Pitfalls of selling to global ad networks: The math doesn’t add up!

Global networks have shaped Indian advertising over the last few decades. Today, they cumulatively control 75-80% of Indian ad spends across all spectrums and verticals. While global alignments had their merits, times have changed. Ambitions have changed.

And most importantly, the math just doesn’t add up anymore. But we will get to that in a bit. No advertising entrepreneur worth his or her salt should consider selling their agency to a global network.

Let me show you why.

It was October 2019. I was at a dinner with Sir Martin Sorrell. Given that  Sorrell is a person of finance, I wore my investment banking hat (I was with JPMorgan before starting Gozoop), rather than that of an advertising agency founder.

We jumped right in, even before the appetisers set in. “The math just doesn’t add up,” I claimed. And surprisingly, he agreed right away.

All global networks to date follow the ‘earn out model’ for acquisitions, a model designed by Sir Martin as he built WPP (Wire & Plastic Products PLC) to become the largest advertising group, both by revenue as well as headcount.

Yes, Wire & Plastics, the world’s largest ad group was a British wire shopping basket manufacturer. But that’s another story.

While Sir Martin himself has moved on to the ‘buy-in model’ at his latest venture S4, all other networks have stuck to the earn-out model, a cookie-cutter model highlighting how uncreatively the creative industry is being run. Call it lazy, or perhaps just convenient, as the risk-reward of this model is skewed heavily in favour of the networks.

For those who like numbers, here is how it pans out:

The earn out model gives you a certain multiple based on profit margin of a business and revenue growth over a period of five to seven years.

This multiple is multiplied by the average operating profit after tax (OPAT) of the business across these five to seven years to get the valuation of your business.

Let’s understand using an example. Consider a hypothetical example where the following OPAT represents an agency’s performance over the five years since its acquisition.

The average OPAT is INR 10 crores. Suppose, the multiple assigned is 10x, at the high end. That imputes a valuation of INR 100 crores (Average OPAT INR 10 crore x 10x Multiple). Not a small amount.

But in reality, out of that INR 100 crores, the agency itself would have earned a total of INR 50 crores in PAT over the five years. So net-net, the valuation realised is only INR 50 crores, which is a 5x multiple on the five-year average OPAT. If you consider how publicly listed companies are valued based on trailing twelve months (TTM) profits, it works out to be a mere 3.6x in the fifth year (INR 50 crore/ INR 14 crore profit of year 5).

Now compare this multiple to RK Swamy’s IPO valuation at 41x. I could rest my case here.
Yes; there is a dividend payout over and above. But it is small, and post the dividend distribution tax and income tax, it gets even smaller. Please note, this is from the target company’s own profits and cash flows, not from the network’s!

Now, the above calculations represent a good case to a best-case scenario. The realised valuation is even worse for a six- or seven-year earn out or for a multiple lower than 10x. But I will leave that calculation to you.

The numbers only make sense if the entrepreneur is not confident of running her / his business long term. Given this background, receiving 50% upfront payout may be a good de-risking mechanism for the target company.

But no entrepreneur worth her / his salt who wants to run the business for the long term should sell into the earn out model. Over the eight to 10 years, the entrepreneur will make the same cash flows and yet own 100% of her/ his company. The math just doesn’t add up.

Networks will keep selling the ‘strategic’ story of global knowledge transfer, global brand alignments, best business practices and fancy yacht parties. But I will elaborate on that, as well as its cultural impact on the target company and its people, in the next article.

- Rohan Bhansali, chairman and co-founder, GoZoop Group.