Over the last twelve years, I’ve had the opportunity to get a behind the scenes look into many different professional services organizations. A couple of them being ours - but a lot of them consist of partner agencies around the country (and sometimes the world). There’s a common theme I see repeated across many different agencies. It commonly comes in two forms, but it all comes down to a desire to transition the agency business from “trading time for cash” to a revenue model that looks more like recurring revenue and/or equity value that achieves higher multiples on exit.
The two most common versions of this are:
We started the consulting company to bring in revenue until we could develop product internally. Once we find that product (or products), we will stop consulting.
We do consulting, sometimes for cash and sometimes for equity.
This is a post about why these are terrible ideas. I’ll dive into what we’ve learned (mostly the hard way), and what you can take from those lessons if you run a professional services firm and you’re thinking about how to make this type of transition over time.
When we started DeveloperTown, the original idea was to work with startups (SaaS companies specifically) for a mix of cash and equity to help them build and launch products. One of our original tag lines was “We are your technical co-founder.” The original vision around compensation was to get enough cash in the door to cover payroll and take any margin/upside within a deal in equity value.
For example, let’s say a prospect shows up, and we estimate the work to build their product at $100k “retail.” If a typical consulting organization is targeting 30% margin, then you’d expect roughly $70k of that work to be COGS, and $30k of that work to be profit. In that example, we would have gone to the prospect and said to pay us $70k in cash, and $30k worth of equity. The final numbers/math could vary, but the idea was to bring in enough cash to make payroll on our end while building real equity value.
At the same time we were doing this mixed cash and equity deals, we were also exploring internal products that we could build with “bench time.” We’d have monthly pitch nights, occasional hack-a-thons, and we’d try to treat internal products like clients in most ways. We shared economic outcomes with employees for both client equity we picked up, as well as any equity value created by internal product development. If any one project “made it” - either client or internal - then all of our employees would win as well.
After working in this model for a couple of years (and failing for numerous reasons explained below), we decided to pivot and started doing more work for cash. You know - like a normal rational consulting company. It turns out, once we started doing that - growth came more easily and we were finally able to start to make the strategic investments we had been talking about for years. Once we focused on building a profitable and successful consulting business - we finally had excess capital to invest in building new SaaS businesses of our own. Or if the right outside investment opportunity came along, we could finally write a check as an angel investor.
Here’s what we learned…
Your agency is worth more than you think.
There are a lot of people who run professional services organizations who think of them as lifestyle businesses. They don’t think they can truly grow them, and even if they do - they also don’t think they can sell them. This is incorrect thinking. Now don’t get me wrong… it’s unlikely you’re going to build the next Accenture. And it’s very unlikely you’ll ever exit a professional services business for any more than 1x to 2x revenue. But you can build a real business (not just a lifestyle business) and you can sell it for real value.
I’m 100% confident that the DeveloperTown partners could sell DeveloperTown today and retire. And that’s with numerous other partners and shareholders. We also aren’t that big. If you think of and treat your professional services business just like you would any other business - and don’t ever think of it as a lifestyle business - you can grow something great and create life changing economic outcomes for the people involved. It doesn’t “have to be more” than a professional services business. In fact, if you want it to be “more” than that, you’re likely best served to shut it down and go start the business you really want to start. Only run an agency if you want to build a kick ass agency. Then invest in it, grow it, and someday sell it.
Internal products and equity deals screw up your KPIs.
If you’re trying to build a profitable professional services business that’s worth money someday when you exit - you’re going to need to monitor and manage the same KPIs that the “big boy” consulting companies like Accenture and Deloitte track: utilization, realization, efficiency, turnover, customer concentration, AR aging, etc. (A great book on this topic - The Art of Managing Professional Services by Maureen Broderick.)
When you work on internal projects, you completely crush your KPIs. Unless you’re using bench time (Don’t! - see Bench code is crappy code below), it means you’re giving up billable hours to work on that internal project. And if you’re doing an equity deal, you have to provide some “market” value math after the fact to get your KPIs to actually work. Having tried to do that corrective math a number of different ways, there are flaws with all of them - because at the end of the day they don’t actually represent fair market value for those “invested” hours. The only actual value you can assign that can’t be argued with is the cash value of those billable hours.
If someone is working on an internal project - is that bench time or billable time? If it’s considered billable time, when you look at your utilization at the end of the year, what does that number represent? Does it mean your sales team is full of rock stars because anyone on the bench got put on the internal project? If it’s not considered billable, were you bad at sales because you decided to invest? How bad? It ends up forcing you to question every hour that ends up getting logged to that project. What was the opportunity cost of a resource that could have been sold to a client, or a project that was missed due to lack of availability - because those resources were considered “booked” on the internal project?
It can make it more difficult to set clear client/project priorities.
Related to messed up KPIs, what’s the impact on how you set priorities internally for which projects and/or clients are most important to the firm? Here’s a couple of classic examples of how most consulting companies encounter priority conflicts:
You have two existing clients who need design help on their current projects, but you only have one designer available right now. Which client gets that designer?
You have two prospective clients who both need a team of three front-end developers, but you only have four developers. Which potential engagement is more valuable to the firm?
You have two statements of work that were signed at the same time for full product builds, but to do them both - you need to pull a resource from an existing client project - slowing down that client’s velocity. Which client do you pull that resource from to be able to kick off the new work?
Normally, when a consulting company is faced with these constraints, they have heuristics for how they resolve them. The types of factors that are typically considered can include:
How long have all the parties involved been clients?
How much are the bill rates for each client?
What’s the total annual spend of each party involved?
What’s the future project potential of each party involved?
How strategic is the project work to our future portfolio of clients we want to build? (Things like industry focus, technology specialization, etc.)
How much trust and transparency do we have with the clients involved?
Internal projects complicate these heuristics. Does the internal project always lose in these situations? If that’s true, what message does that send to the team about the importance of that work? Does the internal project always win? If so, what message does that send to the team that’s not working on the internal projects? Is their work (which pays the bills) less valuable? Who represents the internal project in these discussions? The CEO who might also be the salesperson who sold the new deal? A project manager or product owner who likely reports to the CEO who sold the new deal? As you can see… even if the debate is healthy and well intentioned, there are several conflicts of interest that emerge. And those decisions - while valid business decisions - might send a different message to the team who’s staffing the various projects. A message you didn’t think you were sending.
Bench code is crappy code.
For a number of reasons, the code written by resources “on the bench” - consulting slang for employees not currently assigned to billable client work - is often low-quality code. This can be for a number of reasons - and often you’ll see more than one of these reasons in play at any given point in time.
Your less skilled and less experienced team members often find themselves on the bench more often than our most skilled and most experienced resources. Just like a basketball coach, your “starters” are your best players. They get put on your highest value clients. The folks left over - more often than not - are the folks who are hard to place on projects for some reason.
Consulting companies use internal projects as “learning projects.” New to React? Cool, why don’t you learn by writing the new React interface for this new internal product we are building? Do we have a client who’s paying us a discounted rate because we have equity in the project? Cool, let’s put Patrick on that project. He needs more experience with Node and he’s on the bench anyway. We can rationalize this to ourselves by thinking that since it’s a discounted rate, we don’t need to be as effective as we’d normally be.
Do your internal projects run with all the same rigor you apply to client projects? The same project management? All the same tooling? All the same peer review processes? Pair programming, the same account reviews, and the same documentation around deliverables? Maybe you’re good at doing all of that - we were not. This is a classic cobbler's children situation. Some of the best software development companies in the world can write some truly horrendous software when they do it for themselves. To most of us, it’s obvious that our client projects need discipline and process. But us? Pfft. We know what we’re doing.
If you’re deciding to make the investment into an internal project - make it a real project. Give it to a product owner whose job is to act like the client. Do all the things you’d normally do to make a project/product successful. It’s okay to have younger and less experienced team members on the project, but just like you would for client engagements - surround them with your most experienced folks who can coach and teach them.
The haves and have nots, and the “bait and switch.”
In the early days of DeveloperTown, we told new hires, “Sometimes we work for clients, and sometimes we build our own things. You should join DeveloperTown so you can do both!” What I feel like those employees often heard was, If I join DeveloperTown, I’ll get to work on internal projects while other people - who aren’t me - work on client projects.
Now, I don’t think anyone actually thought that. But it’s hard to not feel like you were sold a bill of goods if you’re the employee who’s been doing billable client work for twenty-four months, while other people were given the opportunity to work on internal projects. It’s difficult to balance who will work on what. Maybe you’ll be more consistent in finding a way to rotate folks on and off of client projects, but we found that very difficult to do.
In a consulting company, your focus should be on the core job of consulting. That means your best people should be focused on the best client opportunities. In a product company, your focus is on building great products. Your best people should be focused on your best product opportunities. If you’re a consulting company that also builds products often, where do you focus your people? How likely do you think it is that you’ll rotate people evenly across those competing opportunities?
Hidden behind all of this, you have the haves and have nots. Some of the people (the haves) get to work on the fun equity projects, and others (the have nots) have to work on those billable client projects. What does it mean to be in one group and not the other? Is one group smarter? Is one group better paid - or compensated differently? Does it create an us vs them culture? Does it create classes of team members? We made mistakes in all of those areas.
You’re not running a real diligence process.
When a private equity firm or a venture capital group go to make an investment, they don’t just look at deals that come to them. They are active in the market - looking for opportunities before anyone else gets a chance to see them. In addition, they run a diligence process on each company that ensures it meets their minimum criteria for a safe investment that’s going to get them their target returns. It’s unlikely you’re doing any of these things.
Almost all of our early investments were deals that came to us. Guess what types of founders are attracted to investment from software development firms? The founders who (most likely) can’t write code and may not be the most tech-savvy. The founders who may not be well funded enough to hire their own in-house team, who also may not be able to attract early talent to their idea. And the founders who have a great idea, but don’t know how to turn it into an actual business.
I remember a podcast interview with Chris Sacca said something like [paraphrasing], “With my early investments, I made a major mistake. I only invested in companies where I could directly make a difference in the company. I didn’t want to just be capital. I wanted to help. Most of those investments failed. I didn’t become a successful investor until I learned that I needed to invest in companies that were going to be successful despite my help. Meaning, they were going to be successful regardless of my investment and help. With the first group of companies, you have to be involved. With the second, you get to be involved.”
If you’re only taking a look at the ideas that come to you, without running a rigorous process, you’ll likely not be working on the best product opportunities. When you do get an idea for a product you like, if you’re not running a process that rejects more of those ideas than it ends up investing in, then you’re likely not working on the best product opportunities. No investment fund invests in more companies than it rejects. (Well, maybe not until Tiger.) At VisionTech - a local angel group - they look at hundreds of deals a year, and invest in only a handful. Are you putting up screening numbers like that? What’s your criteria to say no, even if you like it?
Your investment often isn’t viewed as an investment.
The phrase “work for equity” implies you’re making an investment in that client. Instead of giving them cash, you’re giving them the hourly equivalent of cash. If you invest $100k worth of work, you expect that would be treated the same as if you had invested the same $100k in cash. Often, this is not the way it works.
We had numerous cases where future investors questioned the amount of equity we picked up as part of our “work for equity” arrangement. They would challenge the value calculation we used to calculate the investment. Was that really a fair market rate? Did we really work that many hours? Weren’t we really just using people on the bench, so we wouldn’t have made money with those folks anyway? And on, and on. And there’s some truth hidden in some of these questions. Opportunity cost is a difficult thing to calculate unless you’ve been operating at full capacity for months with steady rates. And my guess is, if you’re the kind of consulting company that would look at these types of deals in the first place - then that’s not you.
In some of these past cases, we had to agree to cut our amount of recognized equity in order to attract future capital. We could have said “no,” but what would that accomplish? Does that mean the startup fails to get funding and fails? Then we’d simply own more of an asset that’s now worth zero dollars.
On the other side of the equation, you’re going to feel like you’re not getting enough equity for the risk you’re taking. You will likely be the earliest (read: riskiest) “money” into the company. You’re likely providing valuable product experience to the feature set and roadmap based on all of the work you’ve done with other clients. You’re giving up market opportunity and future growth in your core business to make this investment. Why doesn’t anybody value those things?
They do. But somewhere between 5% and 50% of how much you value them. There are a handful of ways you can try to fix this. A few times we were successful by investing actual cash as part of a formal round, and then allowed that company to purchase our services commercially. That’s better, but still has conflicts embedded. We also built out a venture studio - which allowed us to gain a much better investment return and fundamentally different co-founder status. But it also still has challenges if it’s not a completely separate business.
Working for equity breaks the client / vendor relationship - both ways.
Once you have equity in a client’s company, things get interesting. It leads to interesting changes in expectations and relationship dynamics. And it happens to both parties. Let’s list a few of the top concerns that both sides will struggle with:
Shouldn’t they get a discount on rate since you’re an owner?
Will they always get the same project priority cash-billable clients receive?
When their production is down - and you don’t normally do production support - will you do it for them?
They are out of budget, but you’re an owner - can’t you just finish this last feature?
Can you fire this client once you’re an owner? Under what circumstances? Can they fire you for non-performance?
Healthy client/vendor relationships work when both parties have a balance of power. If you’re a consulting company in high demand, you can fire a difficult or high-maintenance client and replace them with a more congenial client. If you’re paying a fair market price for the work that’s getting done, as a client you can threaten to take your work elsewhere if the consulting company isn’t delivering at a high enough level of quality or at the pace expected. These checks and balances are good.
At DeveloperTown, we do our best work for clients who hold us accountable. When we hold our clients accountable, they normally step up and fix the behavior. This is how it’s supposed to work. In our experience, all of this breaks down once there’s equity. Either difficult conversations cease to happen all together (leading to silent resentment), or they happen with a bit more passion than is called for (because someone feels taken advantage of). Services for equity will not make your performance related conversations easier.
Who’s balance sheet does this investment go on?
In both services for equity and when building in-house IP/software, you have a challenge of where to hold the asset. Do you keep it on your consulting company balance sheet? Or do you create a new entity to hold the equity? If you create a new entity, is that a child company to the consulting company (making it a disregarded entity), or is it a sister company?
If you keep it on the consulting company balance sheet (or a subsidiary company), then any assets and IP are at risk of a lawsuit to the consulting company. If the consulting company gets sued for some reason, these are assets that a creditor could then lay claim to. Conversely, if the assets created invoke IP claims (or any other legal action - just choosing that one for illustration purposes), then the consulting company is at risk in that claim since it’s an owner of the asset directly.
In addition to the legal risks of carrying equity in other companies/products on your balance sheet, how does your bank view those assets when they evaluate your creditworthiness? Do they like to see those investments on your balance sheet? Or do they view that as a potential risk? Will your bank require compiled financial statements as part of their annual credit review? What will that cost? Will the other owners of the assets be open to their finances being included in that analysis?
Finally, when you have those assets on your consulting company balance sheet, what happens when there’s an ownership change in your consulting company? Do you price in the value of that equity in the buy/sale price of your consulting company unit or share prices? Are the other owners of those assets/companies okay with those ownership changes over time? How will you value investment assets like these? How often will those valuations change?
After about four or five years of wrestling with these concerns, we figured out we should always hold these assets in completely separate companies. Each time we’d form a new company, we’d copy and paste the consulting company capitalization table as a starting point for the new company. In addition to providing separation of legal concerns and keeping the consulting company balance sheet clean, it also made it easier for us to change our ownership structures over time. People could buy in and out of the consulting company without concerns of pricing the spin-out entities, it allowed us to grant company specific stock options and incentives in the spin out companies, and made it easier for us to raise outside capital into the spin-out entities (since they had no formal legal relationship to the consulting company).
Of course, separate companies also have a downside. With separate companies, you have to deal with conflicts of interest. As ownership across companies changes over time, different people on the team will have different incentives to “back” the companies where they have the most ownership. You’ll want to attempt to keep as much parity between companies as possible - for as long as possible. While we were never perfect at this, we did work really hard to try to keep as much parity of ownership as possible in our spin out companies - for as long as possible.
Get outside investors and advisors, quickly.
One of the great things about having an outside investor is that you’ll have a fiduciary responsibility to that investor. It can serve as an excellent forcing function for you to get serious about that business. In one of the examples from our past, we had started an internal project that we believed we would eventually spin out into a separate company and monetize as a stand-alone SaaS company. While the project was an internal project, we moved people on and off the project based on bench time, other client priorities, etc. We found it difficult to give the project the focus it really needed. That all changed once we decided to raise outside capital.
Once your company has outside investors, you lose the ability to do what’s best for the consulting company. You have a fiduciary responsibility to your shareholders to do what’s best for them. This can be a fun and challenging balance to strike, but the fact that you now have to think about it - can be incredibly stabilizing for the new product/company/team you’re launching. They cease to be “fungible” resources that you can move back and forth. Investors - at least for us - were an incredibly focussing force.
You don’t have to raise outside equity to do this. We’ve also been able to earn some of those same advantages by building boards for some of our venture companies. These can be actual fiduciary boards, or just boards of advisors. We’ve found that having a handful of outside decision makers, who we respect and don’t want to let down, hold us accountable and ask really difficult questions can be a great way to add some of that same rigor without the need to raise outside capital.
TL;DR - a summary of some of our lessons learned.
We still don’t have this figured out. Building and launching SaaS products is hard. Building and launching a business is hard. But while every situation is a little bit different, here are some of the principals we try to keep in mind.
Build a kick ass consulting company first. We didn’t do anything right until we became serious about building a profitable and successful consulting company first. Once we had a stable growing consulting company that was throwing off cash, that's when we started to get serious about who and what we invested in, and how we structured it. Make your business successful before you make someone else’s business successful.
Hold the equity in a new separate company. This provides the best legal protection. It allows for easier equity changes over time (either buy/sell or stock option grants). And it will almost always be more attractive to outside investors if you want/need to raise capital. If it’s easier, you can start the company as a child/disregarded entity and spin it out with a tax-free distribution of equity. Or if you’re going to do deals like this a lot, you can consider setting up a Series LLC structure.
Unless you’re truly a cofounder, invest with cash - not services. If someone wants us to invest, we write a check. Then they can choose to hire us (or not) on the other side of the investment. This forces a couple of excellent behaviors. First, we run a real diligence process. Writing a $100k check is a very different thing than giving up margin or opportunity cost. It forces a different process internally. Structuring the investment and resulting consulting services agreement as two separate transactions also retains the client/vendor relationship. Both of these should lead to more successful outcomes for the companies you invest in. They will likely be higher quality opportunities from the start, and they will get the same treatment as your best clients.
When you do invest with cash, do it in a way that allows you to maximize your tax incentives. Many states (and some cities) have various tax incentives for investing in early-stage businesses. In some cases, there are even federal incentives (think Opportunity Zones) that you can take advantage of. It’s hard to leverage these incentives when you trade equity for services. It’s much easier when you write a check. Consider setting up an investment company for future investments. We do most of our investing these days via Start Something Ventures. But I’ve also really come to like the Service Provider Capital model as well.
If it’s truly your company, or you’re a significant equity holder - investing services might be fine. The only time we were consistently successful just investing with services was in our venture studio model. These were very specifically structured deals, selected through a competitive diligence process, and we ended up with significant equity in each opportunity. Even with this structure, we still had all the interesting “client” dynamics. But our stronger equity position did ameliorate some of those dynamics.
Actively manage employee expectations. When we hire today, we’re hiring people who want to be software development consultants first. If there’s a chance we might ask them to take a role in a future product company, great. That’s a bonus if it happens - not an expectation. And that’s a good thing, too, because it turns out that it doesn’t happen all that often. For years we made a big deal about our “family of companies” and startup equity. And in some ways, it was and is a big deal. But for most of our employees - most days - it means nothing. It took us too long to realize that we were setting and reinforcing the wrong expectations.
Actively manage conflicts of interest. Hopefully, someday you’ll find yourself with multiple companies, partners across various businesses, and employees who have worked and transferred across a number of different companies throughout the years. If you do find yourself there, it’s really rewarding. But it’s not without its challenges. In the beginning, it’s making sure that everyone is treated fairly, and no one is being taken advantage of due to a conflict of interest. In the later years, it’s more about making sure everyone understands how governance works, where they fit, and how they can get into and out of a given deal or opportunity. Get in the habit early on of talking about where conflicts of interest exist, and how you’ll handle them as you and the team continue to grow.
Good luck on your next venture.