In my experience, an agency under two (or even three) years old can have a margin above 40%. Sometimes above 45% without trying too hard or skimping on spending.
The kind of number that makes older agency founders slightly jealous.
Then, a few years in, it starts to slide. Nobody can quite point to why.
The usual explanation is overheads and that’s partly right. But it’s rarely the whole story and the part that gets missed is the one that matters most to an agency.
Why young agencies look so profitable
There are two reasons the early numbers look so good.
The first is the obvious one. A young agency hasn’t built its centralised overheads yet. It doesn’t have overheads that relate to:
- Finance.
- HR.
- Operations.
- Marketing.
- Sales.
- Middle managers.
The founder(s) are doing all of these jobs themselves, often in the evenings and none of it shows up as a cost. Even if this isn’t the case, the costs are often fairly minimal such as a HR advisor or bookkeeper who does a few hours a month.
The second is the one that most people don’t talk about. Most young agencies haven’t been through their first big batch of client churn – yet.
If you’re good at what you do, you’ve probably kept all or most of the clients you started with. They came on board, the work was strong and they stayed. So for the first year or two, almost every new client you win is pure growth. Nothing is leaking out of the bottom.
That doesn’t last. It can’t. Even at the best agencies.
Even happy clients leave
This is the bit that catches founders out, because it isn’t a failure.
Clients leave agencies that are doing a good job for a bunch of reasons that you can’t control such as:
- A new marketing director arrives with their own preferences.
- A budget gets cut.
- They’ve been with you for a few years and simply fancy trying someone new.
And my favourite reason why clients leave despite you doing a good job?
They get bored.
Yep, seriously – clients get bored of seeing results go up and to the right – this isn’t always enough.
None of that means you did anything wrong. It’s how the agency model works.
But it changes the maths completely and that’s the bit that most owners don’t consider.
Once churn arrives, a chunk of every new client you win isn’t pure growth any more. It’s a replacement. You’re winning work to fill the hole left by the work that walked out the door.
And replacing revenue costs money in ways that never appear as a single line on your P&L. So the margin shrinks and because you’re hiring a finance person and an ops lead at roughly the same point, it’s very easy to blame all of it on overheads.
Yes, it’s overheads – but this is only one part of the equation.
The maths (a hypothetical)
These numbers are made up to show the mechanics. They’re not from any real agency.
Take an agency turning over £1.2m, four years in. Over the year, three clients worth a combined £300k leave. Not unhappy ones, just the normal kind of churn.
To stand still, the agency has to win £300k of new work before it grows at all. Here’s roughly what that replacement costs in real terms.
Selling it
Founder and senior time on proposals, calls and pitches to win back £300k. Call it £30k of time that could have gone elsewhere. This is called opportunity cost. Sure, it’s time well spent, but it’s still time spent and it has a value.
Onboarding it
New clients usually take more hours in their first few months than the fee covers. If they need an extra 20% for the first quarter, that’s around £15k of additional time delivered.
The gap
There’s usually a period between a client leaving and the replacement starting where some of the team’s capacity sits idle. A couple of months of one person’s time is another £15k or so in value.
That’s around £60k. Five points of margin, gone, in a year where the agency technically didn’t lose any revenue.
Nobody writes “cost of churn: £60k” in the management accounts. It’s spread across salaries, sales time and slightly lower utilisation, which is exactly why it’s so hard to see and understand the impact of.
Protecting the margin can make it worse
When a founder sees margin sliding, the instinct is to protect it by pushing prices up or squeezing hours or holding off on hiring.
I’ve worked with a founder who’d done exactly that and their margin looked healthy as a result. But it wasn’t funding anything. It was being spent on replacing the clients they kept losing, which left nothing to invest in the things that would have kept those clients longer. So the churn carried on and so did the squeeze.
You end up running fast to stand still, with a respectable margin hiding the fact that you’re not getting anywhere. This can lead to a frustration that is hard to see the source of. You’re working harder than ever, yet you don’t feel like you’re seeing the impact.
If your margin is mostly there to absorb the clients you keep losing, churn has stopped being a retention problem. It’s become a tax on your growth.
What to actually do
1) Separate churn from overheads in your numbers
Track how much of the revenue you started the year with is still there at the end of it. If your margin has dropped, you want to know how much is the finance hire and how much is churn, because they need very different fixes.
(This sounds simple – but you’d be shocked how many agencies don’t measure this simple measure of their performance).
2) Put a number on your replacement cost
Use your own figures, not my hypothetical ones above. Once you know what it costs to replace a lost client, retention stops being a vague “nice to have” and becomes something you can actually manage.
It’s fine that you can’t always put exact numbers on this. Simply start by estimating and using the number of hours that you invest in a new client win and your marketing efforts.
3) Build churn into your forecast
Even the very best agencies lose clients. Budget for a realistic churn rate so a normal year doesn’t feel like a crisis and so you’re not planning growth as if nobody will ever leave.
It’s very easy not to do this in the first few years because, well, you don’t lose many (or any!) clients.
4) Spend some margin on not needing to replace clients
Ring-fence a portion for whatever keeps your clients longer, whether that’s senior time on key accounts or better account management. It’ll usually do more for profit over a few years than another round of squeezing.
Most agencies don’t think about client retention in this way i.e. something that they can invest time and / or money into. But it’s probably one of the best (if not the best) investments that you can make as an agency.
When this doesn’t apply
Not every drop in margin is churn. Overheads are real and most of them are necessary as you grow. A young agency running on founder goodwill and late nights isn’t more profitable in any meaningful sense. It just isn’t counting the cost yet. Building proper finance, HR and ops is part of growing up.
Not all churn is bad either. Losing a legacy client on a budget that no longer works for you can be the right outcome.
So I’m not saying every lost client is a disaster. I’m saying you should know how much of your shrinking margin churn accounts for, rather than assuming it’s all the new finance hire.
The number you’re proudest of
Your margin in year two was never quite as good as it looked. It was flattered by clients who hadn’t left yet.
That’s fine. Every agency goes through it and it doesn’t mean that you’ve done anything wrong.
The danger is spending the next five years trying to get back to a number that was partly an illusion, without ever working out what churn is actually costing you.
So work it out. You might not like the answer, but at least you’ll be fixing the right thing.
