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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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