The dilemma of performance-based pricing

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“What is your monthly ad spend?”

“Rs 5 lakhs”
“Ok, in that case, we will charge you 15%”
“15%! That is too high. I have never paid any agency a double-digit commission”
“Well, what will be your credit period like?”
“30 days”
“If we receive 20% as advance every month, we can get our commission down to 12%”
“Let us make it 9.5%”
“Let us close it at 10%”
“Deal” “Yes, deal!”
This is a typical conversation between an agency and a prospect.
Of course, all kinds of strategic inputs are also added, however, most conversations follow this template.

And then there are certain prospects who wish to work on a purely performance based model. They are willing to offer you the x percent of revenue instead of a flat commission percentage if you are able to drive conversions.

Most agencies decline this model as it might turn up to be a messy affair. For instance:
a) While reconciling, if there is a mismatch, whose numbers would be considered final?
b) In India, return a percentage of products is quite high. Now if a product is returned, would it counted as a sale or not?
c) What about cancellations?

b3

However, the clients who insist on a performance based model seem to be those who are just starting off with their businesses.

Why so?

Well, imagine a business which is well established and clocking healthy numbers month on month along with a robust monthly growth rate. For example, An online shoe selling company which achieves a turnover of Rs 10,00,000 in April. Every month, the business is growing by 15%. The monthly marketing spend is Rs 3,00,000 per month and remains constant.
Now let us consider Case A in which the shoe selling company is willing to pay 10% as commission on marketing spend:

Now let us consider Case A in which the shoe selling company is willing to pay 10% as commission on marketing spend:

Month Apr May June Jul Aug Sept Oct Nov Dec Jan Feb Mar
Turnover 10L 11.5L 13.2L 15.2L 17.4L 20.1L 23.1L 26.6L 30.5L 35.1L 40.4L 46.5L
Ad Spend 3L 3L 3L 3L 3L 3L 3L 3L 3L 3L 3L 3L
Commission 30T 30T 30T 30T 30T 30T 30T 30T 30T 30T 30T 30T

You can see that the agency makes a fixed amount every month: Rs 30,000

Therefore in the first year it makes 30,000*12 = 3,60,000

Consider Case B in which shoe selling company is willing to pay 1.5% of its turnover as payment:

Month Apr May June Jul Aug Sept Oct Nov Dec Jan Feb Mar
Turnover 10L 11.5L 13.2L 15.2L 17.4L 20.1L 23.1L 26.6L 30.5L 35.1L 40.4L 46.5L
Ad Spend 3L 3L 3L 3L 3L 3L 3L 3L 3L 3L 3L 3L
Earning (1.5% of turnover) 15T 17.2T 19.8T 22.8T 26.2T 30T 34.6T 39.9T 45.8T 52.7T 60.6T 69.7T

(T – Thousand, L – Lakh)

The agency in the first year makes Rs 4,35,025.

Interesting and obvious right?

Also keep in mind that 1.5% is quite conservative as we have received offers as high as 5% from established businesses.
So coming back to our original question, why do companies which are starting off are keen on offering a part of their revenue as agency earnings rather than a straight forward commission? Well possibly because they aren’t sure of how well their business would do and are quite dependent on the agency to drive business for them.

For an agency which has a strong cash flow to manage operations for the next 3-4 years, it would be quite prudent to take such bets with even newly formed companies which may hold immense promise. But once the clients reach a stage when they discover that they are paying their agency more than market rates, would they revise the payment model or continue?

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