Managing Marketing: The challenges facing the advertising agency business model

Andrew Reeves

Andrew Reeves is the Founder and CEO of ARC Limited with a lifetime of experience as an agency CFO. Here he chats with Darren on the current agency remuneration and business models and the challenges facing agencies in finding ways to make this work in rewarding agencies for the value they create.

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Transcription:

Darren:

Welcome to Managing Marketing and we’re coming from downtown Shoreditch in London and today I’m spending some time with Andrew Reeves who is the founder and CEO of ARC Consulting. Andrew’s a long-time agency CFO and CEO. Welcome, Andrew.

Andrew:

Thank you very much, Darren; it’s a pleasure to be here.

Darren:

It’s interesting being here in what feels like the new hub of London creativity: Shoreditch.

Andrew:

Yeah, it used to be Soho and I think in the last five years it moved spectacularly towards Shoreditch, which is where all the best gigs are from an advertising perspective these days.

Darren:

Well, probably also because of the real estate cost, isn’t it? Soho became quite expensive.

Andrew:

Yeah, it certainly did. I think Shoreditch, at one stage, was one of the cheapest parts in town; £34 per square foot or something but as soon the marketing folk moved in here they’ve done it all up to suit the market and it’s gone literally through the roof. It’s gone from about £34 per square foot to 60 in the last year.

The role of finance in the creative industries

Darren:

Look, the reason I bring that up is because one of the things I want to discuss today is the role of finance in accounting in the creative industries because it’s one of those areas that people have really quite diverse views on.

Andrew:

Absolutely. I’ve been in the industry for about 20 years now and it’s funny because even working for some of the big brands like WPP, which is headed by some of the most astute financial people in the industry, finance and operations always seems to come way down the chain in terms of priorities for owner-managed creative businesses.

Darren:

That’s one of the issues isn’t it, where does the balance get struck between running a sound business and investing in things like creativity? If you listen to some people it’s impossible to manage the creative process. But they’re still businesses, aren’t they?

Andrew:

It’s funny the amount of times that I’ve been into agencies and they talk about it being a creative business but the business element of it is the weaker part. As an industry we pride ourselves on the creativity but we’re not very good at the business side.

And I think that comes from both how we look at our client’s businesses, which is why we’re in business in the first place, and the input that we have and the impact that we have on their top line and bottom line as well as how we run our own businesses. I just don’t think we’re particularly astute at it.

Our preference is always the creative side, which is building something and developing something for the sake of it to a large extent as opposed to the impact it makes in terms of making hard bottom line cash.

Darren:

Part of this is also because the agency business itself has changed a lot in the last 20 or 30 years. I mean you’d have to be the biggest idiot in the world not to be able to make a profit on the old media commission’s service fees, wouldn’t you?

Andrew:

Yeah, I think that’s a really good observation and starting point. I think that’s what happened throughout the years: there was so much money awash back in the day that we took our eye off the ball in terms of how we managed that and looked after it and how we grew it.

As we moved from the commission system where the industry was making 25%, 30% more easily and still having a nice lunch on the back of it, to a system where that level of profitability and how we manage it has changed.

Darren:

Well talking to Michael Farmer, he says, that even back in those days, although they were incredibly profitable, they were incredibly lazy business people. You talked about 25%, 30% margin, he was saying in some cases the actual profits were tiny because they weren’t managing the cost of the business because it just seemed like this flood of money coming in from media commissions.

Andrew:

Yeah, I think back then the flood of money obviously trained the businesses to become lazy and that certainly was an issue at the time. There was always enough money despite how relaxed they were about controlling the costs. Effectively they didn’t.

What happened after that is we developed a new model, which was the resource based model, which made it probably even easier because effectively the money came in as long as you had the people in business. I can’t think of a better business model if you bring in people and you sell them with a profit then the more people you bring in the more money you can make. So, it was a very safe period then.

The limitations and problems with the cost recovery agency model

Darren:

But it’s a cost recovery model, isn’t it? Basically, you have a base cost and you have the overheads and then everything on the top of that should be profit, right?

Andrew:

Right. And that was the labour-based pricing model at that time.

Darren:

But isn’t that also lazy? How many other businesses and especially other professional services business would work on a 2.4 or a 2.5 multiple on cost? And even at the earliest days of moving from commission to resource fees that’s the sort of multiples. Law and accounting firms, still some of them are working on 4 or 5 times.

Andrew:

Yeah, it’s an incredibly easy model of being able to make money; you’ve just got to make sure that you’re able to provide the right level of people at the right time and you’re guaranteed a cost recovery and a profit margin.

Darren:

But the other thing about this market, the advertising category, isn’t it oversupplied?

Andrew:

I think coming from the resource based model, you think about the dynamics of an advertising agency, you think about the pricing model in the first place but also think about the setup of an advertising agency. It doesn’t take much and I don’t think it ever did take much to set up an advertising agency; you needed an office to work out of, you needed a telephone to contact your people and that was just about it. You needed the right people around you and so the barriers to entry were very very low.

Darren:

Almost any idiot could set up an advertising agency…and they do.

Andrew:

Absolutely. And that obviously spurred an entire industry of independent hotshot creatives in particular that would go off and try and create something. I think the motivation there was that it was easy to set up. If you got it right there were lots of riches to be had. You would create one or two client profiles and at some stage you would be able to sell your wares to a network provider and make a lot of money.

Darren:

But isn’t that counter to what the industry actually sells its clients, which is strategy and creative ideas, which they’re basically selling on an hourly basis? Isn’t that a bit like selling a book by the pound or the kilo? How much does the book weigh, therefore it’s a much bigger book I’ll charge you more for it?

Andrew:

Irrespective of the content that’s in there.

Darren:

If one more person tells me the Pablo Picasso story about being asked to draw a picture and he did it and said that’ll be $10,000 euros and the woman said but that only took you ten minutes…. but it took me 30 years to do it.

Great, but you charge by the hour. A client can come into any agency and go ‘what do you charge an hour? I’ll buy 30 minutes of that.’

Andrew:

I look at where we are today in terms of an industry and that whole model has screwed us. It’s screwed the advertising agency; clients aren’t happy, people aren’t happy, agencies aren’t happy, and the parent companies aren’t happy either.

When you’re going through a lazy pricing structure and it’s easy to recover your costs and it’s easy to recover your profit or make a profit then the ability and the creativity you have in terms of your own business goes through the floor. So, innovation goes through the floor. The aptitude towards your client’s business is completely irrelevant.

You’re getting paid by the hour; it doesn’t matter whether you’re good or bad, you get paid a benchmark rate. You’re making as much money as the guy who’s absolutely the Picasso of his industry to somebody who is just starting out. So, I think that has all come around to a certain extent.

I think in the last five, ten years the pressure is on the agencies, quite rightly, to be able to deliver. We’ve been under pressure in terms of resource based pricing for a long time; we haven’t been able to figure it out. But clients know who’s good and who is not good. Clients know whether or not it’s worth their while to spend money with one agency versus another agency.

Agencies are having to become innovative in terms of their approach. They’re having to invest in specific areas. If I think of this particular agency that we’re sitting in today, Darren, it is a digital agency. It has evolved out of the need for clients who are looking for something quick and something consistent and something that deals with the internet side of the marketing: fast turnaround email communications.

Darren:

Yeah but let’s be honest. There’s 1,000 agencies available in the market place. Isn’t one of the biggest problems that the industry faces (on the basis of supply and demand), that it’s oversupplied with a category of agencies that are poorly differentiated or even significantly distinctive from each other?

Which has turned it into a buyer’s market and agencies themselves are not equipped to be able to negotiate the value that they bring to the relationship in the face of a procurement team that are incentivised in most cases to reduce that cost?

Andrew:

There’s two issues there, right? There’s the issue of being able to provide the value in the first instance. So, what is it you do that is different and unique to your competitors and how do you genuinely provide value to your clients? Are you helping them grow their revenue, are you helping them with cutting their costs? Because that’s what value is at the end of the day and how as an agency are you doing that?

Darren:

No, I’m producing unique ideas that are going to be game changers in the category that will completely revolutionise and win some awards. I know that sounds cynical but seriously that’s the way the market plays out.

Andrew:

Which is nuts, right? We’ve disappeared up our own you know, whatever.

Darren:

Because for 30 or 40 years, as an industry, we didn’t have to worry about value delivering. Whatever the client spent, a certain percentage would go to the agency. And sure, we’ve lasted what 15, 20 years on a resource based model and the wheels have fallen off. No one’s willing to admit it, but it’s got to the stage that most agencies have to find other sources of income to make it.

Andrew:

Well, that’s not sustainable either. We are a resource based business or another way of putting it is we’re a talent business, right? So, the talent thing is the most important thing that we offer to our client. However, we’ve become more and more squeezed over the years in terms of our ability to provide that talent and the talent isn’t coming to our sector anymore.

Because if you’re a graduate and you’re smart where is the last place you’ll go?

Darren:

You’ll go to a technology company.

Andrew:

Absolutely.

Darren:

With a big Start-up VC funding.

Andrew:

You’re not going to come to the likes of here and so, we, our talent and our ability to deliver that value has gone to the floor alongside it. We’re not getting the talent in anymore and we can’t afford to pay them.

The value and role of talent in advertising agencies

Darren:

So, you’ve brought up talent and the Academy Awards were on just recently and Hollywood is all about talent. People actually make a lot of money promoting talent and making them desirable. Some of the biggest names in Hollywood just being in a film will guarantee a box office success and there’s a whole business about trading on that talent, the agents, the managers are all in Hollywood maximising the cost of accessing that talent because they make their 20, 30%, right?

The advertising agency doesn’t do that, do they? They actually try and hide. They have awards that only creative people care about but in actual fact making that relevant to clients has never been part of the deal because the fear is that suddenly those creative people and those strategy people would be out of the control of the agency management.

Andrew:

It’s happened. You talk about some of the agencies that were set up in the good years, it was the talent who went off and did that. I think it’s a double-edged sword to some extent. You’ve got to be able to promote and look after your talent to be able to do the right thing for your clients but because we’re in an industry where there’s a risk of the talent becoming more important than the business, then you’ve got to manage that reputation and that support for that talent as you go.

We’re a business; it’s not about any one individual. The business has got to be able deliver against our client’s objectives first and foremost.

Darren:

But if it’s a talent business than it is about individuals.

Andrew:

Yes.

Darren:

So, we’re turning talent into a commodity.

Andrew:

Yes, I think the business performs best when the talent is freed up to do what they can do. If you put talent into a factory and you ask them to do backflips for you under duress then the talent will not perform.

I think we’ve created factories amongst our agencies that have fundamentally restricted our ability to work together and come up with genuine creative solutions that helps client problems.

So, you’re right, it is absolutely a talent issue and the longevity and the root of how you manage your talent is everything from how we get paid, and procurement involved in screwing us so that we can’t afford the right talent or us not being able to negotiate or whatever it is, but fees within our business being too tight for us to be able to give and promote our talent to do their job.

I think when I look back at my career in creativity it’s probably one of the saddest things that’s happened because we have kind of affected this factory oriented advertising that is no good for the client and is no good for the talent and that talent then finds other routes to be able to go out and do their thing.

Darren:

So, there are two streams here, one is the holding company, which I’ll come back to because the holding company really only appeared in the form that we see today around the mid 90’s. The other thing that we’re seeing now is the big consulting firms moving into the very territory that agencies used to have.

What have they identified about the gaps? Because management consultants move into the areas where they see unrealised value as a way of making money for themselves. What do you think they’re seeing in the current landscape that’s made this territory really attractive for them?

The rise of the consulting firms in marketing and advertising

Andrew:

I think it’s probably a couple of things. You can’t let go of the fact that the talent isn’t what it used to be in advertising compared to how it is in consulting. So, when we talk about those grads going where they’re better looked after, consulting is still a highly-revered area to be. You get paid a lot more money, you get a better partnership structure, you’re amongst other intellectuals that allow you to grow and continue to grow.

Darren:

You’ll still work 80 to 120 hours per week.

Andrew:

You’ll still work your fingers to the bone but you’ll get paid three times more than we will.

I mean if you look at the consultants, design is probably one of the first areas where the consultants have gone into, design consultancy and if you go to one of the established consultancies they will still charge you three to five times more than what an advertising consultancy will charge you for a piece of brand consulting for a piece of work that arguably the advertising consultancy should be better placed to do.

But we’ve lost credibility.

Darren:

Do you think it’s also because the industry has started talking about value and delivering financial performance to clients but have not been particularly good at either committing to that or proving the value that they create, whereas business management consultants feel that they are in a much better position to do that?

Andrew:

It’s a good observation. I think from a communications perspective, the holding companies’ entire MO evolved from being able to create and buy communications companies that could provide an entire communications strategy for clients and the holding companies’ proposition is embedded within communications.

I think that communications as a discipline is something that has had a hard time and CMOs and their longevity is something that’s had a hard time too and I think that’s a big part of the picture.

Whereas consultancies don’t focus on a communication problem, they focus on a business problem so I think the consultancy’s ability to provide added value is a broader framework. So, the old adage if you’ve got a hammer every problem is a nail that was part of the value proposition problem with holding companies and communications companies. Clients got bored with hearing the same solution for all of their problems.

I think the consultancies were better at articulating.

Darren:

Also the consultancies have come from the top down. They’re already talking to the CEO and the CFO, identifying the business problem, coming up with the strategy. Now all they’re doing is moving into, ‘here’s the implementation and the execution’.

Andrew:

Absolutely. The advertising agencies, I think, at one stage back in the mad men days of the 70’s, were businesses. When you think about business it’s about selling stuff. Most businesses are marketing businesses, right?

To survive, no matter how good you are at being able to engineer something or manufacture something, at the end of the day you have to sell it. So, in the 70’s marketing was the business solution but because over the years we’ve turned marketing into the colouring-in department we lost those relationships with the CEOs and CFOs.

You’re absolutely right; consultancies own the business problem with their clients and are able to impact that far better than we can.

Darren:

So now we’ve seen some of the larger agencies move or try and move into the consulting area. I’m sure you’ve read as I have, some of the bigger agency names have set up consulting arms.

Andrew:

Absolutely.

Darren:

But they don’t seem to get the traction, do they?

Andrew:

No, because I still think that when it comes to credibility… first it’s the consultants, the credibility will never be there. An advertising agency can go in as a consultant but they’ll only ever be consulting in communications. Whereas, a consultancy can communicate on a broader brush but can implement any one of those disciplines as they see fit. Hence why you’ve got consultancies stealing our lunch because they can deliver. It creates lock-in for them as well.

They can create an integrated strategy that may have an element of pricing distribution but also communications and then they can plug in an implementation solution that allows them to deliver against that as well.

Remember consultants were always accused of stealing your watch and telling you the time. That’s been the big thing with consultants. Whereas now they can actually steal your watch and set the time for you and set the measurements in there and be accountable for it.

Is creativity still a distinctive difference for agencies?

Darren:

And hand you back a digital watch from the winding up watch you use to have. But one of the things agencies used to rest on their laurels and say was, ‘well, these consulting firms will never be able to attract the type of talent that we attract: the creative people’.

Yet don’t you think that’s changed because the talent coming out of universities or just in society now, they look at all of these as valid options. I mean tech start-ups are not advertising agencies but they’re seen as a lot cooler than advertising agencies.

Andrew:

I think people who come to advertising agencies are very creative and they want to do something non-corporate so I struggle hugely with the concept that consultancies will eat our lunch over time because I don’t think they have the right culture.

But Tech, other industries, oh absolutely. They will attract the same mavericks and bohemians and the same creative types that advertising used to and I think there’s a point of convergence at some stage because creativity and communications is as much about coming up with the big idea.

Darren:

I think that’s where the consulting firms will be able to attract that creative talent because they’re also closely aligned to the technology companies. So, they’re investing in those technology companies, the same technology companies that are seen as a viable non-corporate environment for this creative talent but it’s going to be attached to a consultancy.

Andrew:

Probably. Time will tell. Take the Accenture/ Karmarama deal that was recently done. Everybody’s, bated breath, waiting to see what will happen. On paper, it is fantastic.

Darren:

Or will they kill the fatted pig?

Andrew:

Absolutely.

The role of holding companies on the advertising agency business

Darren:

So, let’s go back now to the point I made before about holding companies because I know you’ve worked in holding companies. Let’s not talk about any one in particular because I think they’re all in the same boat. I know they’ll argue that they’re all different but largely they’re all the same.

The rise of the holding company in the 90’s was interesting because it’s around the mid 90’s that technology, the internet started becoming something that the public could use. Where do you see the end-game of the holding companies? Not the beginning game, the end-game.

Andrew:

It’s a really interesting question because the holding companies, there are a few of them, are dominated by individuals and those individuals, at some stage, need to move on.

Darren:

Well we’ve already had a couple of them announce that they’re moving on.

Andrew:

Absolutely. I think that is a huge challenge because it’s the personalities of those individuals that make those holding companies what they are. The personalities are huge. It’s hard to think the company is driven by the personality of that individual and once they leave where does that leave them?

So, I think that’s a problem. The whole holding company thing is now 40 years plus. They’ve got to a level and their ability to continue growing at the rate that they did is under pressure. I think, not least because of the individuals running them but because of the pressure they have put on their business over the years.

The model in the first place when you talk about the beginning of the holding company was to be able to integrate like-minded propositions and cut out back office. You’re talking about IT, finance, those kinds of things where you can make some big money.

Darren:

Or big savings.

Andrew:

You could make big savings without tinkering around with the actual product and make money. Then as you evolve from savings there’s only so far you can cut and they cut everything out. The next step that you need to evolve is the proposition. So, you buy complementary goods. You go from advertising to direct marketing, to media and to research, to data, and to tech.

So, they have created these monster businesses that have all of these different disciplines in place. And all of these disciplines in their own right at that time were the zeitgeist of the day but how you evolve that structure and make it relevant to the client is really really difficult.

So, you’re looking at holding companies now that have all of these expert skills in different structures that I can imagine are really difficult for clients to access. Which is why the holding company structure has now broken down those silos that initially made them, the individual brands, the businesses that they were once valued for, has broken them all down and has now created horizontal client-led structures, which have become, for want of a better word, homogenous and vanilla.

Darren:

Yes, it’s interesting isn’t it. They did invest in vertical integration, the end to end solution and yet we’ve had, and I’ll name them, Ogilvy and Publicis, have all come out with this idea of the one PNL that goes horizontally as you say right through all of these different entities.

Yet it almost sounds counter intuitive to the business model of why they acquired. A lot of these agencies were acquired by funding debt against the equity that they held. In fact, there are a couple of people, industry observers, financial observers who say that debt to equity ratios for some of these holding companies are ridiculous.

Andrew:

Well what happens to the equity once you’ve bought a business and you change it and make it vanilla? The equity is written off isn’t it? So that’s really interesting, the parent companies are now having to break down structures that they built over time, and partly because of cost because all of those structures have had their own management core structures and they need to break them down. You talk about Publicis and Ogilvy, in particular.

Darren:

I think Havas as well are moving down the same path. In their case, they call it the village. This idea of villages of agencies working as one against a single client P&L. So, it’s not isolated. It’s a trend

Andrew:

It’s predicated on two bases. One, in the first place the right thing for the client giving one point of contact that allows me to solve and move back to business problems, not just my advertising problem because that structure in itself will create silos that don’t work in terms of the overall business structure. You’ve got to create a single structure that allows you to look back at the business problem so that was the first reason.

The second reason, obviously, is the core structures within those networks are just too heavy for today’s competitive landscape.

What business advice would you give to someone starting an agency today

Darren:

Now, as a finance person and someone that knows the advertising business, there are way too many agencies in the market place but if someone was starting an agency today what would your advice be? Would you say, ‘don’t do it’? Or would you say, ‘do it but this has got to be the end-game’?

Andrew:

I’m an agency man through and through; I would always say, ‘do it’ because it’s a fascinating industry and I think there’s opportunity now for smart start-ups to beat the networks.

Darren:

Right up until the point they acquire you, and put you on an earn out.

Andrew:

Obviously, that’s why many people do set up their own agency.

Darren:

Time and time again.

Andrew:

Time and time again; we never learn. If I was to set up an agency today the structure would be a much leaner structure and it would be focused on the business problem. It would have a high-end level of strategic input in the first place as opposed to creative, which is again understanding their customer base and particularly who they’re trying to attract and how they can drive more sales because that’s what marketing is all about.

Then I’d bolster it with a team of people that are genuinely multi-channel–people who are able to deliver multiple solutions that will help achieve those strategic goals.

Darren:

If you could build that type of agency what remuneration model would you recommend? A cost recovery model?

Andrew:

Certainly not a cost recovery model. I would love to recommend an outcome-based model because obviously if you’re able to get some skin in the game then that has you perfectly aligned.

I wish we had the tools and measurement capabilities to be able to demonstrate the input that we have on our business towards our client’s results. I don’t think we’re there yet. I know passionately that without going back to all businesses are marketing-led businesses the level of input that an agency can make on a client is phenomenal.

I think that if you were able to bottle and measure that then we’re off to the races but I think it’s really hard. In the absence of that and in the context of cynicism, which is where we’re operating today I would move towards an output-based model in the first instance that talks about a client’s business objectives, looks at a suite of activity that needs to be done to achieve those objectives and gets paid for that suite.

And every so often, once a month, once a quarter, we look at what the business objectives are and we tweak what we are delivering against that objective in terms of the scope of work in particular. We make sure in particular that that scope of work, those activities, those communications are delivering against that objective.

Darren:

So that kind of model requires having a marketer client that is actually aligned to business objectives. A lot of agencies say to me that their clients are just not in a position to be able to articulate what the desired outcome is.

Andrew:

Don’t work for any of them.

Darren:

That’s what I say. If they can’t do that then don’t work for them, but of course in a market where you are going after any piece of business that walks through the door then suddenly they’re compromising the very thing that could differentiate them, which is being about performance and actually aligning themselves to delivering value.

Andrew:

Absolutely. I don’t know how you get around that problem. Again, it’s an industry problem in terms of the seniority of our clients and it’s all very well to turn around and say, ‘don’t work for them’ but when you have mouths to feed and you’ve got to put money in your pocket.

Darren:

Or mortgages to pay or business loans or overdrafts or expense accounts.

Andrew:

Absolutely, for the heavy lunches in Soho. I think that if you’re going down the route of an output-based remuneration then actually you can still do that because I’m not precious. The philosophy of advertising is we should be able to help grow our client’s business but there is another side of it and that’s to help them save money.

So, I’m not precious whether or not I’m aligned to a specific outcome as long as the client is clear to me what they want. If they don’t want me involved in the business strategy either because their CMO isn’t respected to that extent and hasn’t got voice or authority then fine.

Tell me what it is that you do want to achieve and be very clear with me and I will help you achieve that. It may be speed to market, it may be core savings, it may be some other thing.

Darren:

What is the problem that I would bring value to the equation by delivering?

Andrew:

Absolutely, and then in the ideal world I would help you grow your business but in the absence of that I will help you achieve your objectives.

Darren:

But, Andrew, you realise you are sounding so much like a business person and not very much like an advertiser.

Andrew:

I’m in the wrong business.

Darren:

Or maybe just passionate about the fact that advertising has a role to play in creating business value.

Andrew:

You started this interview, this conversation with the role of finance people and I think this is one of the things we have missed because I am passionate about it and I am passionate because I have seen us as an industry make so many mistakes and we get carried away and we get distracted by the shiny things over here, there and wherever.

My background as an accountant is business and we need to up our game from a business perspective. So that’s why I’m passionate about it because I can see the opportunity, I can see the capabilities that we have; we just need to do better.

Darren:

So we’re running out of time but I’ve got one final question for you and that is, over the years I’m sure you’ve had to sign off on some interesting account management and creative expenses.

What’s the most controversial one you’ve ever signed off?

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