This article was originally published on ReadWrite.
When I talk to founders of service firms, many of them express the same desire to me: They want to become software companies. They see SaaS companies taking the world by storm, and they wonder if they haven’t made a giant mistake not choosing that path.
They see the valuations of SaaS firms and get intoxicated by the numbers. Understandably so, with a SaaS company like Salesforce worth $132 billion and the most valuable professional service firm, Deloitte, worth $27.9 billion.
Some founders believe that service firms are more work-intensive and that somehow building a SaaS company means a better work-life balance. And there are some founders who are driven by the need for fame. They want to be commonplace names in the way that the Zuckerbergs, Musks, and Kalanicks have made headlines and had slick documentaries made about them.
However, SaaS companies are twice as likely to fail within five years, according to Professor Scott Shane at Case Western University.
The five-year survival rate of service firms is 47.6 percent, and the five-year survival rate of product companies is 23.4 percent. Founders of both service firms and product companies take a big risk when they become entrepreneurs, so it is wiser to play the odds and start a service firm instead of a product company.
In reality, and this is what I tell professional service founders, the challenges and limitations of SaaS life should put you off, perhaps for good. Consider three things before jumping into the SaaS world:
The SaaS world can be very inviting but remind yourself of the potential of your firm before you start building a SaaS company out of fear of missing out. Founders of professional services firms can create more personal wealth than their counterparts in product companies. The reason for this is the impact of capital intensity.
For example, let’s say two friends, Sue and Kim, start companies at the same time. Sue starts a consulting firm, and Kim starts a software firm. Sue does not need to raise capital.
Consulting firms have very little costs and aren’t capital intensive. Therefore, Sue owns 100 percent of the firm. Kim, on the other hand, must raise $5 million from investors. SaaS companies have product-development costs and are capital-intensive. Therefore, Kim owns only 15 percent of her firm.
Ten years later, Sue and Kim sell their firms. At the time of the sale, both were making $10 million annually in revenue. Sue’s firm gets valued at 1.5x revenue, resulting in a purchase price of $15 million. Since she owns 100% of her firm, Sue makes $15 million.
Kim’s company gets valued at 5x revenue, resulting in a purchase price of $50 million. Since she owns 15 percent of her firm, Kim makes $7.5 million, meaning Sue makes twice what Kim makes at exit.
Additionally, Kim’s investors pay Kim a salary and prohibit her from pulling money out of business. Sue doesn’t have investors; she pays herself a salary and takes cash distributions regularly. Kim must sell the company to get rewarded in proportion to her efforts, but Sue rewards herself twice, once with regular cash distributions and once upon exit. Effort and rewards are aligned consistently.
Second, founders of professional service firms work less than founders of product firms. The reason for this is that they can control the scale. Founders of product companies are forced by their investors to grow at all costs. And this requires a non-stop, grueling work schedule.
A founder of a well-run marketing agency, for example, can achieve a work-life balance. She can ratchet up work when she feels inspired and can ratchet down work when she feels burnt out by taking on clients as desired. She controls the firm and is not duty-bound to venture capital tech investors.
Her cost structure is variable, the talent she needs to serve clients is readily available, and she has job security because she will not fire herself when she hits a bump in the road.
In contrast, the limitations of SaaS companies go beyond business; product company founders have no work-life balance. They lost control of their life the minute they took capital from investors. Their days are now filled by keeping investors happy, and their cost structure is not nearly as flexible because investors are managing the burn rate.
In addition, the talent SaaS founders need to build the product is tough to find and very expensive. Quality software engineers are in short supply. Lastly, and most troubling, if the founder of a product company misses the projections, they will lose their job. Investors replace founders when trouble shows up.
The promise of SaaS success is rapid scaling, but you can learn this lesson and apply it to your professional services firm without the risk of trying to raise capital.
There are many professional service firms that have scaled by expanding their reach. Gartner Group is a professional service firm with $4.7 billion in revenue, servicing over 15,000 clients.
The company has created economies of scale for its unique brand; it produces market research reports that clients subscribe to. The cost to produce the reports is high yet fixed. This means that with each new client, the cost to serve (on a per-unit basis) falls.
Economies of scope suggest that the cost of selling two services together is less than the cost of selling them separately. Some professional services are not scalable. Services that require specific client knowledge do not have the unit economics of a product.
A service firm would be wise to build a portfolio of service offerings with complimentary demand. This is when the consumption of one service increases the demand for another.
Overall, building a SaaS company isn’t all it’s cracked up to be, even if your venture does reach the heights of billion-dollar unicorn status. While the fast growth of certain unicorn companies can be tempting to pursue, the realities of raising capital are not as fun.
Instead, focus on how to find your niche in business — the areas where you have unique expertise and can build a scalable services firm that will help real people solve problems in their life. Working on creating the best scalable professional services firm you can is far more likely to reward you, both in the present and in the future.
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