
of Mayans, and now lives in Nashville, TN.
To contact David, please visit:

www.punctuation.com

CR ED I T S
Cover Design: Faceout Studios
Illustrations: Emily Mills
Book Design: Aespire
Editing: Bryn Mooth
Titling Typeface: Objektiv,

designed by Dalton Maag
Body Typeface: Laski Slab,

designed by Paula Mastrangelo
and Ramiro Espinoza
Printing: Nashville, TN
Pooled Blood, Sweat, and Tears:w35.897081, –86.298126

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courageous thought leadership insight

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Copyright ©2010 and 2022, David C. Baker

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Library of Congress Control Number: 2010913358

With no one listening until a high-priced consultant

1) Your Compensation & Ownership Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Sample Balance Sheet. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

One of the courses I was forced to

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M vi

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M vi i

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M vi i i

Money isn’t everything.

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M ix

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M x

This chapter begins by explaining the rationale for a compensation strat-

How much money should you make?

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 1

substantive answers to clients in a sustainable business environment.”

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 2

and by extension the clients

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 3

More specifically, how does money relate to these three options

A company delivers profit beyond expenses. This occurs after

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 4

also be giving up significant risk, loads of management hassle, and

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 5

T H E TH R E E R E AS ONS WHY YO U GET PAI D

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 6

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 7

HOW S H O U LD YO U PAY YO U RSELF ?

HOW M U C H S H O ULD YO U PAY YO U RSELF ?

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 8

Pay Yourself in Relation to Other Highly Paid Employees

Pay Yourself a Percentage of Your Personal Budget

Pay Yourself According to Salary Surveys

Pay Yourself for Three Things

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 9

Checking Your Numbers

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 10

An ownership agreement relates to compensation issues because

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 11

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 12

Unequal Financial Risk

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 13

This chapter examines the basics of reporting, looking particularly at

I N T E R PR ETI N G THE PAST

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 14

overhead in check, how responsibly you’ve incurred fixed obligations

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 15

the value of strong financial advice, and in our consulting practice we

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 16

BAL ANCE SHEET

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 17

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 18

CASH F LOW STATEMENT

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 19

L EGA L F O R M O F O RGANI ZATI ON

F INA NCI AL MANAG E ME NT O F A M A R KET ING FIR M 20

community to find a better one. Ideally you’ll be using an accounting