I’d suggest a sensible way for a paid search marketing agency to charge for their services is “capped percent of ad spend.”

If you’re not someone who cares about paid search agency pricing models, this is about the right time to exit this post.

Talking Pricing

Pricing structures and rates aren’t secret in established service industries. Real estate agents get 3% to 6% of the house’s price; recruiters get 1/3 of total first year comp; trial lawyers take 33% of the settlement; list brokers charge 20%. While specifics vary, each industry has conventional pricing arrangements.

Not so in paid search management. Not yet. Not only are rates kept under wraps, as an industry we’ve not even yet converged on the most appropriate structure for those fees.

You might ask, “Why does the pricing structure matter? If client and agency deem the fee fair for work performed, why does it matter how that fee is computed?”

Incentives drive behavior, and fee structures (not just amounts) influence how a SEM agency serves its clients. When we review prior results from prospective clients looking to move their search marketing to our firm, we can often guess the incumbent agency’s pricing structure just by looking at their results – even before peeking at the agency logo on the reports.

To see why we like capped percent of ad spend, let’s consider the strengths and weaknesses of three other models: percent of revenue, percent ad spend, and flat fee.

Model #1: Percent of Revenue SEM Agency Fees

Some advertisers like paying their SEM agency based on resulting revenue. They reason rev-share will incent their SEM to grow top line, just like commissioning a sales force. Here’s our take on the downsides of rev-share SEM fees.

First, under this approach, the SEM could earn the bulk of their monthly fee via sales on the client’s brand name. The SEM didn’t create the client’s brand equity. These sales don’t reflect the SEM’s effort, and brand search is often non-incremental – so why should these brand clicks drive the invoice?

Another problem with rev-share fees: order allocation. Here’s the scenario. Searcher clicks a paid link to client’s site, doesn’t buy today but instead signs up for client’s email list, then buys two days later from link in first email received. If the SEM and email agency are using different tracking cookies, likely both will “claim” that order. Now, whether that PPC click or that email should get credit for that order is an important and subtle marketing question. (Aside: a major cataloger mentioned to me last week that a whopping 96% of their web orders involve customers with recent marketing touches in two or more channels: catalog, search, email, affiliate, print, list rental, etc). It is hard enough for an agency to help clients suss out multi-channel allocation, and I’d suggest an agency can’t provide impartial guidance on this critical topic when their comp depends on the outcome.

Yet another problem with rev share: no economies of scale for client. When revenues double (think Christmas), the agency’s fees double. In most cases I don’t think that’s right. (You’ve probably guessed by now my resume has more years on the client side than on the agency side.) The agency doesn’t cause Christmas. So why should the agency earn double fees in November and December? Like a cataloger amortizing printing press make-ready fees over larger print runs, online advertisers deserve some economies of scale from their partners. Heck, given the rising cost of clicks and the new postal rates, direct marketers often require favorable economies of scale to stay afloat these days.

Rev share encourages SEMs to act like affiliates (stifling data sharing), and rev share can lead some agencies to “skim” (only tackling low-hanging opportunities) – but let’s move on.

Model #2: Percent of Ad Spend SEM Agency Fees

Some paid search agencies bill clients based on a percentage of their SEM advertising spend. Rates range from 5% to 20% of spend.

Percent of ad spend fixes several of the problems discussed above. Search costs are pretty unambiguous, so order allocations don’t impact the agency’s fee. (Advertisers: if you’ve not done a PPC cost audit and a PPC sales audit recently, do so.) The client’s brand name and trademarks, while responsible for a large chunk of tracked sales, usually comprise a modest chunk of PPC ad spend, so that mitigates the brand name problem discussed above. And Percent of Ad Spend billing should incent an agency to build out and maintain a robust keyword and copy portfolio, capturing value from the long tail.

But Percent of Ad Spend isn’t perfect. As with the Percent of Revenue model, the client doesn’t enjoy economies of scale. While holiday sales typically soar faster than holiday ad costs, many clients will still get hit with super-sized SEM invoices in November and December. Does this reflect more work on the part of the SEM? Somewhat – campaigns do need closer attention during the holiday madness, due to stock-outs, shipping windows, and competitors’ actions. But has the agency’s actual work increased as much as the ad spend? Nope.

For many advertisers, the glaring flaw with Percentage of Ad Spend pricing is that it incents the SEM agency for spending the advertiser’s money regardless of results. Point well taken. We’d suggest that if a SEM agency isn’t hitting mutually-agreed-upon performance metrics – that is, if the agency is failing to keep the ad-to-sales ratio within acceptable limits, or is failing to stay within budgets, or is failing to meet sales commitments, then the client should simply dismiss the agency. Advertisers, give an underperforming agency two weeks or 30 days to remedy, and if they can’t get their act in order, exercise your out. We recommend SEM contracts have 15 or 30 day outs for this very reason.

For the agency, pure Percent of Ad Spend fees can pose a downside risk if the work is too great and the fee is too little. Some SEM clients demand/require considerable effort managing modest PPC budgets. Examples include B2B clients in highly specialized verticals, or national specialty store retailers running numerous complex local campaigns in hundreds of geographies.

Model #3: Flat Monthly Fee

This is the simplest model: the client pays the agency a consistent flat monthly fee. Don’t laugh – this is the structure in use when advertisers choose to manage paid search in-house. Salaries for in-house PPC staff, accompanying benefits, bid management software – those are essentially flat each month, regardless of ad spend or sales.

Simplicity is a key advantage to the flat fee approach, and it certainly provides the advertiser economies of scale. But it has disadvantages. Going into the deal, neither agency nor client has a firm sense of the true work required. One side is likely to guess wrong, leaving either advertiser or agency disgruntled about pricing. And certain agencies might view a flat fee as a disincentive to hustle. But as above, fast-out clauses ensure clients stay satisfied.

Model #4: Percent Ad Spend, Capped, with Fast Out

We believe Percentage Ad Spend, Capped, with Fast Out offers the best pricing model for SEM management. Client pays agency a monthly management fee calculated as a percentage of ad spend. Client and agency also agree on a monthly minimum fee cap to protect the agency if the ad spend is very small, and a monthly maximum fee cap to protect the client if the ad spend is very large.

Choosing different values for the min cap, the max cap, and the percentage allow agencies to signal potential clients where they’re positioned in the market place. For example, dividing the monthly min cap by the percentage yields the typical minimum suggested monthly ad spend for target clients.

We’ll Show You Ours If You Show Us Yours

We’re not really sure why our industry is so secretive about pricing. We don’t have problems sharing our rates. (Perhaps we’ll start a trend?) If useful to readers, our standard SEM pricing is $3000 / 12.5% / $9500, per site per month. The monthly cap goes higher for highly complex retailers. NB: this pricing is now out-of-date, our current pricing can be found here.

Want to share the structure and parameters of your pricing? Please chime in on the comments.

Of Course, Don’t Buy SEM Services By Price Alone

Agency fees are clearly not the most important aspect of picking an agency. What matters far more is performance. Compared to an average agency, a great agency can often produce double digit increases in profitable sales, just by building better campaigns and managing them better. For most advertisers, a difference of a few thousand dollars in management fees each month is completely dwarfed by your Google bill, by your resulting sales — and by the gain in profits you could realize from well-built campaigns and smart bidding.

So SEM fees aren’t the most important thing. But their size and structure do matter, both to client and to agency.

(this article republished from Search Engine Land earlier this week)