Performance-based compensation isn't exactly a new idea in the agency world. Thirty-five percent of agencies responding to a recent Association of National Advertisers survey use an incentive-based compensation plan. Procter & Gamble Co. a year ago stopped compensating its traditional agencies based on media commissions and began paying them a commission tied to product sales.
Now, the concept is gaining momentum among i-shops. Why? Chalk it up to the current economic environment. I-shops are struggling to get and retain clients, and marketers are looking for solid proof that the dollars they spend on the Internet are working. What better way for an agency to prove the effectiveness of an interactive initiative than to put some of its own skin in the game?
"We really believe in putting metrics on our work, and if we're going to assume the same risk our client does, we also want to participate in the upside," said Steven Marrs, president-chief operating officer of Tribal DDB, a unit of Omnicom Group's DDB Worldwide. "It helps align everyone's interests properly."
Marketers are keenly watching the developments. The Internet for years has been touted as the great measurable medium. In marketers' view, it's a natural evolution for i-shops to put the money where their mouth is. Delta Air Lines, for one, is looking for ways to tie compensation to performance measures at its interactive shop, Modem Media, Norwalk, Conn., which is minority-owned by True North Communications.
"Even if we were in a great economic boom, and money wasn't an issue, I'd still want to do this," said Rob Casas, general manager of business-to-consumer e-business at Delta. "We just want to get more out of our dollars like anybody else. These are creative ways to help you do that."
MAKES SENSE OF IT ALL
In many ways, performance-based compensation seems like a more natural compensation model for i-shops than it does for traditional ad agencies since the entire medium is response-driven. But it's not just accountability that's driving the change; it's the economics of supply and demand, which right now favor clients. Eighteen months ago, the i-shops could take a "Take it or leave it" attitude. After all, marketers were desperate. They needed a Web site yesterday, and were willing to pay whatever the shops wanted to charge.
"It is chaos," said one i-shop executive. "Everything is in flux."
Average hourly bill rates at many i-shops plummeted in the first quarter, a reflection of the slowing market for Internet development services and overstaffing at i-shops [see chart]. Hourly rates at Agency.com and Razorfish fell 14% from the previous quarter; rates at Digitas and Modem also were down, according to research by Bear, Stearns & Co. During a conference call to discuss its second-quarter earnings last week-in which the Boston-based company pared its estimate-Digitas executives would only say that the issue has come up with clients, attributing any changes in its compensation to "mix adjustment" in the kinds of initiatives that clients are currently spending money on.
JUST ONE ELEMENT
But it's important to note that performance-based compensation is just one element in a scenario that, overall, has served to drive down the cost of hiring an i-shop in a depressed industry. Mr. Casas, of Delta, said he's been approached by i-shops offering to do work free just to prove themselves. In pitches, potential clients often use price as leverage, said Luminant's chief operating officer, David Quackenbush.
Marketers tell i-shops "I've got 15 companies saying they can do what you can do for a lot less money," Mr. Quackenbush said. "The projects these guys are doing, they're shopping them really hard. They're hounded by so many companies that are coming in with great deals."
"Everyone is fighting for all the projects," said Tribal DDB's Mr. Marrs. "I think price plays a large role in it."
DIFFERENT PRICING PRESSURES
In most cases, i-shops aren't explicitly cutting their rate card when they pitch new clients or new projects from existing clients. Some shops will throw additional people on a project, essentially giving a client free labor. Or they will intentionally underestimate a project's cost, creating a hidden discount.
A different type of pricing pressure comes from clients that are cutting interactive budgets and delaying projects until the economy improves. When an i-shop starts work on a project, only to see a client pull back, it forces the i-shop to scramble to gain revenue. At Digitas, for example, clients have cut budgets an average of 10% for 2001, CEO David Kenny told analysts recently.
Although other factors are also changing i-shop compensation, the longer the economy stays soft, the more logical the idea of performance pricing becomes. Such deals often are structured so that a shop will take a smaller fee and then create a list of deliverables that must be met in order to receive additional compensation.
A shop could get a bonus for launching a Web site on time, take a commission based on the number of transactions at an e-commerce site, or get a percentage of sales generated from a site.
At Ogilvy Interactive, for example, the agency works with clients to decide on criteria, and then hammers out a profit margin that both parties feel is fair, including an upside if the deliverables are met.
"If everybody thinks `X' is the appropriate profit margin an agency should make, then [a performance deal would have] a lower profit margin with the ability to make a higher profit margin if you deliver," said Dorothy Young, chief financial officer of OgilvyOne, parent of Ogilvy Interactive.
She said a "large percentage" of the agency's clients have such a relationship with Ogilvy Interactive, but like most agency executives interviewed for this story, she said specifics of client contracts are confidential. Ogilvy Interactive's clients include IBM Corp., Unilever and American Express Co., which are major clients of the Ogilvy & Mather Worldwide unit of WPP Group, as well.
Bcom3 Group's Novo, based in San Francisco, is willing to include performance measures in its compensation negotiations. Said Chairman-CEO Kelly Rodriques: "Our view is that in periods of price pressure, what companies are looking for is firms that are going to have skin in the game."
Mr. Rodriques said three of the agency's 15 clients have done performance-pricing deals, where the agency received a small bonus on top of its normal hourly compensation if it met certain objectives.
Tribal DDB will take a lower amount in fees and stake some of its profits on the success of its clients' campaigns, said Mr. Marrs. So far, about 20% of its clients are on some sort of performance pricing, though he wouldn't identify which ones. The i-shop's clients include Pepsi-Cola Co. and Anheuser-Busch, which are also clients of Omnicom.
Some shops, particularly those that handle media buying or customer acquisition, are making performance the base of their business.
At Orb, a media buying and customer acquisition shop based in New York, performance-based pricing is key to the company's revenue model [see sidebar].
However, it's worth noting that the agencies that seem most supportive of the trend are those with plenty of distance between them and the street, Wall Street, that is. Stand-alone interactive consultants that went public during the IPO boom tend to be most wary of pricing their work with performance goals attached. When the pressure is on to produce revenue in the short term, they simply can't take the risk on performance-based agreements.
About the biggest vote of confidence for the trend among public shops is at media shop i-traffic, a unit of publicly held Agency.com. It takes part of its revenue based on performance, although to a lesser extent than Orb does. However, a deal is currently pending for Agency.com to revert to private status under the aegis of Seneca Investments LLC. Other public i-shops said they're open to performance deals, but it's the kind of begrudging openness that really means "we'll consider anything these days."
WPP Group-backed Luminant Worldwide Corp., for example, is willing to discuss performance deals with clients but hasn't done any yet, said Mr. Quackenbush. Modem Media said it's done a few such deals, but is reluctant to pursue them now.
"I personally am not a fan of it," said Modem CEO Marc Particelli. "If you're doing your job right, your job is to deliver value to the client regardless of the situation, and situations always change."
But he acknowledges the momentum gathering behind performance deals. "As we learn more about what drives performance, we may actually get to the point where pay for performance makes sense," Mr. Particelli said. "We would be open to pay for performance if we can precisely define what success is."
Defining success is probably the biggest sticking point in the use of performance pricing. "You're asking the agency to wait to get paid until your sales go up," said Skip Pile, chairman-CEO of Pile & Co., an agency review consultancy in Boston.
IT'S ALL ABOUT CONTROL
Unless an agency has full control over all the variables that could make or break a project, it might shy away from the risk.
"It's hard for a company like Organic to take utter responsibility for a client's sales," said Jonathan Nelson, chairman of the San Francisco-based i-shop. "It's hard to take all the risk when you have half the control."
But performance pricing can work if the agency and client can come to agreement. One i-shop lowered its profit margin to 15% from its typical 20% for one client, but the shop can make as much as 25% if certain targets are met. This same company, which declined to be identified, also structured a deal with a different client giving it a margin of about 6% to 8%, with a chance to make as much as 30% based on performance.
Fortunately for those who are wary of such deals, marketers acknowledge the challenges in performance-based compensation.
"Modem [depends] on us as a company to come through on the IT side," said Mr. Casas, of Delta. "We couldn't possibly tie the overall product delivery on them. ... We have to be careful in making sure that it is a process that is totally within their destiny to own."
At Williams-Sonoma, which recently hired Digitas, pay for performance is an intriguing idea, but one that the company sees as carrying risks for both sides.
"It's a one-sided dive for agencies to want to get into that relationship," said Shelley Nandkeolyar, VP of e-commerce at Williams-Sonoma. But he warned if shops seem too willing to take a lot of their compensation on a performance basis, they may not be around to complete the job. Digitas declined comment on its pricing models.
Sony Electronics, even as it compensates Orb, its interactive advertising agency of record, based on performance, is adamantly opposed to paying other i-shops, with a more diverse set of responsibilities, that way.
"How could you possibly be fair to somebody like that?" asked Michael Sive, VP-marketing for Sony Electronics e-Solutions Co. "If I were on the professionalservices side, I wouldn't find that fair. As a potential client I wouldn't want to treat a professional-services firm in a way I wouldn't find fair."
Even if i-shops do start to do more performance deals, they probably won't take all of their compensation that way. Retainers, time and materials fees and fixed-fee bids will still make up the bulk of compensation. But there's no reason why marketers shouldn't take performance into account when they negotiate fees for interactive services.
"From the get-go, part of what [i-shops] were promising ... was the fact that they had a measurable tool and the proof would be in the performance," said David Beals, president-CEO of agency search consultant Jones Lundin Beals in Chicago. Bottom line, if enough clients ask for it, i-shops will have no choice but to deliver.
"A year ago, agencies foolishly were turning away clients. [Now] they're all doing what it takes to get business," said Barry Judge, VP-marketing and e-publishing at online consumer electronics retailer BestBuy.com, which recently tapped Digitas. "They're open to creatively looking at how the business could be managed. We're in a fortunate situation. We're a big advertiser out there. There's a lot of potential business."