When digital was a novel offering, we saw agencies with that narrow focus receive extravagant valuations. Today, digital expertise has become a given rather than a point of differentiation. I heard the comment at an AMI event that basic online digital services are part of the “table stakes” that every agency must put up in order to be seriously considered by a prospective new client, or by a current client for some types of projects. That is consistent with my experience. Most agencies have it in-house and the others outsource it. But it’s a very rare agency today that just doesn’t offer digital services. So, how do advertising agencies charge for services?
Agency values continue to be simply defined as a semi-subjective combination of profitability, size, the client list and the services the agency routinely provides. There are plenty of other factors that influence the final number but we always start with these.
So, what about the seller’s goals? Many agency owners begin down the path of selling their agency only to quickly retreat once they are shown the valuation and what they can hope to get as a purchase price/package
A very important aspect of the transaction is the actual structure of the deal.
How, how much, and when are you going to get paid? In many cases, the sales price doesn’t matter as much as when are you going to get paid.
First of all, how much cash are you going to receive at closing? What can you expect? And, how negotiable is it?
Managing Your Margin
Let’s assume that your agency is profitable, with a respectable margin. Say that the net margin is 15%. (Note: net margin is the percentage of revenue remaining , after all, operating expenses, interest, taxes and preferred stock dividends (but not common stock dividends) have been deducted from a company’s total revenue)
Experienced buyers will expect that agency’s business will fall off 20% to 25% in the first year following the acquisition. Every buyer I have ever worked with will consider the cash on cash return of their initial investment. Most do not wish to wait three years to get their money back.
The reality is that with a 15% net margin, you are likely to have an EBITDA Margin (net profit) of over 20%. And, this is the minimum many buyers stipulate. If your net profit is less than 20%, you are going to be negotiating at a significant disadvantage.
The EBITDA Margin will be the principal factor in the calculation of the cash down payment at closing. In general, the down payment will fall within 1.5X to 3X EBITDA for the trailing 12 months of the seller’s business.
In general, the higher the EBITDA margin, the higher multiple applied to how much cash to pay at closing. This isn’t the total cash a seller could expect to receive at, or before closing. There will be a cash balance or balances on your Balance Sheet. You will be entitled to take part or all of it.
Now, part of this balance is attributable to your working capital, which you may (should) have accrued for client work for which you have received payment but have not completed. Under normal circumstances, you will have a surplus of cash above the working capital requirements. You may or, may not be able to keep the entire surplus. The buyer may want to have all or, part of the surplus left in the agency for a period (normally) for 2 to 3 months.
There will be a document referred to as, “Reps and Warranties” which you will sign to account for any liabilities, which have not been provided for in the calculation of final obligations that were not accounted for in the closing financial statements. Cash accounts are typically escrowed for 2 to 3 months to pay unexpected agency-related charges.
That isn’t the end of the world if your closing accounting statements are accurate. The funds are yours to collect. But later.
Determine the True Value of a Sale
However, if the seller did not accrue unearned retainers, or has spent some of the cash, there will be a reckoning, and the seller will pay. I cannot recall any transaction in my experience where there has not been a discussion about cash balances as closing approached; some more heated than others.
In general, without special circumstances, the total value of the selling agency will often be calculated at 4X to 5X EBITDA. If total value was valued at 4X, and the cash down payment was calculated at 2X, there is another 2X EBITDA to be negotiated.
This balance will be paid as an earn-out The buyer and seller negotiate and, agree upon performance milestones that the agency has to achieve in order to be paid the earn-out over time. The earn-out period has shrunk to around 3 years rather than the 5 years that used to be the norm.
As the seller’s representative, I have normally asked for funds to be escrowed. This is more important if the buyer is another independent agency or a new network, rather than a publicly-traded agency Holding Company. It gives the seller more security when dealing with private buyers.
Another variable worth mentioning is the structure that includes equity in the buyer as part of the purchase price. In principle, this is intended to be an added incentive for the seller to receive a higher ultimate value as he and his new owner build the newly combined entity.
This piece was a contribution to the Agency Management Institute blog from Henry Corona, of FinanceSur.
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