The Capital Formation Process of Professional Service Firms

One hundred dollar bill distributed among five phases.

The Capital Formation Process of Professional Service Firms

One hundred dollar bill distributed among five phases.

Professional service firms need capital to scale, as do product companies. However, the capital-formation process used by a service firm is different than the one used by product companies.

Why should founders of boutique professional service firms care about this distinction? Founders of service firms who do not pay attention pay a dear price. For example, founders dilute their ownership stake more than they should. And when they exit their firms, their payout is less than they had hoped for. They often enter partnerships that are very difficult to get out of if the need should arise. And many others.

 

Capital formation is a fancy term but the definition is simple. It is the process used by a company to create the funding to start, scale, and exit a firm.

Professional Service Firms: A Unique Capital-Formation Process

Founders who go through a capital-formation process can expect a demanding and long path. However, those demands and processes are not the same between product-based firms and professional service firms. The following is an overview of the process of capital formation for professional service firms.

Step 1 – Pre-Launch Capital:

This is a grit phase. An aspiring founder is employed full-time for a company and works a side hustle as a 1099 contractor serving a small number of clients. She uses extra cash saved as capital to provide the runway to quit the job and make the side hustle the primary job.

Step 2 – Launch Capital: 

The founder has moved the capital generation beyond himself; the founder uses an anchor client who commits to a “large” project. The cash flow from the large project is used to hire employees and launch the firm.

Step 3 – Growth Capital: 

The founder uses debt to fund the working capital needed for growth and to deal with the unpredictable revenue stream of a young boutique professional service firm. This often begins with credit cards and progresses to real estate lines of credit, then eventually to a personally guaranteed small business loan from either the government or the service firm’s bank.

Step 4 – Scale Capital: 

The founder uses the free cash flow from operations to fund the scale of her boutique. The firm is generating enough free cash flow to fund expansion, and the founder is disciplined enough to pour the cash back into the business.

Step 5 – Exit Capital: 

The founder taps into institutional capital for the first time to fund his exit. This comes from a strategic acquirer, a financial acquirer, or a lending institution. The funds are used to buy out the first generation of leaders and support the next generation of leadership.

Professional Service Firms vs. Product-Based Firms: Important Differences and Distinctions

The primary difference between a service firm and a product business is the founder of a service firm takes institutional capital only at the end (exit), whereas a founder of a product business takes institutional capital in the beginning and at every step along the way. Why? There are several key reasons why the capital-formation process varies between product-based firms and professional service firms.

Difference 1: 

In a professional service firm, the founder provides the pre-launch capital himself. A founder of a product company, in contrast, would raise money from friends and family in the pre-launch stage. Why? The amount of capital required for a product company in pre-launch exceeds the founder’s ability to self-fund. The capital to hire employees, buy technology, develop a product, and fund the initial overhead can be too significant of a hurdle for a product company to generate itself.

Difference 2:

An anchor client provides the launch capital for a professional services firm. A founder in a product company, in contrast, would raise money from a seed-stage venture-capital firm. And the reason for the difference is the same—the capital intensity of a product company is much greater than a service firm. Therefore, a founder of a service firm has a big advantage in that she does not have to dilute her equity percentage by taking on venture-capital funding.

Difference 3: 

In a professional service firm, the founder provides the growth capital himself. He does this by borrowing money from credit-card companies, mortgage companies, banks, or the government. The founder personally guarantees the debt, exposing himself to financial risk if the firm fails. A product company founder, in contrast, raises a Series A round of growth capital from a venture-capital investor. Rarely does the founder have to personally guarantee this funding because it comes in the form of equity—not debt.

Difference 4: 

The service firm provides the scale capital itself. Therefore, the time it takes to scale a service firm is constrained by the amount of free cash flow generated. In contrast, a product company can scale much faster because it is using institutional money and is not constrained by free cash flow. However, the founder becomes a minority shareholder in the process.

A Similarity: 

An institution provides the exit capital in both professional service and product-based companies. This is the only stage of the capital-formation process whereby there are similarities between a service business and a product company.

Professional Service Founders Need to Begin with the End in Mind

The most important thing for founders of boutique professional service firms is to not make an irreversible mistake. Many founders are first-time founders and, therefore, do not know what they do not know. When faced with a need for capital, they follow the advice given to product companies, and this is very costly.

For example, raising money from an institution early means giving up equity much too soon and, consequently, at a big discount. This equity will be worth much more later on. This mistake destroys wealth. Why do founders of pro serv firms make this mistake? They do not know any better.

Hopefully, this advice from an experienced founder will prevent this mistake from happening in the future to you. Take a deep breath and carefully study your capital-formation plans, making sure you’re considering your downside protection and how to manage the upside.

Episode 109 – How To Avoid The Devastating Fall Out Of a Botched Reorganization Inside of a Professional Service Firm – Member Case by Mike Desjardins

The design of your boutique’s organization can either aid or hurt a successful exit. Any astute buyer will factor this into their decision-making. This is why simple integrations are attractive. They are cheap, quick, and have a high success rate. On this episode, Mike Desjardins, CEO at ViRTUS, shares their firm’s best practices for a successful reorganization, including the much-awaited backstory of how his team redesigned key roles to keep their top individual contributors.

TRANSCRIPT

Greg Alexander [00:00:15] Welcome to the Preserve podcast with Collective 54, podcasts from founders and leaders of boutique professional services firms. For those that are not familiar with us, Collective 54 is the first mastermind community dedicated exclusively to helping you grow, scale and maybe someday exit your boutique pro search firm. My name is Greg Alexander. I’m the founder and I have the privilege of being your host today. And on this episode, we’re going to talk about organizational development, but we’re going to do it with a twist. And the twist is what to do when you have a top performing individual contributor and you promote that person into a supervisory or managerial job. And for whatever reason, it doesn’t work out. And you’ve got to bring that person back into the fold. And the tricky situation to handle. It’s one that our members deal with a lot. It’s a common issue, and we hope to give you some insights as to how to handle that. And we have a wonderful role model this week who has firsthand experience with this. His name is Mike Desjardins, and that was my best French impression. And he’s a member of Collective 54, and he’s going to share his his wisdom with you. So, Mike, it’s good to see you. Welcome. 

Mike Desjardins [00:01:43] Yeah, thanks. Great. Thanks for having me on. 

Greg Alexander [00:01:45] Would you mind introducing yourself and tell us a little bit about your firm? 

Mike Desjardins [00:01:50] Yeah, sure, I’m happy to do so. So my name’s Mike and I live in Vancouver, B.C., Canada, and the firm is Vertis and we’ve been around for 22 years and our focus is 90% on leadership development for medium to large enterprise. So and I’d say medium to large enterprise for us is about 100 million in revenue. That’s usually when a client hits that number where they start to the issues around leadership development that are at the scale that that we operate at. And then 10% of our work is in strategic planning. And that is we do obviously executive team development. So we also work with those executive teams in doing their strategy work as well, which is an annual and quarterly cycle that can go on for 10 to 15 years. 

Greg Alexander [00:02:40] Okay, got it. Very good. So as I mentioned, I set up the problem with this promotion of these individual consumers, and I just had a little bit more color to that. You know, we serve entirely boutique professional services firms. And I should I should define that as you have defined your medium size companies. For us, that means more than ten, but fewer than 250 employees. And in that single industry of professional services, that’s the reason why the number 54 is in the name Collective 54. That’s the industry code for pro serve. And people join professional services firms for careers, not jobs. They they value their expertize. They’re motivated intrinsically by things like the job content, the intellectual stimulation, the variety of the problems they may get a chance to solve, the types of people they’ll meet as very, very specific type of person that joins. And it attracts folks that are driven by competence and achievement and they excel at individual achievement. And then when a firm scales, which is what you’re doing, what most of our members are trying to do. The Law of numbers says is we got to promote some people. They get promoted and sometimes it doesn’t go so well. And then we’ve got this issue where we have this almost demoralizing effect on, unfortunately, one of our stars and we get stuck and we don’t know what to do with it. So my team told me that you are the master at handling this. So I’m on I’m on the edge of my seat. 

Mike Desjardins [00:04:19] I may have misspoke. I think it would be closer to the truth is that I screwed this up and recovers. And so I have a story to share. I think that’s closer to the truth. All right. 

Greg Alexander [00:04:31] Well, let’s hear the story. 

Mike Desjardins [00:04:33] And so yeah, the story is, is that I have a team member who is an executive who I have worked with for over 20 years now. And she’s been with me from almost from the very beginning of the business. And her name is Shannon and she is her title right now is director of Learning Strategies as a business group. One of the things that I read was EOS traction. And through reading about U.S., I learned about an integrator role, which effectively is a chief operating officer role. And I started thinking about restructuring the firm in a way where there was a single person in this integrator role. And to me, that logically is Shannon. Now with Shannon, I thought, well, she did great in the integrator role. And I started thinking about the structure of the business and thinking about how well-respected she is in the business. And I thought, you know, everybody would love to report to Shannon. She’s fantastic. And so she moved from having two direct reports to having really effectively almost all the direct reports except business development and accounting, the controller. And so I figured this would be great. She’s going to love this. And as I started chatting with her about the future of her career and what she wanted, she started saying to, I think what I really want is no direct reports. And I love to really focus on being a director, but focus on the future of learning for the business. And that will take me all of my time. And right now I get I sort of get pulled into projects, and I also have. I also direct reports. And so I don’t really get a lot of time to spend on our strategy and on what the future learning is going to look like. And I think that to really achieve this ten-year strategy that we had set out, I need to be able to focus on that. And so in my infinite wisdom, she went the other direction and convinced her that no, she would be great. 

Greg Alexander [00:06:40] Of course she did. Class. I got to go out there. 

Mike Desjardins [00:06:44] And, you know, offer her the salary and all that kind of stuff to go with it. But what I said to her was, Listen, I think you’re going to be amazing. I know that everybody in the company would love for you to be in this role. And would you be willing to give the role if jobs for six months? If it doesn’t work out. We’ll go back. We will restructure the company and we’ll figure out something different for you. But it won’t. It won’t harm you. You’ll be back. You’ll be financially in the same position you’re in right now prior to being promoted. And and we’ll figure out what that structure is going to be if it doesn’t work. In my mind, I’m like, this is just she’s going to love this. It’s going to work great. I think one of those classic entrepreneurial mistakes that that can get made equally when there’s we’re thinking of profit sharing programs or equity programs. Right. As an entrepreneur, I think about it from my lens. But the reality is that isn’t empathizing with what the other person wants. And in this case, I did the same thing with this promotion. So Shannon got four months into it and we were sitting down for lunch and you know, how’s it going? You know, this is a on I’m. She’s like, I don’t like my life right now. So my grand plan wasn’t working out the way I expected. And I said, Oh, okay, like, what’s going on? And she’s like, I’m back and I love the people I work with and but I’m back doing more of the things that don’t really bring me joy. What brings me joy is working on the future of this business and the strategy, and I’m not getting time to do that. And so, you know, I’d really like to take you up on your offer. I know it’s not six months yet and it’s only four months. And I said, no, I think it’s been long enough for you to figure out whether or not this is the right fit for you. And so I said, okay, well, how do we structure this team? So she and I work together on a newer structure that had her as director of Learning Strategies and had one of our returning teammates who was coming back from maternity leave. After a year, we get a little bit longer in Canada than kid in the States. And we said, okay, well, why don’t we make that role? Director of People in Operations. And her name is Nadia. And so Nadia will roll up the content team and the project management and logistics teams will report to her, and that will free up Shannon to be able to focus on actually on our learning strategies and on this future scale mode of our business, which there is a lot of work that we still have to do on that. And so we did that effective October 15th of 2021. So it’s been a year and almost a month of that structure in place. And what I can say to you is that. What ended up happening is Shannon has dotted line responsibilities to the content team that used to report to her, but she is able to focus on building out the future of the business. And that’s what her day to day looks like. Researching what’s happening in adult learning, researching what’s happening in e-learning and blended learning, and slowly helping to convert what we’re doing into a model that we know will scale more effectively and and also fits really does fit the needs of learners today, particularly post-pandemic as a result of what’s happened and the changes in how people are wanting to learn. It’s quite different than it was prior to March 2020. And Nadia, who’s in her role, is thriving and the team that reports to her loves reporting to her. And so yeah, so it’s actually worked out really well. It’s just worked out differently than I would have expected. And we ended up promoting some people as well. As a result of this change in strategy and a change in approach to our organizational structure. So that’s why I say I would love to take credit for this being some sort of grand plan. I’m definitely not the master, but we kind of scaled our way or I failed my way through it and with Shannon empathizing with me as I had my grand plan and it didn’t work out, we were able to make that change. And then ironically, we put it in an equity based compensation strategy this past June, which level sets everyone’s compensation mark to market every June. And for Shannon, her salary went it went back down when she took the role, but then it went right back up to the level that she would have been asked as the integrator. And so it took a little bit of time for that to happen from October to June when we did that. But when we went to market to look at an individual contributor director role and her salary was actually the same salary it would have had with the direct reports as an integrator in a different capacity, more of a chief operating officer versus director of strategy and saying that’s to bring you full circle of how that worked out. It worked out great for for Shannon, it worked out great for ViRTUS and it ended up working out great for me as well. So yeah, that’s the that’s the full story. 

Greg Alexander [00:11:51] And worked out great scenario. 

Mike Desjardins [00:11:54] Yeah. Well, right. Sorry for Nadia. Which is why it worked out great for ViRTUS too. So it worked out great for Nadia. She’s just thriving in her role. And then a few other people got promoted as a result of this whole structure change. So, you know, it’s another good lesson. Great for me. I can always have these grand designs of how things are going to work out. And then I go to the team and I ask them about what that’s actually going to look like. And sometimes they just tell me like just plain no. Yeah. And when enough people say that to me, and particularly people that are senior and tenure, then it’s important for me to really like listen and try to understand why they they feel that strongly about this. 

Greg Alexander [00:12:37] You know what strikes me about that story and thank you for sharing that. It is a fantastic story and a great use case is obviously you and Shannon had a fantastic relationship built on trust because sometimes when this happens, the person who gets promoted, they don’t feel comfortable sharing with the boss, for lack of a better term, that maybe this isn’t exactly what they want to do. It comes usually with an increased responsibilities and compensation. So they get excited about that and then they take a job, right? And then it doesn’t work out and they feel like they’re failing. And instead of raising their hand and saying, Hey, I want to go back to the old job or let’s reorg around a new job. They leave the company and we’ve been dealing with now it’s changing. It’s moderating now, thank heavens. But we were dealing with this great resignation where a lot of people lost a lot of employees during this time. And sometimes, like, I would call that a an unforced error. Right. I mean, it’s like that was avoidable, I should say. And how did you develop this relationship with her and the culture of your company that we’re. It tolerated the experiment. It didn’t work out. No one’s feelings or egos get bruised and you were able to pivot to a new solution. 

Mike Desjardins [00:13:53] You know, I think it’s really taken a village to build to build this culture. And. We we really ought. Brené Brown talks a lot about vulnerability. And in that she’s really talking less about rampant self-disclosure and more about authenticity and transparency. And and we’ve had that in this business the whole time. I think, you know, when we hire, we’re really careful to hire really smart people who are emotionally intelligent and have these qualities that are they’re great to collaborate with. And we’ve run an open book company since 2008. So other than exact salaries, everybody has every other piece of information about this business. So it’s really kind of baked into our culture to have these types of open conversations. And what I’ve noticed it’s happened as a result of that is that there’s really no surprises, right? So when somebody has a review, they’re not surprised by the review because we talk about feedback pretty openly all the time. I think. Inherent in the fact that we’re a leadership development company. If we weren’t doing this and we didn’t have a great culture right. It would be ironic if we were out in the marketplace talking about how leaders should show up. And so I think it’s deliberate. It’s a choice that we’ve made, and it hasn’t hurt us. I can’t think of a scenario in the past where being this way has been to our detriment. Now it means people have their tenures here, and but a short period of time working here is five years that’s growing fast. Whereas I have there’s team members that have been here like Shannon’s 20 years, 12, 14, relatively long period of time. We’re growing now. So we have some, some new people that are joining the company. And when we hire, because we’ve been around for a while and we’ve had these longer term relationships, we take quite a bit of time to get to know people in advance because we’re thinking about this as a long term relationship. When somebody joins our team, we’re not thinking about like, let’s see how it goes over the next couple of years and we’ll see where things are at. We are really thinking long term. 

Greg Alexander [00:16:04] And the candidates that you’re interviewing, are they thinking long term as well? And how do you how do you judge that in an interview setting? 

Mike Desjardins [00:16:10] I mean, it’s hard, right? Like I. It’s hard because you could say, oh, look at somebody’s LinkedIn profile or look at their resume and have they moved around a number of times? That’s not fair because I think, you know, I look back at where like I turned 50 this year, so I look at where I am right now in my thought process and my decision matrix and and how I think about life. And I think back to when I was 25 and my priorities and my values have shifted as of aged and I’ve had experiences which have helped me to figure out what I want. Now, luckily for me and I only really had two main jobs in life so far away, like I was with a group of companies from 18 to 28, and then I did this from 28 to today. So but not everybody had that. A lot of people are people are trying to figure out what it is their career is going to look like. And they may have to go through different jobs and different companies to sort out what that’s going to be. So I think it’s less about. It’s less about trying to determine whether somebody is interested in a longer term career, and it’s more about creating a culture where that happens. And that’s the decision that we’ve made, is less about trying to figure that out on intake, but instead provide a culture in an opportunity where people actually really do want to stay and grow their careers here. When people have laughed and they’ve laughed and said, a lot of the times are really sad to be leaving, they don’t want to go. But maybe our company isn’t growing as fast as they want to grow. And so even though they’ve been here five years is an opportunity and I’m excited for them because I think that is an awesome opportunity and we don’t have that opportunity here so I’m pumped. There is something like that available and so we would kind of refer to people as alumni and we’re excited that they’re out there in the world doing great things and that we got this unique opportunity to work with them for whatever period of time. We had a chance to do so. 

Greg Alexander [00:18:09] Yeah, that’s wisdom there for sure. Let’s come back to Shannon. So the professional services space is one built on apprenticeships. So junior people learn from senior people and then they kind of move up along the way through the apprenticeship model, at least historically. That’s how it’s been done. So our members are more than likely going to fill the promotions that become. Get created because of the growth with internal promotions. It’s a grow your own model, which works really well in the context of a professional firm. So there’s those that are listening right now that are going to want to go promote somebody internally, much like you did with Shannon. And looking back on it now, a year later. You know, what would you have done differently? What lessons would you want to share with those that are getting ready to go promote their Shannon’s today? 

Mike Desjardins [00:19:09] You know, I think my mentor, Walter, actually said something to me in as we were talking about this and reflecting on this. He’s mentored me for the past six years, and we were chatting about this exact scenario and he said, you know, the learning here is when people tell you what they really want, believe them. 

Greg Alexander [00:19:27] And they’re telling the truth. 

Mike Desjardins [00:19:29] And part well and part. Yeah, well, they’re telling their truth. Right. And park what it is that I would want if I were in them because that doesn’t matter. Now there is, there is a piece of it where. So here’s the piece where I think it’s challenging. The balance of that is sometimes I will see people and I will see some that they are capable of, something they haven’t seen yet. And so they might not like. So for Nadia, Nadia was coming back to come into a program designer role. And but Shannon and I in chatting saw she could come back and the director role sounds like she’s the chief the next most senior person here. So why would we why wouldn’t we offer her this director of people in operations role? And she’d be fantastic at it and she’s ready to take that step. And so we went to her saying, Hey, we think you’d be amazing at this job. And and so sometimes it’s it’s it’s seeing the to for people and what they could grow into. And but the flipside of that, of course, is the situation I ran into with Shannon where I, I wasn’t hearing her and I was thinking too much about what I would want if I were her and and why it would be such a great role for her as opposed to really deeply empathizing with what she knew she truly wanted. I think that’s the lesson, is that there’s always going to be this balance of trying to do both, right? Like help somebody along who you might think isn’t, like, ambitious enough for what you see they’re capable of. But tempering that with really hearing them when they say what they want. 

Greg Alexander [00:21:17] Yeah, for sure. You know, when we have our Friday member Q&A with you, they’re going to ask a lot of questions about this and and the way you set up the what I would call a job trial. You know, you said let’s try it out for six months and and how you monitored that, etc.. So it’s just a it’s a great use case. It’s a very real issue for our members. So thanks for being on the call today and for sharing your story. And my pleasure. It was very informative. Thank you. 

Mike Desjardins [00:21:44] Yeah. I appreciate being on. Thanks. Great. 

Greg Alexander [00:21:46] All right. All right. So if you’re listening and you’re a founder of a or a leader of a boutique processor firm, and you’re not yet a member and you want to meet great people like Mike and learn, you know, around stories like this one. Consider joining Collective 54 and you can apply for membership on our website, which is Collective 54 dot com. If you’re not quite ready to join, but you want to educate yourself, we got lots of resources called Collective 54 Insights, so podcast benchmarking data, a blog or a book, etc. And you can also find that at Collective 54 dot.com. But thanks for listening and I’ll see you on the next episode.