Should Retailers Buy Web Marketing Agencies?

by Rob Laporte

Visibility Magazine – Winter 2013

(original article reprinted below)

Executive Summary

If a retailer needs years of at least thirty weekly hours for one of the seven specialties within web marketing, buying an agency is certainly better than contracting with one and probably better than hiring in house. Acquisition helps the agency too, though at the cost of forfeiting a possible higher price in the future. The agency’s projected profits, which the retailer will own, can and should equal or exceed the purchase payments that are spread out over a few years. I focus on retail as opposed to business-to-business because usually retailers must spend more on marketing and can’t omit any of the seven parts of web marketing. However, the rationale often holds true for B2B companies as well. I discuss salient pros and cons for both retailer and agency. I conclude with sound mathematics for determining the maximum price a retailer should pay and the minimum an agency should accept.

Micro- and Macro-Economic Background

My Winter 2012 Visibility Magazine article on the Freakonomics of search marketing shows that a modest increase in competition for top search listings–in any searched medium, from search engines through social to video–greatly increases any one competitor’s costs, with the notable exception of conversion rate optimization (search “Rob Laporte” on VisibilityMagazine.com). This means that ever larger businesses can’t afford adequate web marketing if paying the typical hourly rates of good agencies. Hiring in house cuts hourly rates, but the accelerating sophistication within sub-specialties of web marketing makes it difficult and rare, if not impossible, for one employee to master even two of the top four main areas of web marketing listed below.

  1. SEO, including link marketing
  2. PPC and other paid media placements
  3. Social/Local/Mobile (SoLoMo) marketing
  4. conversion rate optimization
  5. email marketing
  6. affiliate and other online partnership marketing
  7. ROI reporting and subsequent rebalancing of the web marketing mix
    * (Currently one pro probably can master the final three areas).

If the retailer wants all this work in-house, it would need to hire at least three full time specialists to cover the first and most important three, maybe four, of the above. With luck, one or more of these three specialists will have some competence in the bottom three areas of web marketing, enabling the retailer to buy fewer hours of outside consulting. Otherwise, the retailer must hire more than those first three employees. Hiring–and keeping–these employees will be expensive if one buys talented experience sufficient to beat most of the competition.

A retailer’s decision to buy an agency depends in part on how much labor time is needed. Published statistics on average US expenditures likely lag current and future needs because the channels and sophistication of web marketing grow monthly and because most executives fear investing in what is new, complex, and unfamiliar. Nonetheless, past statistics will serve our purpose here. Let’s posit a retailer with one hundred million of annual sales:

  1. The US average retail marketing budget is 15% of sales, of which 21% goes to digital marketing. (I discuss these statistics and their sources at www.2disc.com/blog/how-should-you-budget-for-digital-marketing.) This equals $3,150,000 for digital marketing.
  2. The larger the digital marketing budget, the smaller the percent of labor vs. online ad spend. Let’s assume that for a retailer around the $100M category, labor is 20%, which is $630,000, rounded to 600,000 even.
  3. A retailer with only ten million in annual sales would need to allocate more like 40% of the digital marketing budget to labor, which comes to $126,500.
  4. It is better to build a marketing budget bottom up (from costs of needed work) rather than top down by broad US averages, but top down is sufficient to get a general idea of the labor budget for web marketing that wins. This budget in turn helps decide how many specialists to secure by hiring people or acquiring a firm or balancing both.

The great flood of Fed money printing (or “quantitative easing”) and interest rate suppression means that retailers with good credit can acquire agencies at historically low costs of capital. This money printing will end badly for most everyone, but that day of reckoning is three to eight years away, despite what the gloom and doomers decry. (I wish I had room to explain this here.) In any case, money is very cheap for solvent larger corporations, and that can buy ownership of plenty of valuable and necessary web marketing resources. Of course this logic applies outside of web marketing as well, and indeed US M&A (mergers and acquisitions) have been climbing handsomely since 2010.

Advantages for the Retailer

When buying a good agency, the retailer immediately deploys highly qualified, battle-tested professionals. There’s a huge shortage of qualified web marketing professionals: see www.wantedanalytics.com/insight/2013/10/30/digital-marketing-skills-grow-in-demand-becoming-harder-to-recruit/. Agencies keep records of past work for clients, so the retailer can see the successes of each specialist.

The typical stipulation that purchase payments span years and depend on agency specialists remaining those years means there’s much less risk of loosing an employee to a competitor or another job.

The retailer’s proprietary marketing data and plans are kept confidential. An unowned agency could later work for the retailer’s competition if a current contract is terminated or not renewed. Or worse, the unowned agency may manage PPC for both the retailer and a competitor of the retailer, bidding one against the other. (I’ve often wondered how large agencies handle this–do they really restrict themselves to only one of each kind of client? And what about those agencies that boast of specializing in a certain industry?) This conflict of interest is especially vivid in PPC, but it applies somewhat to other web marketing too.

Agencies have non-human intellectual capital which they are accustomed to using, and this increases performance as compared with a new employee walking into the retailer’s offices.

To prevent sticker shock, agencies have to offer what sells and often what fits into a few month contract that is too small to accomplish all that should be done, rather than offer what is best for clients. Even a one year contract, never mind the common 3-6 month engagements, requires that the agency omit a coordinated sequence of tasks that reinforce one another over months and years. Owning the agency enables immediate boosts in performance to synch with tactics that must wait for months and years until prerequisites are in place.

If the retailer’s situation changes unexpectedly, the owned agency can change tactics quickly, whereas an unowned agency may
not want to revise and re-sell the contract’s work orders.

When owned by the retailer, the agency is more likely to cleave to the retailer’s interests because the agency partners get paid regardless of how much work the retailer agrees to.

The retailer gets people who are used to working together productively and with synergies. This kind of harmony will take time to develop among new in-house employees, and it may not happen well or at all.

If the agency needs to hire, it typically has proven training programs in place (assuming they’ve been in business for a few years). Most retailers don’t have such programs.

The agency has incentive to learn and implement tactics that are promising but hard to sell to clients, thus perfecting service for the retailer and other clients and producing more profit for the retailer.

Good specialists want to do their best work completely, rather than be restrained to what fits into a (typically insufficient) contract. Doing lots of work for one client over years satisfies the drive to build a prosperous empire, increasing motivation and productivity.

Agency specialists, as opposed to in-house specialists without recent agency employment, tend to have more familiarity with other areas of web marketing because they have dealt with a variety of clients and had to integrate with client’s other web marketing, if not work on those other areas directly.

The big retailer has many business connections that could lead to rapid growth of the agency, which over time leads to higher profits and asset value for both the agency and its new owner.

Disadvantages for the Retailer

Assuming that the purchase and sale agreement is done right and the retailer ascertained that the agency’s people are effective, the main disadvantage for the retailer is that in at least the first year and probably first few years, the total cash outlay is higher than when hiring in house. True, the retailer owns the agency’s profit, which at least equals the yearly purchase payments. And yes, in theory the cost of owning the agency is counterbalanced by the retailer’s ownership of the exactly corresponding value of the new asset. But still, more cash is required during the years of purchase payments than is required when hiring in-house (unless the agency rapidly grows more profit from other clients).

If the agency does not perform well for the retailer, replacing the agency’s work with either in-house hires or another agency means that the bought agency will have to acquire lots more business to replace the owner’s withdrawn business and to thereby make enough profit to equal the retailer’s yearly purchase payments.

Advantages for the Agency

The owners of the agency will yield more cash, at least in the first two years if not all years of purchase payments.

The agency does not have to spend as much time or money in sales and marketing because the retailer brings lots of work. Agency specialists inevitably get involved in sales, whether or not there is sales staff, and most specialists prefer to wield their core skills rather then stuff their heads in sales hats that rarely fit well.

The empire building discussed above bestows more job satisfaction.

Having a new boss could be either a plus or a minus, depending on the predilections of the agency’s owner or vested partners. It can be lonely at the top, and contrary to work-at-home infomercials, most people actually want a good boss. For long-time owners, the change can be invigorating.

Disadvantages for the Agency

The agency surrenders the opportunity for a higher sale price in the future. This bears repeating: the million now could forfeit ten million in a few years.

The specialists who are bound to the terms of the acquisition can’t take better employment opportunities that may arise during the years of purchase payments without loosing those payments.

The agency depends on the financial health of the retailer. If the retailer is over-leveraged or incurs other financial problems, it may default on the annual payments. A fair purchase and sale agreement will mitigate but probably not eliminate this damage.

The Mathematics of a Deal

Warning: this section is dense reading that compacts and elides a lot of important details deserving a spreadsheet and an accountant.

Most of the inputs in the math below apply equally to hiring in-house and buying an agency. So please don’t be distracted by the likes of the 100G salaries–they could be higher or lower without altering the essential math.

The purchase and sale agreement can and should be structured so that the projected annual profit of the agency at least equals the retailer’s five annual payments. One must factor the annual payments’ interest not accrued to the retailer (the “discount rate”), but such details aren’t important in this general illustration. So, in this math the purchase price washes out of the equation for the first five years. After that time, of course, the agency’s profits go directly to the retailer’s bottom line, but here too this admittedly important detail distracts us from understanding the essential math structuring the deal. This math assumes that the retailer pays the agency’s standard hourly rates for work over the years, which we’ll posit at $150 per hour. A retailer’s in-house specialist costing $110,000 per year (~$10,000 in benefits and taxes and $100,000 salary) costs about $75 per hour, assuming that specialists, whether at the retailer or agency, can do 30 hours of directly productive labor per 40 hour week. This means that the in-house person can do twice as much labor per retailer dollar spent. Said another way, the retailer pays $200,000 in agency labor for every $100,000 of the same specialists employed directly by the retailer.

Let’s illustrate this math by comparing the hiring of three in-house specialists vs. buying an agency with three such specialists. After buying the agency, the retailer will have to spend an additional $300,000 per year to get the same amount of web marketing work done by in-house employees. This means that the price of the agency should not exceed $1,500,000, which is 5 years x $300,000. Well, interest on that additional $300,000 paid each year might make the maximum price more like $1,400,000, and God (or a good CPA) knows how tax issues weigh in. In other words, each agency specialist to be owned for five years equates to a maximum of ~$466,000 in agency sale price. This maximum should be lowered to projected annual profit x 5 years, if that figure is lower than $1,400,000. The agency should not accept less than this lowered amount.

This formula requires that some of the agency’s profit must come from work done by agency employees or subcontractors being paid less than the specialists, and/or from selling to clients other than the retailer packages which demanded lots of labor to produce the first time and much less labor to implement subsequently, as in software and training packages. Most seasoned web marketing agencies have such packages, and/or have systems enabling less experienced, lower paid workers to contribute to the specialists’ work without compromising quality or efficiency.

Conclusion

That math does not account for the substantial advantages to the retailer discussed above. Those advantages may argue for a higher purchase price. Of course myriad situational factors influence viability, valuation, and structure of an acquisition. Urgency of needed web marketing may require just paying a firm for services, or paying an acquisition target now and folding those payments into a subsequent deal. If a retailer needs only thirty hours per week, the target firm with one specialist may be too small to realize the retailer’s advantages sketched above. Much of the decision to acquire an agency depends on discovering the amount of web marketing work needed. The first order of business is learning what those needs are and about how many hours of professional labor they require. The known unknowns are tough enough, but the unknown unknowns can become a void which the freakish speed and Freakonomic nature of change in web marketing will fill with victorious competition.

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