In 2018, you may see more of your agency’s opportunities structured with non-traditional compensation models than in previous years. Part of that is a result of marketers’ desire for greater transparency and “fat-free” invoicing. Amid financial pressures, agencies are also exploring cash flow-impacting alternatives, including new compensation models. Meanwhile, the compensation models are not new, but the feasibility of their implementation is evolving as technology makes strides.

Agency Compensation Model Trends

Two major factors influencing changes in agency compensation this year are:

• Advertising budgets are leaner, trimmed of fat, and there is a greater emphasis on budget accountability and transparency (per Agency Mania).

• Improved technology and more mainstream access to better data tools are making performance-based compensation more realistic for agency-client relationships (per Megan Harris of Syzygy in Digiday).

“The birth of data-driven targeting tools and acquisition-based digital marketing has made success more predictable. This now gives greater validity to exploring incentive and performance-based fee models on both the agency and client side,” — Joseph Anthony of Hero Group (in Digiday).

What Payment Models Currently Dominate?

Labor-based compensation (billable hours) continues to dominate — though it’s not growing at the same pace it previously was — incentives are declining, and commission-based, performance-based, and value-based payments have regained a minority foothold. 

According to Tom Finneran, EVP of agency management services at the 4A’s, the breakdown of agency-client compensation arrangements is roughly as follows (AdAge):

• 60 percent labor-based
• 25 percent are fixed-fees
• 15 percent  “...combinations of commissions on media and production, and sales or other hybrid models”

The Association of National Advertisers’ (ANA) latest report (released in May 2017), “Trends in Agency Compensation: How Marketers Are Simplifying Agency Management and Seeking Transparency,” included the following findings:

• For the first time since 2006, “the use of labor-based fees and performance incentives by marketers is decreasing as advertisers look to simplify their agency compensation practices.” Though these “remain the most-used method,” they are “losing momentum” to a small but growing segment of “traditional commissions and value-based compensation.”

• “..the use of incentives has significantly declined for the first time in 50 years of the survey. Respondents indicated incentives do not improve agency performance. Structuring and managing effective incentive plans is complicated, time-consuming, and often ineffective.”

• Commission-based payments climbed to 12 percent since 2010 (when they were at three percent), aided by marketers’ desire to simplify compensation. These are primarily for media services.

• Value-based compensation reappeared in their research after no mention during the previous two surveys. Only seven percent of marketers they surveyed use this method.

• Compensation structure varies by agency type. 24 percent of media planning/buying agencies are compensated by commission, but only 6 percent of creative agencies are (ANA data in MarketingProfs).

The Agency Compensation Models

These are the standard compensation models for agency-client engagements:

Fixed Fee, Flat Fee, or Project-Based:

The agency prices a project based on an estimated number of hours and hourly rates, plus a buffer fee or margin.

Pros: The advantages of the fixed-fee model for clients is that they know exactly how much they will have to pay, and when.

Cons: The original project estimate must be spot-on for the agency to profit. As projects change, they can outgrow the original estimate, forcing the agency to reduce its profits or submit additional bills to the client. When project costs exceed the estimate, it can undermine trust in the client-agency relationship (Hubspot). This model can also impede new and better ideas as the project progresses.  Clients may feel like project completion trumps project quality for the agency, while the agency may feel squeezed by additional requests by the client (Hubspot). 

Agencies should also be cautious when the client has a fixed budget at the outset, which can lead to unrealistic budgets and budget shortfalls. In those cases, be ready to negotiate, walk away, or take the loss purposefully for a long-term gain (Smart Insights).

Fee-Based or Hourly Rate:

The agency earns an hourly rate, exchanging time for a set price.

Pros: The advantages of a fee-based rate for the client are transparency, agency neutrality (for media), and access to agency overhead and profit. For agencies, it delivers guaranteed income, a predictable profit margin, and the ability to plan and stretch resources (IDComms).

Cons: Drawbacks of the fee-based model for the client are that it rewards slowness and inefficiency, it guarantees agency profit without results, and it makes time the currency. For agencies, the transparency can be a negative, particularly when exposing operational costs and overhead, and it also limits their access to rebate income (for media) (IDComms). 

Value-Based:

The agency earns a profit based on the value of their strategy or creative thinking (vs. their cost to do it). Staff time, costs, and profits are not factored into fee negotiation.

Pros: The advantages of the value-based model for the client are total transparency, less financial risk than a fee-based model, and it makes the agency accountable for the value they add, aligning them to the client’s goals (IDComms). For the agency, the advantages are an opportunity to make a better profit margin, projectible, reliable income, and elevation to valued partner status (IDComms). This model also frees the agency up to focus on the end product instead of productivity and pre-determined project limitations (Hubspot).  

Hubspot characterizes valued-based pricing as the “most advanced” model, shown to be “highly effective at increasing an agency’s profits.” However, to employ it, the agency must determine the KPIs that are valuable to the client and be able to track and measure results. “Most prospects come to the realization fairly quickly that they want to buy results, not hours or even projects,” (Hubspot).

Cons: Disadvantages of the value-based model for the client are that it is hard to roll-out initially, and requires more management of scope of work as well as auditing and evaluations (IDComms). On the agency side, negatives include an initial loss of profit, a reorganization of resources, and no room for non-transparent income (IDComms). According to Smart Insights, what has prevented many agencies from adopting this model to date is that it goes against the market paradigm of time, not value.

Commission, Incentive, or Performance-Based:

The agency earns compensation based on agreed-upon goals, alone or in a combined base plus commission structure (blended hourly rates).

Pros: The advantages of this model for the client is that it is predictable, needs little management, and is easy to negotiate downwards. For agencies, it provides predictable income and makes it easy to under-resource accounts while appearing competitive (IDComms). Harris Diamond of McCann refers to this model as the “holy grail” (in AdAge).

Cons: Drawbacks of this model for the client—with media agencies in particular—is that it makes the agency a “selling supplier,” it promotes a culture of rebate retention, and it makes it impossible to get media neutral advice. For agencies, it makes their offering commoditized, it doesn’t recognize the value of good work, and it makes their income dependent on client budget changes (IDComms).

For this payment model to be effective, you must be confident that your work will result in demonstrable, measurable impact based on the agreed-on KPIs. The challenge with this, as pointed out by Smart Insights, is that it is difficult to isolate your specific contribution to a campaign and attribute that to the KPIs, which may also be fed by other campaigns and factors. With new data tools, however, that may be changing.

Ken Robinson of Ark Advisors has pointed out that, "Most often, the agencies don't come up with metrics to make [the incentivized/performance-based model] worthwhile and clients find it hard to manage a cash flow if it's incentive-based compensation." He adds that getting everyone to agree on the specific KPIs that will measure success can also be difficult (in AdAge).

Another negative of this model for agencies is that clients may be “...reluctant to fork over incentive payments—even if terms were already agreed upon and the fee was reduced—because they look at it as a bonus, so it's a struggle to get paid,” says Lynn Power of JWT New York (in AdAge).  She says she's even seen clients agree to an incentive-based model just to pay a smaller fee with no intention of ever coughing up the extra dough, noting that even contractual terms are hard to enforce when based on subjective metrics (AdAge).

You can get more information about agency pricing models from the sources referenced here, including this guide from IDComms, this article from Smart Insights, and this article from Hubspot.

Other Agency Compensation Models

According to Ken Robinson of Ark Advisors, “One of the smartest models is when agencies, like Bullish, offer their services in exchange for a stake in the company because then they truly have a horse in the race.” This is also something we’ve seen Mcgarrybowen’s mbForge do with startups, taking pay via equity or revenue share on sales.

How to Position Your Agency for More Revenue Opportunities

• When selling services, sell based on outcomes not hours
• Invest more deeply in data/analytics to better support the business case; i.e., outcomes
• Try to control access to data/analytics needed to measure client performance, such as by writing access to performance data and KPIs into contracts. Particularly because “63 percent of marketers admitted that they are not willing to share meaningful KPIs with their agencies," and your revenue may depend on it (AdAge)
• Get much more selective about RFIs/pitches and get better at the ones you pursue
• Refuse to compete on price
• Be prepared to push back and walk away, when necessary, when low-balled
• “Decouple” higher value creative strategy from lesser value marketing logistics services, as have Publicis and Ogilvy with Prodigious and Redworks, respectively (Williams, in Forbes)
• Experiment with pay via equity or revenue share on sales (like Mcgarrybowen’s mbForge does with startups)

Closing

It is unlikely your agency can determine what your payment model will be across the board—unless you are alright with passing up potential opportunities. However, with preparation, you will be less exposed to payment models that are more favorable to the client than you. Know what works best for your agency, and you just might be able to negotiate a more favorable compensation model.

At the risk of ending on a negative note, Digiday writes, “Whether or not agencies manage to win clients with different pricing models, their margins will remain low.” They go on to quote Deep Focus’ Ian Schafer: “In a world where even making profit is taboo for agencies, it seems like nothing is off the table for public holding companies.” It’s true; the outlook is far from rosy.

Ultimately, your compensation model will impact your agency’s profitability, financial stability, and the satisfaction of your internal team and your clients. Don’t be afraid to push back or say no! When more agencies refuse to accept terms that make it impossible for them to make a profit or deliver their best work, marketers may be forced to recognize they are cutting too deep.

Learn how the Duval Partnership helps agencies win new business:

Read more:

• What Agencies Need to Know About Ad Industry Conditions in 2018
• Leveraging Marketing Trends for Agency New Business in 2018
• Media Agency Pitching in 2018: Overwhelming Opportunity
• Agency Case Studies: Upgrade Your Case Studies for New Business

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