The contracts that agencies sign with their clients are complex and often secret. Every now and then though, one clause pops up into the industry consciousness and demands analysis.
Right now that clause concerns payment terms. More and more clients are demanding that they get longer and longer to pay for the inventory their media agency has bought for them.
Over the past two years it’s been reported that companies like Heinz and Mondelez have extended the length of time they take to pay suppliers, with both reported to have pushed payment terms to 120 days. Other big brands too have been accused of seeking savings in the same way.
Agencies rightly fear that if they say yes to one client (and the world hears that they have) then everyone will want the same terms.
In the UK, a survey by specialist marketing services and media accountants Kingston Smith W1, found that 91% of agency executives had been asked to extend payment terms.
UK agency trade body The Institute of Practitioners in Advertising has been vocal in protesting about this and its former finance director Alex Hunter pointed out that standard industry terms should be 30 days. “For media buying agencies, it is essential that they collect payment for media space and time prior to settling with media owners, where such media owners operate industry standard payment terms that typically require payment in the month following appearance,” he wrote on the organization’s blog.
Most recently, the UK Marketing Agencies Association called on their members to boycott working with AB InBev over concerns about their payment term requests.
Extended payment terms mean that agencies have to hold more cash to pay media bills before they are reimbursed by clients. That requires additional borrowing and in turn adds to agency costs.
It’s true that agencies (or more accurately their parent groups) are probably also pressurizing media owners to extend their payment terms so it’s not just a one-way street.
What matters most is not the actual payment terms themselves but the difference between the terms negotiated by the buying group and the terms requested by the client.
It’s this credit gap that costs the agency money. The greater the gap the more money they need to borrow and the higher the cost.
So before the procurement team decided that it’s a great idea to extend payment terms, perhaps it’s worth thinking about what the implications of that might be.
The benefits to the advertiser’s business are clear – better cash flow. But what does the loss of cash flow do to your supplier and the service they are meant to be providing?
I think it’s worth breaking down a scenario in which the credit gap is 10 days and exploring how that affects the agency and how this might impact on the service and value that a client then receives.
I’ve made a couple of what I think are realistic assumptions in this scenario, notably that the holding companies are unlikely to be happy to take a reduced profit margin.
I’ve also made assumptions about the cost of borrowing money. You may argue that the holding companies could easily borrow lots of money at lower rates but I would argue that if investors found out that their borrowing was simply to finance longer payment terms that would be reflected in a reduced share price and more negative sentiment.
So let’s take a business managing a $100 million account and assuming it’s spent evenly through the year. The agency holding company has only been able to negotiate 90 days with media vendors but isn’t recompensed for a further 10 days.
Working on an 5% average commercial interest rate, using sustained borrowing to service the credit gap will cost the agency around $135,000 each year (it will have to have a rolling loan of $2.7m).
Assuming the agency has negotiated a 3% fee – worth $3m – then this will mean that 4.5% of its agency fee will be used to service the credit gap debt.
So instead of a team of 15 featuring say 10 decision makers, the agency has to service this account with more junior staff and perhaps just six or seven senior decision makers.
That might not sound like a major shift but at a time when the value that clients receive from their agency is more likely to be based on talent, innovation and strategic insight, the loss of senior, more expensive resource from an agency team sheet has a major impact.
Procurement might hit its targets and get its bonus but the danger is that the insight and effectiveness of the whole budget could be seriously undermined, resulting in a $100m investment that is sub-optimized. The impact of this would likely far exceed the cash flow bump the client secures from payment term extensions.
Are you willing to take that risk?