Tag Archives: contract

Why Contract Definitions and Demonstrations are Important

1 Feb

contract complianceFor as long as there have been advertisers and agencies, there have been Client-Agency agreements. Contractual instruments, which are often referred to as “terms of divorce.” This is likely because one of their primary roles is to spell out the guidelines governing how each party must conduct themselves and identifying their respective obligations in the event a relationship is terminated.

The fact of the matter is, a contract is much more than that. It is a binding agreement between advertisers and their agencies which should identify the terms and conditions that will govern all facets of the relationship, ranging from how an agency is to be compensated to the level of staffing that an agency will deploy on a client’s behalf, to the scope of work to be undertaken by the agency. An effective contract also asserts both parties expectations for how they will conduct themselves while providing a mutual understanding for how the agency will steward a client’s marketing investment from a performance, financial and legal perspective.

Unfortunately, when it comes to contracts, there are too few “industry standards” within the advertising marketplace, varied definitions for descriptive terms and too often a lack of clarity around what is being represented by certain aspects of the agreement language. These gaps create gray areas which are seldom understood, much less agreed to by both parties. Unchecked, these gaps can be costly, particularly to advertisers that aren’t supported by knowledgeable industry experts and attorneys with solid industry experience.

As contract compliance auditors we have reviewed hundreds of Client-Agency agreements and have sat across the table from advertisers and agencies to help mediate gaps in understanding over even the most basic terms or representations. Examples include the definition of “Gross Media,” the assumption that individuals listed in an agency “Staffing Plan” are full-time employees of the agency (rather than contractors or part-timers) and or whether or not the awarding of work to agency affiliates is allowed, let alone how that activity is to be billed.

Let’s examine the financial impact of one of these items. Hypothetically, an advertiser with a $100 million media budget engages a media buying agency. The agreement indicates that media is to be placed on a net basis and that the agency will be paid a commission of 2% on that activity. This appears to be a relatively straightforward description. So the question is; “How much commission should the agency earn?”

  1. $2,000,000
  2. $2,040,000
  3. $2,353,000

It would not be unusual for a lay legal or procurement advisor assisting an advertiser in drafting or reviewing contract language to assume that the answer was 1) $2,000,000. Their assumption in this instance is that the agency’s commission would be calculated by multiplying the net media spend by the agreed upon commission rate.

On the other hand, a seasoned agency finance executive would advocate that the correct answer is 3) $2,353,000. How did they arrive at this figure, which is $353,000 higher than the prior scenario? By “grossing up” the net media spend by 17.65% and then multiplying that total by the agreed upon commission rate. Why would they do this? The answer would likely be; “that is the standard methodology used in the industry.”

This view has its roots in the golden days of advertising, when agencies delivered “full-service” and earned a 15% commission on their clients’ gross advertising investment. In that era, a biller would have to mark-up a net expenditure by 17.65 % in order to account for the 15% commission rate:

  • 15% divided by (100% – 15%) or 85% = .1765
  • If the net expenditure was $85, the total cost would be calculated by multiplying or “grossing up” the net amount by 1.1765 to arrive at a total cost to the advertiser of $100.
  • On the $100 gross expenditure the agency would earn $15 or 15%.

One might legitimately question why an agency would gross up a net expense by 17.65%? After all, it has been many years since full-service agencies were compensated at that rate. Should not the mark-up amount be specific to the negotiated commission rate? Using this approach for the 2% commission example could suggest that the correct answer to the aforementioned question would be 2) $2,040,000:

  • 2% divided by (100% – 2%) or 98% = .0204
  • $100,000,000 net media “grossed up” would be calculated by multiplying the net amount by 1.0204 to arrive at a gross amount of $102,040,000.
  • The agency’s commission on the grossed up media total would be $2,040,000

So which methodology represents the proper approach for calculating an agency’s commission in this example? Unfortunately, there is no definitive answer. This is a classic case where had a term such as “Commission” or “Gross Amount” included an example of how such formulas were to be applied, it would have clarified the intended agency remuneration, staving off a potentially difficult conversation between client and agency long after the ink on the agreement had dried. We can all learn from the words of the 18th century Scottish philosopher, Thomas Reid:

There is no greater impediment to the advancement of knowledge than the ambiguity of words.

 Interested in a securing a second-opinion regarding the clarity and soundness of your organization’s agency agreements? Contact Cliff Campeau, Principal of AARM at ccampeau@aarmusa.com.

How Do Agencies Do It?

13 Feb

ad agency profitsEarlier this month the Japanese agency holding company Dentsu announced quarterly financial results.  For the nine-months ending December 31, 2012 revenues were up 4.5% and net income was up 48.1% year-over-year.  Impressive?  Certainly, but not inconsistent with other players in the ad sector; WPP achieved a 43.3% increase in net income on a 7.4% revenue gain and Omnicom Group reported a percentage net income increase which was twice that of its revenue growth. 

A healthy advertising sector represents good news for clients and agencies alike.  Growing, profitable advertising agencies are able to invest in; infrastructure, personnel and research which ultimately allows them to better serve their clients.

There are two interesting observations with regard to the aforementioned agency financial reporting; 1) the recent results fit a pattern of extraordinary net income growth for the category, relative to revenues. 2) In a professional services business, the ability to generate net income growth of 2X to 10X that of revenue can only be achieved through a combination of significant expense reductions and or dramatic increases in direct margin.

Let’s be clear.  Like most other professional service providers whether in the financial, legal or consulting sectors, payroll makes up a disproportionately high percentage of an advertising agency’s expense base.  The publicly traded agency holding companies break out salary expense within their financial reports, allowing for a review of this cost center.  In a 2010 review of agency expense structures, Adweek reported that for the top five agency holding companies, expenses represented between 83% and 94% of revenues.  Salary expenses ranged between 59% and 72% of revenues.  The difference between the two is largely made up of real-estate and overhead costs.

Thus it is unlikely that agencies are relying on expense reduction as the primary source of net income accretion.  This would have a dramatic, negative impact on the caliber of work, service levels and ultimately, client retention and would be unsustainable over any prolonged period of time. Therefore margin growth would appear to be the primary contributor to the extraordinary net income gains.  But how you ask?  After all, industry compensation surveys consistently report that the average agency profit level identified within client/ agency agreements is 15%.   

Unfortunately the answer is clear, while not altogether transparent to advertisers.  A portion of the improved margin is tied to the provisioning of agency-owned services such as in-house studios, trading desks, poster specialists, barter firms and production companies. These services have tremendous margin upside for an agency because there is limited disclosure to the advertiser of the rates paid to the ultimate media seller and or the fees earned by the agency in the form of incremental commissions, spread between planned and purchased costs or volume rebates paid by the media.  Then there are sources of agency revenue which are seldom discussed and rarely audited which contribute to an agency’s bottom line profits.  These include but are not limited to AVBs, interest income from float, earned but un-processed discounts, rebates and no-charge media weight.

These practices are neither good, nor bad they simply represent the nature, albeit murky, of the global advertising industry today.  In the end, knowledge is power.  For example, the agencies that have been smart enough to vertically integrate and to leverage non-transparent income “opportunities” have generated solid bottom line performance. 

For advertisers the answer is simple, extend your knowledge of what is clearly a dynamic and often opaque marketplace: 

  1. Revisit your agency contracts to make sure that the requisite legal and financial controls have been incorporated to protect your interest. 
  2. Make sure that your agency contract extends to the parent company and any sister divisions which may be engaged as part of your agency’s service offering.   
  3. Examine your agency performance evaluation process and remuneration methodology to ensure that you are incenting the behavior and outcomes which you desire.
  4. Engage an independent auditor to assess your marketing service agencies contract compliance and performance to make sure that the requisite level of transparency is always maintained.

In the words of Sir Edward Coke, the renowned seventeenth-century English jurist;

Precaution is better than cure.”

If you’re interested in a second opinion of the soundness of your client/ agency agreement or would like to discuss the benefits of an agency contract compliance audit, contact Cliff Campeau, Principal at AARM via email at ccampeau@aarmusa.com.

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