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Path to Freelancer Profit: Start an Agency or Stop Billing Hourly

In case you haven’t caught my recent posts, I’ve sort of inadvertently started an ongoing series.  I’ve now given it a category tag, so you can read the posts in sequence, if you’d like (though the tag shows them to you in reverse order).  This is another post in that series.

(Quick editorial interlude: you don’t see it in the comments, really, but A LOT of people are writing me direct via email/social media to comment about the series or ask questions.  I want to say that I really appreciate the feedback and enthusiasm.  And I also want to pre-apologize if I miss some things from you all.  There are dozens of you and one of me, and I do my best with the responses, on top of running our growing business.)

I’m not planning to recap the entire series history for each post.  But suffice it to say that, up to this point I’ve talked about how a “freelancing business” isn’t really a business and that moving toward business ownership in earnest requires you to reason about profit and think like an owner.

I’m mentioning this because so far I’ve basically just given you background information.  Don’t get me wrong — it’s important background.  But background nonetheless.

Time for Your First Concrete Action on the Path to Profit

So, I figured today I’d switch it up a little and give you a bit of decisive action: the first step along the path toward business ownership and profit.

It turns out the action itself is easy to summarize.  I’ll do it right now:

Decide whether or not you want to own an agency and have a “managing director” kind of role.

If the answer is “yes, then,” great!  You have your business plan.

If the answer is “no,” then you need a business plan.  And the first step toward having that plan is recognizing that you need to stop billing by the hour.

The agency vs. non-agency decision is simple to conceptualize, but it’s important to mull it over for a while. So much so that the only actionable ‘homework’ I’ll ‘assign’ here is to make that decision.  For the rest of the post, I’m going to explain why you have to make this decision.

First, My Full Disclosure on the Subject of Hourly Billing

Let me start with full disclosure.  I’m not a fan of hourly billing.  It’s been years since I offered any pricing other than flat from the vendor side, and, as a client, I hate consuming hourly labor (for so-called “expert services,” that is.)

I could go into my reasoning for this.  But if you really want to go down the rabbit hole, I’d check out Jonathan Stark and his position that hourly billing is nuts.  He goes into far more detail on the subject, in far more eloquence, than I ever would or could.

And, besides, that’s not really what I want to talk about in this post.  I’ll set aside my personal feelings about billing by the hour and give it a neutral treatment from here forward, as I explain its relationship to your prospective business model and your profit.

Profit and Loss in the World of Hourly Billing

When you bill by the hour, what you’re really doing is selling an unspecified number of hours of your life for some price per hour.  That is, hours are your “product” and the proceeds from selling them are your revenue.

Let’s take look at something called an “income statement” to drill into this further.  At its simplest:

Total Revenue

– Total Expenses

—————————

Profit

(Fun fact, this is why revenue is called “top line” and profit is called “bottom line.”  It’s just a description of where they hang out on the income statement.)

So, what, exactly, does this look like for a freelance software engineer, billing by the hour?

Well, revenue is simple.  Just multiply the number of hours you sell by your hourly rate.

For costs… well, recall that employee salaries are a cost, and you’re in the habit of paying yourself everything you take in (less fixed expenses, but let’s leave those aside for the sake of discussion).  So, your expenses are basically your total revenue.

The freelance hourly biller’s income statement:

Hourly Rate * Hours Sold

– Hourly Rate * Hours Sold

—————————

$0

Okay, so that’s not great.  What if we wanted to see some profit on the bottom line?  How would you make that happen?

Given that all of your revenue and all of your cost are exclusively associated with the hours of your life that you’re selling, you don’t have a lot of levers to pull.  Your only choice is to sell your hours to others for more than you pay yourself for your hours.  You have to mark up your own labor.

Yeah, it makes my brain hurt too. 

The Agency Profit Model Options

But don’t worry.  I’m going to dive into detail into the different profit models for agencies that bill by the hour.

The (Absurd) Solo Freelancer Profit Model

Let’s be very clear about something.  The only path to profit from hourly billing involves two very simple requirements:

  1. You sell someone’s labor by the hour to a customer.
  2. You pay the laborer less than you charge the customer.

This makes a lot of sense when you think of the seller (“profiter”) as a different person than the laborer.  But it makes your brain and mine hurt when the seller and laborer are the same person.

It is for this reason that profiting from selling your own person-hours degenerates quickly into nonsense.   You could charge $100 per hour, but declare that you only pay yourself $80 per hour in salary, so, hey, profit!

But that profit vs salary is a distinction without a difference.  (If you don’t believe me, trying making the argument to the IRS that you shouldn’t pay FICA on that incremental $20/hour ‘dividend’ and see how that goes for you.)

If you sell someone your own hours for $100 each, there’s no ambiguity as to what sort of hourly rate you can command on the market.  You know exactly what you’re worth, which is a problem, since marking up hourly labor depends entirely on information asymmetry in practice.

The Pure Asymmetric Information Profit Model

Information asymmetry is simply the idea that one party in an economic transaction knows more about the landscape of that transaction than the other.  In order for me to sell hours of your life for more than I pay you for them, I need to know some things that you don’t.

Not only does this reinforce why profiting from your own hourly labor is absurd, but it also segues nicely into the simplest form of profiting from agency-style hourly billing.  This occurs when I, the “marker-upper” bring nothing to the table but knowledge that you don’t have.

For instance, let’s say that you sell hours of Ruby on Rails app dev for $80 each.  And let’s also say that I’m at a cocktail party and, at that party, someone remarks to me, “gosh, I would sure like to buy some Ruby on Rails app dev hours, and I’d be willing to pay $100 each for them.”

Warrent Buffet protege that I am, I get an idea in my head for how I can make some money.  I tell my fellow-partygoer that she has a deal and I agree to sell her hours for $100 each, and then I separately buy a bunch of your hours for $80 each.

I call this pure information asymmetry because the only reason that I profit in this scenario, as the middle man, is that the Rails developer and the party-goer don’t know one another, but I know both of them.

This is conceptually the easiest way to profit from hourly billing, but it’s the least tenable upon which to build a business.  I don’t suggest trying to earn a living by hoping that people don’t meet one another.  Taking a finder’s fee in that transaction would be reasonable and ethical, but marking up someone’s hourly rate… wouldn’t be my play, anyway.

The Greater Network Profit Model

You can, however, do a little better by being generally well connected, and working with newbie freelancers who generally aren’t.  I still wouldn’t build a business on this basis, but it’s a bit less tenuous (and shady) than the complete information asymmetry.

To understand what I’m getting at here, imagine someone with a rolodex absolutely filled with directors, veeps, and executives in the IT org chart.  Imagine that this person also has project management and consultative experience.  This is someone who can broker a lot of work for freelancers.

Here, the information asymmetry is systemic, rather than coincidental and spontaneous.  The connected consultant with the prodigious network can routinely and consistently bring business to freelancers, so doing so under the agreement of marking up their hours is generally going to be a fair deal.

And so we have the first reliable mode of agency-style profit from hourly labor.

The White Label Profit Model

With the greater network model, it’d be somewhat hard to start a true agency.  Indeed, you’re more likely to see recruitment firms operate in this space, and they typically take a finder’s fee proportionate to the amount of the contract.  It’s less common for them actually to mark up the freelancer’s hours, though they could conceivably do so.

The white label model, on the other hand, is the first one we’ll talk about where it is common to mark up the price of hours.  The white labeling agency is one that offers some service of their own, billed by the hour, but is also happy to plug you, the freelancer, into the mix.

For instance, let’s revisit our cocktail party-goer in need of some Ruby on Rails app dev.  Maybe she needs so much of it, so quickly, that one person can’t possibly do it.  And maybe I’m a Rails developer myself, so I agree to the business.

But now, I’ve got a bit of a problem.  I can’t, by myself, deliver the 500 person hours she wants over the next two month.  But if I sold her 320 of my person-hours and 180 of yours, I could.

So I sell her 500 hours for $100 each, totaling $50K.  I then buy your hours for $80 each, for $9,600, but sell them for $12K, netting me a profit of $2,400 on your labor.

(This is called “white labeling” because, to the client, you just seem like an employee/contractor of my business, so it’s like you putting a “white label” on your hours to let me put my own branding on them.  The terminology works better with physical products, but whatever.)

The Labor Broker Profit Model — A True Agency

It won’t need to scale too much before I stop having time to actually do any development myself.  It’s one thing for me to take on a project that requires my own labor and that of a few other Rails developers besides.  But scale up much beyond that, and suddenly I have a new job: people and project manager.

Oh, heck, let’s just give me a title and call me “managing director.”

A subtle shift takes place, and I’m no longer billing out at “my” hourly rate and just offering people less to make the management worth my time or to make a bit extra for my trouble.

Now I’m a proper agency, and my agency has a rate sheet.  And I’m explicitly looking for people who will provide me, indefinitely, with a margin.

At this point my business/profit model is purely labor brokerage.  I’ll start with subcontractors, but eventually try to work my way toward salaried employees since, as long as I can keep them off the bench with inbound business, their hours are even cheaper than subcontractors.

And so it will go with scale and growth at the agency. I’ve entered a profit-model situation where I grow by charging ever-more for people’s hours and paying them ever-less for those same hours.  This isn’t mercenary as it sounds, really.

After all, as the business grows, its fixed costs and overhead grow, meaning that taking larger and larger margins on employees’ hours is simply the only option for making the business larger.

What Does Profit Look Like with Fixed Cost Models?

So, there it is.  That’s the freelancer’s career path along the hourly billing track, assuming profit is the goal.  You simply have to find a way to interpose yourself between someone selling their hours and another person buying those hours, and then find ways to take an ever-larger cut.

If that doesn’t sound like the path to joy, what’s the other option?  What do fixed cost profit models look like?

(As an aside, I want to be clear that I don’t think there’s anything morally or ethically wrong with the agency profit model.  I just want to be crystal clear, with no illusions for you as a reader, about what, exactly, your path entails if you want to stick with hourly billing and also have business profit.)

Well, the profit models for selling things other than hours of labor are too many to enumerate the way I did, loosely, with hourly billing mark-ups.  But I’ll talk about them in the general sense.

Efficiency is the Name of the Game

Imagine that you build a SaaS.  Or imagine that you sell a service to companies for a flat rate, where you come in and do an audit and write-up of legacy code.  You offer a good, service, or productized-service to the market at large.

When you do this, you do something subtle but profound.  You decouple the money you earn — your revenue — from the time you spend earning that revenue.

When your company opts into the paid version of Slack, for instance, nobody attempts to compute how many person-hours Slack spent developing their offering.  Instead they say, “oh, $X per seat, I think I can afford that, so I’ll buy it.”

With this powerful difference in their back pocket, the shareholders at Slack have an opportunity to create meaningful profit.  If they can hire a team of engineers to build a chat application and then sell enough units of it at its market price to more than cover the cost of those engineers, the rest is all profit.

So the non-hourly profit model becomes one of efficiency.  Can you build and deliver your offering efficiently enough that there is money left over when all of your happy buyers get done making their purchases?  Or, better yet, can you be a true owner/shareholder, and build a business system that does it efficiently on your behalf?

Decide on Profit (or not) First, Figure Out the Path Second

Don’t worry.  I’m going to offer a lot more detail on the last few paragraphs as I go along with the series.  I don’t expect you to settle on a way to earn profit, pivot away from hourly billing, and build Slack on the basis of a few hand-wavy proclamations.

Rather, my purpose in describing this contrasting profit methodology is to help with the assignment I gave you in the beginning.  You need to decide if you want to be a managing director, running an agency that brokers hours, or if you’d rather build a business that creates profit through efficiency.  (Or maybe you’d rather just continue freelancing, enjoying the relative freedom of being the employee of your own non-profit-centric business, which is also fine).

I’m thinking that I’ll focus the rest of these posts on the non-hourly profit model, unless some of you are super interested in how to build an agency.  (I can probably speak to that, since while the business we’ve built, Hit Subscribe, doesn’t trade in hours at all, it does bear some resemblance to agencies).

So make your choice, and, if you want to work your way towards non-managing-director profit, stay tuned.

10 Comments
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cerb
cerb
2 months ago

Supposing I am an agency with my fat rolodex, multiple contractors, a few employees and my shiny “managing director” title, how does the hourly billing equation change for me? It appears that – although there is a fundamental difference between selling my own hours and selling other people’s hours, (the latter being more scalable than the former) – there is also a clear motive for me to not dabble in hourly billing at all, and try to push for productized services and package deals. Hey, if I switched away from hourly because I value my time and wish to decouple… Read more »

Erik Dietrich
Erik Dietrich
2 months ago
Reply to  cerb

If you’re asking me to defend the practice of hourly billing, I can’t and wouldn’t want to. On its face, it’s an institutionalized perverse incentive that quite literally rewards inefficiency. As an hourly biller doing find and replace and aware of a better way, you’re faced with the ethical quagmire of (1) knowingly doing it inefficiently to make more money or (2) doing it efficiently, lying and saying you did it inefficiently, and profiting. The only “ethical” approach (for some definition of ethical) would be to avoid acquiring the knowledge that a better methodology existed — mediocrity by design. As… Read more »

Nils
Nils
2 months ago
Reply to  cerb

Essentially the Employee “business model” is exactly that: Getting a fixed price (yearly salary + benefits) for a variable amount of labour.

Nils
Nils
2 months ago

I don’t think I follow your balance sheet model. If I don’t incorporate then my businesses balance sheet is the same as my personal balance sheet. If I pay myself 100% of the “profits” as a salary, my total assets are still going to grow (unless I spend it all). If I instead own a corporation with me as the sole employee and pay myself 80% of the profits as a salary and keep the rest in the corporation, I still own the same amount of assets. Splitting your money between two bank accounts doesn’t make you poorer.

Erik Dietrich
Erik Dietrich
2 months ago
Reply to  Nils

First of all, I’ll say that, based on conversations with an entrepreneur that I know in Germany, I understand that there are material differences in reasoning behind incorporation as compared to the US. And I can really only speak to what I know, which is the US. In that vein, I’d consider leaving your personal and business finances intermingled a non-starter and a disqualifier from having a business or being a serious freelancer. If you adopted this strategy in the US, you’d open yourself up to being personally sued into bankruptcy for any basic general liability concern or errors/omissions. Because… Read more »

Erik Dietrich
Erik Dietrich
2 months ago
Reply to  Erik Dietrich

As a rider, I will say opting to comingle business and personal finance basically casts the solo operator model in granite. Entering more complex business arrangements, like subcontracting/hiring/etc would get really weird and sometimes impossible in a hurry.

(At least in the US — again, I can’t really speak intelligently to how this works in other places.

Nils
Nils
2 months ago
Reply to  Erik Dietrich

Why would you have a business if not to better your personal finances (or that of your children)? It’s a tool, not an end in itself.

Erik Dietrich
Erik Dietrich
2 months ago
Reply to  Nils

I don’t understand the context of the question. What makes you think I’m suggesting a different reason for owning a business than to profit from it? Businesses/business finances exist to earn dividends for shareholders. Personal finances have the exclusive purpose of amassing f-you money. That distinction has to exist for it ever to make personal financial sense to buy shares in a business. If you go buy shares of, say, Microsoft, you do that because you expect to earn dividends/splits on those stocks or because you think you can sell them for more than you paid for them later. Your… Read more »

Nils
Nils
2 months ago
Reply to  Erik Dietrich

Thank you for reading my comment and responding to it. Let me say first, I do not know the system in the US very well especially since it may be different state by state. From what I understand is that it is possible to work as a “contractor” which is like an employee with a fixed term and fewer benefits, but still pretty much treated like an employee tax wise (paying payroll tax/FICA). In Germany you can be self-employed by performing work as essentially not an employee or you can incorporate. Incorporation means you create a limited liability corporation which… Read more »

Erik Dietrich
Erik Dietrich
2 months ago
Reply to  Nils

Oh, I see what you’re saying. I guess I’d respond with a different analogy then. Why have separate personal bank accounts for checking, savings, and investments, since it’s all your money? The answer, in both the case of classified personal accounts or distinguishing between salary and profit for a solo operator, is that classification informs and reinforces behavior. Putting things into a personal rainy day savings account creates a bit of cognitive friction that turns drawing that account into a deliberate act instead of an accidental splurge after a few beers. Likewise, separating money into profit vs. salary clarifies your… Read more »