TL;DR

• You’re not alone. Most agency owners I’ve spoken with have had a rough sales year.
• The combination of cratering expectations and interest rate hikes have changed what companies are buying (margins vs growth).
• Each industry has been affected differently. This has caused serious lumpiness in agency pipeline activity.
• The key takeaway is that clients will likely focus on expanding margins when rates are high. When rates are low, they’ll favor revenue growth. Consider adjusting your marketing and sales content accordingly.

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With the last newsletter being such a softie, it’s nice to get back into some numbers. Today I’m looking at why agencies have had such challenging pipelines lately and what to do about it.

Caution: This newsletter contains finance, economics, and a sprinkle of math. If that’s not your jam, forward it to your CFO. They’ll eat this stuff up!

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What Do You Sell?

“We sell integrated digital experiences.”

Is that what prospects buy?

Sometimes, but not if they’re a sophisticated buyer.

Ultimately, your clients are trying to purchase a path to more revenue or higher margins. Sometimes a combination of both, and maybe, as a byproduct, they’d like a bit of job security too. Executives love to use agencies as cover.

But nothing’s changed on your end. You can still deliver on all of that and more. So why’d clients pause all of a sudden?

It’s a mix of expectations and interest rates.

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Corporate Expectations

Expectations drive everything. If an executive team believes we’re headed for a downturn, they’ll pause hiring and growth plans. If they expect an economic boom, they’ll load up on financing and go all out on growth, often sacrificing significant margins.

The CEO Confidence Index is a good way to gauge overall executive expectations.

As you can see from the chart, expectations were in freefall from mid-2021 through the start of 2023. If budgets are set roughly a year out, we’d expect to see the fallout from this starting around mid-2022. And we did see a pretty sharp falloff in agency growth in 2022 from the highs of 2021 (in the download version).

Now, not every industry will react the same, and they definitely won’t react at the same time, so we’d expect a lot of variation in how these expectations altered outlooks. Add in the fact that everyone was in a mad dash to buy digital services in 2021, with spillover into 2022, and it’s impossible to tell when this shift in expectations hit a particular industry.

The best we can do is say that expectations probably weighed on agency growth starting around the second half of 2022, and we’re still working through it.

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Adding Rates to the Mix

Over the last few years, low interest rates pushed the average cost of capital for U.S. publicly traded firms down to 4%. The business world viewed this as essentially free money, and with inflation, it was.

Shortly after the inflation monster attacked, the Federal Reserve began raising rates in early 2022. Banks base their lending rates on the Fed Funds rate, so as the Fed Funds rate rose, so did the cost of borrowing. This made business capital more expensive.

The key variable that interest rates affect is a company’s WACC (weighted average cost of capital). Everyone’s favorite finance and valuation professor, Aswath Damodaran publishes a list of the cost of capital for various industries. He even updates it annually!

Here’s a look at how each industry’s cost of capital has changed from January 2022 to January 2023: Cost of capital.xls

Capital costs have risen dramatically in a very short timeframe. This is after a long period of incredibly low rates, fantastically high growth, and stellar margins. I believe the speed of this shift is a major factor in how quickly individual companies have reacted.

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The Value of Growth

I’m so glad I found this. I was in the process of modeling all this out (I spent half my Monday morning on it) and figured I should see if someone else had done the work already.

And they did!

This is an excellent article that describes the relationship between interest rates and the value of incremental growth or margin expansion.

The values he presents aren’t hard values. A 1% change in operating margins won’t yield a 5% improvement for every company, but after running a few hrs worth of scenarios, it’s close enough to call good.

What’s important is that margin improvement yields constantly higher valueations at various capital costs.

The value of growth is where the real variability lies.

Some firms will experience minor impacts, while others see more significant swings. It’s all based on their margin profile, depreciation & amortization, working capital requirements, CapEx, and tax rates.

What’s important here is that the value of incremental growth is variable and sensitive to changes in capital costs.

The entire thing boils down to the following:

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How’s This Impact Who’s Slow

From an agency perspective, I’m interested in what your clients are thinking about all this. How do rising interest rates change their decision-making, if at all?

If we use size as a proxy for sophistication (it’s tenuous, I know, but it’s the best we’ve got at a large scale), we can split the market into three segments:

If your clients are primarily small businesses (<$10M in annual revenue), interest rates will only have an effect if they’re using some form of debt financing. These will be the slowest clients to react to these changes, if at all. If you have ambitions of moving up market, then it’d be good to understand some of this. It’ll help with your positioning.

If you work with middle market firms ($10M - 1B in annual revenue), there’s a good chance most of this applies. As with most things, what used to be sophisticated financial positioning 20yrs ago has become relatively commonplace today.

If you work with large or enterprise firms (>$1B in revenue), their finance teams likely flagged this to their strategy team over a year ago. And if they didn’t, their consultants did.

Most of the agencies I interact with work with everyone from the middle market on up. I started hearing about spotty slowness late last year, and it’s slowly gotten slower since.

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Let’s Focus on What We Can Control

A lot of this slow second quarter, slow first half, and what will probably be a middling third quarter has everything to do with your client’s expectations for the future, their cost of capital, and how you’re communicating the value of your services. While expectations are improving, interest rates are expected to remain elevated for some time.

I consider factors like this and more when I help digital agencies optimize or redesign their strategies. Feel free to reach out if you’d like help optimizing your agency.

We’re back in a high-rate environment for the first time in 16 years. As your clients shift their focus toward margin protection/expansion, adjusting how you communicate your benefits might make sense. This will be more difficult for shops that sell digital marketing and design services, but it should be relatively easy for software/web dev shops.

The first step is to start having conversations with your clients about their goals and if their focus has shifted lately. Not just for their work with you, but overall as a company. Agency leaders should be doing this anyway, but that’s a different newsletter.

• If you’re getting consistent answers that your client base is focused on things like “risk reduction” or “cost control,” then take that as a sign that your target market has shifted focus. You can use their terminology to adjust your copy accordingly.
• If it’s a mixed bag, I’d take this as a market in transition and adjust early. It’ll preemptively weed out the laggards in the industry and save you from other headaches later.
• If they’re all still gung-ho on growth, don’t change a thing. Some industries are more resilient, and their industry dynamics force them to focus on growth regardless of capital cost increases.

Knowing your target market (and if you have multiple, analyze them as individual industries) and how they think about the future will help immensely. Just make sure what you learn is communicated to your revgen team (sales, marketing, account management, bizdev).

Finally, a properly designed repeatable revgen system will go a long way in mitigating some of this slowness. There are always pockets of growth. I'm in the process of rewriting our Digital Agency RevGen Guide. LMK if you'd like a copy of the new one when it's ready.

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It's Not You; It's The Market (Probably)

Hopefully this helps put some additional context around the slowness most of us are seeing. We've entered a new environment that many leaders at your clients haven't managed through before. Expect some choppiness, and be prepared to help them navigate it.

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Register for the Digital Agencies & AI Highlight Call

We surveyed a few hundred agency owners across three surveys to help shops benchmark their progress against the industry.

Learn how digital shops are actually using AI, how far along they are in implementing it, and what kinds of impacts (productivity gains, margin improvement, growth) they’re seeing.

I'll be running through the report’s highlights and then host a Q&A session on 8/31.

This event is free for those who participated in the Digital Agencies & AI survey, Promethean clients, and Bureau of Digital members, or you may purchase a ticket for $199 to access the event and the final report.

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Fueling Your Agency’s Growth: The 2023 Digital Agency Industry Report

I'll be chatting with Corey Quinn Thursday 8/17, about some of the key highlights from the 2023 Digital Agency Industry Report. Then we'll have a brief Q&A session to help answer all of those burning questions you have. Make sure to register so you don't miss it!

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