Web consultancies pay the price

Taking just one small segment of the industry alone – consultancies engaged in the design of electronic media – it is obvious that they started off on the wrong foot and many never recovered their balance. Enthusiasm seems to have been the only criterion for many equity investors – particularly venture capitalists in the US. They wrote out fat cheques and the happy recipients had only to spend the proceeds, which they did with unseemly haste.

Businesses mushroomed amidst the euphoric dreams of the benefits that electronic media would offer. People and premises were acquired. Backroom businesses became global corporations at breathtaking speed. Small wonder so many businesses failed or were rescued from insolvency.

In 2001, the most recent year for which figures are available, the top 25 new media agencies in the UK lost £58m between them. That’s equivalent to a loss of £21,569 for every person employed. According to a survey in New Media Agencies Financial Intelligence, only one third of the 25 managed to make an operating profit, and of those only three achieved a profit in excess of £500,000.

In the UK alone, Deepend Group collapsed owing £3m, ailing Razorfish withdrew to the US, and Organic merged, and Pixelpark was shut down by its German parent Bertelsmann. Integra-Net was abandoned by its US parent and Uovo collapsed soon after being taken over by the French consultancy Fi System, which in turn closed its UK operations. Even many of the survivors remain financially stretched.

So what are the key financial rules that should have been applied? First, for any ‘people business’ start-up, it’s sound planning to expect a loss in year one, break-even in year two and cumulative profit in year three.

Expanding before this has been achieved will deny the (probably) inexperienced management the opportunity to learn the first fundamental rule: every investment needs a realistic payback.

Secondly, there are some key operating ratios that seem to apply almost irrespective of the type of people business involved. To most accountants they are obvious. To many young entrepreneurs they seem obscure. Those ratios are:

Operating profit margin – operating profit as a percentage of ‘gross income’ (revenue from clients after deducting only bought-in costs) – should be targeted at 15%. Among the new media agencies the margin averaged an astonishingly negative 31% and the worst case recorded a negative margin of 176%!

Staff costs, as a percentage of gross income (as defined above), should be targeted at 50%. Among the new media agencies the average was 69%.

Fee-earning staff (those providing time-based consultancy services to clients) should be target at 33%-40% of fees charged for those services.

Put another way, clients should be charged three times the direct labour cost. Yet, in the US, the bankrupt internet consultancy Scient had spent 94% of its fee income on paying its professional fee-earning staff. Organic had spent 74% of income on its professional staff, while and Razorfish had spent 66%.

Productivity measures are so important. Gross income generated per employee, staff costs per employee and operating profit per employee all matter.

The most productive new media agencies were generating income in the region of £80,000 to £100,000 per employee. The best in 2001 was Modem Media with £101,791. But some, like Grey Interactive and Fi System, could not earn more than £30,000 per employee. The average was £69,192.

Compare those income figures with the average staff costs and the cause of many of the problems is self-evident. Average staff costs in the period were #47,865 per head. Six of the 25 agencies did not generate even that amount of income per head from their clients, and that’s before paying for premises and other overheads. Astonishingly, 22 of the 25 agencies incurred staff costs in excess of 55% of gross income, let alone 50%.

One agency, Rubus, incurred average staff costs as high as £80,657, frittering away the benefits of a highly creditable £98,604 of income per head.

In a nutshell, clients were not charged enough and staff were either paid too much or did not work productively enough. For many companies it was all too easy because they had too much cash in the bank. Admittedly margins would have come under pressure as demand subsided and the market became more competitive, but few companies had achieved viable financial performance ratios even in the boom times.

Unlike the cash-rich venture capital funded companies, those that were funded by established commercial businesses, whether from the marketing services industry or outside it, were subject to more realistic supervision and called to account sooner. Their balance sheets were inherently weaker as their backers kept a tighter rein on what was happening to their money.

Indeed at the end of 1991, the UK agencies with the biggest deficiencies of working capital were nearly all owned, or funded, by, multinational marketing communications outfits such as Grey Global Group, Cordiant Communications Group and The Interpublic Group of Companies.

Other agencies that had been backed by commercial businesses had already been closed or restructured, but the losses were more modest than might otherwise have been the case and commercial reality has been the winner.

  • Bob Willott is chairman of consultancy Fintellect Limited.

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