Category: Pro Serv Blogs

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How to Win in a Fragmented Market

How to Win in a Fragmented Market

Greg Alexander in American Express 

Understanding and appreciating what makes fragmented markets distinctive is important. When you understand them better – especially those in the professional services field – you can adjust your operations to consistently improve your market share and margins.

What is a fragmented market? From a broad brushstroke perspective, a fragmented market is essentially a large market with plenty of providers. No single firm effectively dominates the market, though. Instead, there is an even spread of companies serving all customers.

A prime instance of a fragmented market is the fast food sector, with its almost endless supply of eateries to choose from. The opportunities to serve are spread out among countless organizations rather than concentrated among just a few key players.

Fragmented markets are so familiar that we tend to take them for granted. Yet, understanding and appreciating what makes fragmented markets distinctive is important. When you understand them better – especially those in the professional services field – you can adjust your operations to consistently improve your market share and margins.

Why Does Market Fragmentation Occur?

Understandably, figuring out how to grow or scale your professional services business in a fragmented market can seem hard. After all, you can’t just go with the typical approach, which involves consolidating the market via acquisitions and roll-ups. This won’t work because of several realities.

The first reality that gets in the way of consolidation is that clients can expect a high degree of personalization from the firms they choose. Consequently, it can be difficult to standardize, develop a routine, and reduce labor. Economies of scale don’t tend to dovetail with customization.

Another snag relates to selling. Professional service firms’ sales tend to be made using relationships and referrals. Here’s why that’s a concern: consolidating a market by rolling up disparate firms often leads to centralized sales efforts and a lowered focus on relationships. Therefore, revenue growth historically attached to relationship selling may begin to suffer.

Along those same lines, professional service firms hired by clients that want help solving new problems with innovative approaches can feel stifled after a merger or acquisition. Rather than being able to adjust, flex, and create, they become bogged down by consolidation-related policies and procedures. Unsurprisingly, this can stifle client responsiveness and hurt growth.

Finally, it’s worth mentioning that many firms are run by individuals who see them as lifestyle businesses. These owner-operators may not be interested in consolidating because they’re not trying to get bigger. They’re fine with having a tiny slice of market share as long as it provides them with enough profit.

SPECIALIZATION IS OFTEN THE KEY TO WINNING INSIDE A FRAGMENTED MARKET, SO DON’T GO OUTSIDE YOUR COMPETENCIES. THE MORE SPECIALIZED YOU ARE, THE MORE BUSINESS YOU CAN WIN.

Expansion in a Fragmented Market

Despite these snags, leaders of services firms within fragmented markets can bypass the typical playbook and grow and scale their businesses by applying alternative methods to get ahead.

The first is through tightly managed decentralization. A firm that’s in the process of consolidating can scale efficiently if its people embrace localization. For example, a notable executive coaching organization has scaled nicely by leveraging the franchising model. This organization creates intellectual capital centrally. Then, the firm licenses the use of its intellectual capital to a network of independent business coaches. Each coach adjusts this toolkit based on the localized market’s unique needs.

The second way to win in a fragmented industry is through geographic expansion backed by a framework of formulas that have worked at previous locations. Another executive coaching organization has been doing this for more than 60 years. It opens new groups by recruiting a geographically focused coach, certifying the coach and expecting the coach to follow a standard operating procedure. This enables the organization to maintain a degree of control as it keeps building its presence outward.

Specialization is a third fragmented market strategy. For instance, many service firms in the IT sector specialize in a technology product and add value through customization and implementation. Case in point: print shops that can handle small batch orders can achieve market share. Players that lead with their deep market segmentation experts are the ones most likely to grab more attention and revenue.

Maximizing Chances in a Fragmented Market

Is a fragmented market an opportunity? Absolutely, if you know the top strategic traps to avoid.

    1. Let go of dominance.

Some firms seek dominance when dominance is impossible. Try not to attempt to consolidate a market that cannot be consolidated. Try to understand the underlying structure of the industry that has caused its fragmentation before you try to consolidate it. In most cases, markets are fragmented for a good reason.

    1. Stay within your core competencies.

Specialization is often the key to winning inside a fragmented market, so try not to go outside your competencies. The more specialized you are, the more business you can win. And inside of a fragmented market, there are plenty of clients to pursue. Try to avoid the temptation of going after clients outside of your core market.

    1. Be cautious of over-centralization.

As firms try to scale, they can often over-centralize. Try not to make this mistake. Consider pushing authority to those closest to the clients to enable and embrace localization and creativity. Remember: the market is fragmented because of the clients. Try to lean into this. Consider developing relationships and be easy to do business with.

    1. Be thankful there are many competitors in your space.

Competition means there are lots of clients spending money on what you do. Therefore, try not to  overreact to your competitors. Their presence is a good thing – and something to be thankful for because it shows a demand for what you offer.

Fragmented markets may be challenging to navigate. However, if you understand how they work, you can gain some serious advantages for your professional services firm.

Photo: Getty Images

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The Six Types of Contracts in Professional Service Firms: An Insider’s View

The Six Types of Contracts in Professional Service Firms: An Insider’s View

When I first began my journey as a founder of a boutique professional service firm, I was engrossed in the logistics of setting up, hiring the right talent, and pitching to clients. As many founders do, I overlooked a critical aspect of the business: contracts. Many founders do not realize they are routinely entering into contracts. Neglecting this can lead to misunderstandings, disputes, and potential legal consequences. It’s important to recognize the different types of contracts to prevent future complications.

There are six types of contracts most commonly used in professional service firms:

    1. Bilateral Contract: At its core, a bilateral agreement involves a promise for a promise. Both parties commit to certain obligations. For instance, in a professional service firm, this could manifest as an agreement where the firm promises to deliver specific services, and in return, the client commits to paying a set fee. These contracts are beneficial when both parties have clear obligations to fulfill. However, they can be restrictive if situations change, and flexibility is required.

    2. Unilateral Contract: Unlike bilateral agreements, unilateral contracts involve a promise in exchange for an act. Imagine a situation where a professional service firm offers a bonus to an employee if they bring in a certain number of clients. Here, the firm has made a promise, but the employee is not obligated to perform the action. These contracts can be motivating, but they also risk no action being taken if the recipient doesn’t see value in fulfilling the task.

    3. Explicit Contract: These contracts spell out the terms and conditions in a clear and unequivocal manner. For a professional service firm, an explicit contract might detail the scope of work, timelines, remuneration, and other specifics. While these are advantageous for their clarity, they can also be time-consuming to draft and may be perceived as inflexible.

    4. Implied Contract: These contracts are not written or spoken but are inferred from the behavior of the parties involved. If a client in a professional service firm continually engages a consultant without a written agreement, and pays them after each project, an implied contract might be in place. They can be useful in ongoing, trust-based relationships but are susceptible to misunderstandings since terms aren’t explicitly documented.

    5. Oral Contract: As the name suggests, these are verbally agreed-upon contracts. A client and a professional service firm might agree on the scope of work during a meeting, and while valid, these contracts can be hard to enforce due to lack of tangible evidence. They’re quick and can be suitable for straightforward, short-term engagements. But they’re best avoided for complex projects or long-term collaborations where the risk of misinterpretation or forgetfulness is high.

    6. Written Contract: This is the most formal type of contract. Drafted and documented, it provides a clear record of the agreement between parties. In our firm, for instance, we always have written agreements detailing service deliverables, compensation, confidentiality clauses, and more. While they might seem cumbersome, they offer protection and clarity for all parties involved. They’re ideal for significant projects or collaborations. However, the only drawback is the time and sometimes the cost involved in drafting them, especially if legal consultation is needed.

In conclusion, contracts form the backbone of professional engagements in service firms. As founders, it’s our responsibility to understand these intricacies and ensure we’re using the right contract for the right situation. It’s not just about safeguarding interests but also about building trust and transparency with our clients and employees.

If you find this article helpful, come join us at Collective 54. Apply here.

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Preventing Employee Fraud: A Guide for Boutique Professional Service Firms

Preventing Employee Fraud: A Guide for Boutique Professional Service Firms

Fraud, a word that sends shivers down the spine of business leaders, is not always committed by faceless outsiders. In most cases, the culprits are the very individuals we trust – our employees. As the founder of a boutique professional service firm, it’s paramount to understand that no organization is immune and take proactive steps to shield one’s venture. Here are six proven strategies to prevent employee fraud:

    1. Get an Audit:

What is an audit? An audit is an independent examination of financial statements, internal controls, and related operations to ensure accuracy and compliance with regulations and policies.

Who performs an audit? External certified public accountants or specialized auditing firms undertake this meticulous task.

Duration and Cost: An audit’s duration varies based on the firm’s size and complexity, usually ranging from a few days to several weeks. Costs can span from a few thousand to tens of thousands of dollars.

When and how often? Initially, when suspicious activities arise. Thereafter, annual or bi-annual audits act as strong deterrents to potential fraudsters.

    1. Founder’s Signature for Cash Disbursements:

       Within a boutique professional service firm, cash disbursements might include vendor payments, payroll, or reimbursements. Unscrupulous employees can inflate expenses, forge invoices, or manipulate payroll. Instituting a policy where the founder signs off on every cash disbursement drastically minimizes these risks, ensuring a higher level of scrutiny and oversight.

    2. Review the Vendor List:

What’s a vendor list? It’s a compilation of all external service providers and suppliers with whom the firm conducts business. Unfortunately, a deceptive employee might collude with a vendor, overbilling for services or even creating phantom vendors. Regularly reviewing the vendor list enables founders to spot irregularities, unfamiliar entities, or suspicious patterns.

    1. Issue Credit Cards in the Name of the Employee, Not the Firm:

      This simple yet effective measure transfers the risk from the firm to the individual. If a card is misused, it’s tied directly to the employee, discouraging unauthorized expenses. Furthermore, it eases the process of tracking and auditing individual transactions.

    2. No Cash or Checks – Go Digital:

      Handling cash and checks presents numerous opportunities for fraud. An employee might siphon off cash receipts or alter check amounts. To prevent such malfeasance, firms should adopt digital payment methods such as credit card payment, wire transfers, online banking, or electronic wallets. These methods offer transparency, traceability, and reduced manipulation risk.

    3. Sole Control of the Bank Account:

      The firm bank account, essentially the lifeblood of any firm, should remain under the stringent control of the founder. Granting multiple individuals access creates vulnerabilities. With sole control, a founder ensures that no unauthorized transactions occur, and oversight remains tight.

Conclusion: Preventing employee fraud requires a mix of vigilance, strategic policies, and an environment fostering integrity. By implementing these six steps, boutique professional service firms can significantly fortify their defenses, ensuring that their hard-earned success remains uncompromised.

If you find this article helpful, come join us at Collective 54. Apply here.

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The Imperative of Employee Documentation in Professional Service Firms

The Imperative of Employee Documentation in Professional Service Firms

In the bustling world of modern business, the divide between product-driven and people-driven enterprises might seem subtle but carries with it profound implications. As a founder of a boutique professional service firm, I’ve learned firsthand that the latter – businesses where people, their skills, and their expertise form the bedrock – demands a different approach, especially in areas such as employee documentation.

Why the Difference?

In a product-driven business, the emphasis is often on tangible assets: inventory, machinery, real estate, and the like. In such an environment, while human talent is vital, the primary value lies within the products and the processes that bring them to market. Employee turnover, while unfortunate, doesn’t typically risk the erosion of the core business model.

However, for professional service firms, the situation is quite the opposite. Our strength, value, and market reputation hinge on our people. Their knowledge, creativity, and relationships form our most prized assets. Thus, safeguarding our relationship with them, establishing clarity on their roles, responsibilities, and entitlements, and mitigating potential conflicts is crucial. This makes employee documentation not just a procedural necessity but a strategic one.

Fundamentals of Employee Documentation:

    1. Offer Letter: This is the starting point of the formal relationship. It outlines the basics – position, department, reporting structure, and starting salary. It gives the candidate a snapshot of their role in the firm.

    2. Employee Agreement: An in-depth document detailing the terms of employment, it’s the constitution of the employer-employee relationship.

    3. Explanation of Duties: This section clearly demarcates what is expected of the employee. In a professional setting, role clarity is paramount for efficiency and performance.

    4. Compensation and Benefits: Beyond the basic salary, this segment elaborates on the structure of bonuses, benefits, perks, and other financial incentives that the employee is entitled to.

    5. Equity Grants/Stock Options: If applicable, this section provides details about any equity positions or stock options provided to the employee, along with vesting schedules and other pertinent details.

    6. Duration and Termination: Details about the employment contract’s duration, grounds for termination, notice periods, and severance packages, if any, are essential to avoid potential conflicts.

    7. Non-disclosure Agreement: In a knowledge-driven business, protecting sensitive information is paramount. This clause safeguards the firm’s proprietary information, trade secrets, and client data.

    8. Intellectual Capital and Property Assignments: For roles that involve creation or innovation, this part ensures that any intellectual property developed during the tenure belongs to the firm.

    9. Non-compete Clause: This prohibits the employee from starting or joining a rival firm for a certain duration after leaving the company, ensuring the firm’s market position and client base remains secure.

    10. Non-solicitation Clause: Employees, especially in high positions, often develop deep client relationships. This clause ensures they don’t lure clients away after parting ways with the firm.

    11. Integration Clause: To avoid misunderstandings, it’s vital to have an integration clause. It ensures that the entire agreement between the employee and employer is encapsulated within the document, superseding any prior oral or written communications.

    12. Mandatory Arbitration: Legal battles are costly, time-consuming, and can tarnish the firm’s reputation. Thus, having a clause that mandates arbitration for any disputes related to employment can save time, money, and unnecessary publicity.

In conclusion, while every business should prioritize employee documentation, for professional service firms, it’s an imperative. The nature of our business makes it essential to establish clear, legally-sound, and comprehensive documentation from the get-go. Such proactive measures not only help in fostering a transparent and harmonious workplace but also safeguard the very essence of our business – our people.

If you find this article helpful, come join us at Collective 54. Apply here.

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Understanding Employee Stock Options in Boutique Professional Service Firms

Understanding Employee Stock Options in Boutique Professional Service Firms

When the topic of employee stock options arises, thoughts usually gravitate towards tech startups and Silicon Valley’s golden handcuffs. However, the world of boutique professional service firms has its own unique landscape. In these firms, the granting of stock options is not common practice. Yet, in specific circumstances, they can provide valuable incentive and alignment between professionals and the firm’s objectives. This article delves into the basics of employee stock options within this niche, explaining why they’re less prevalent and the key considerations when they are implemented.

Why Stock Options are Rare in Professional Service Firms

Professional service firms, such as consulting, marketing agencies, and IT firms, are traditionally structured around partnership models. In these models, senior professionals work their way up the ranks and eventually buy into the partnership, sharing in profits rather than owning shares that appreciate in value. The unpredictability of client-driven revenues, coupled with a lack of scalable products, makes these firms less conducive to the traditional stock option model seen in product-based or tech companies. Furthermore, the valuation of professional service firms is often based on intangibles like client relationships and human capital, which are more challenging to quantify and forecast compared to tangible assets or predictable revenue streams.

Where Stock Options Make Sense

Despite the traditional partnership model, there are scenarios where stock options in boutique professional service firms can be beneficial. They can attract top-tier talent, incentivize long-term commitment, or facilitate succession planning. Especially in smaller, specialized firms where the expertise of a few individuals can significantly impact the firm’s value, stock options can create alignment between individual and company success.

Key Items to Consider:

    1. Number of Shares in the Pool: For boutique professional service firms considering stock options, it’s typical to allocate 15-20% of the firm’s total shares for the option pool. This ensures there’s a meaningful reward for employees without excessively diluting existing ownership.

    2. Exercise Price and Valuation: The exercise price is the cost an employee will pay to convert their option into an actual share. To avoid tax complications and ensure fairness, this price should equal the share’s fair market value at the grant date. Given the intangible assets in professional service firms, determining this valuation may require expert assistance.

    3. Type of Option: Options come in various forms, including Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs), and Restricted Stock. Each has its tax implications, benefits, and constraints, so it’s essential to choose the one that aligns best with both the firm’s and employee’s goals.

    4. Duration: The maximum duration for most stock options is 10 years, after which they expire. However, if an employee owns more than 10% of the firm, this reduces to 5 years. This encourages timely exercise and prevents indefinite uncertainty in ownership structure.

    5. Permissible Forms of Payment: When employees exercise their options, they can do so using cash, by surrendering other shares (net of exercise price), through cashless exercises, or even via promissory notes. The firm needs to define and communicate acceptable payment methods.

    6. Vesting and Early Exercise: Vesting schedules determine when options can be exercised. A common approach sees 0% vested in the first year (a one-year cliff), 25% vested at the end of year one, and then pro-rata monthly vesting up to the end of year four. This structure incentivizes longer-term commitment.

    7. Restrictions on the Transfer of Shares: Even after options are exercised, firms often retain some control over the shares. A common restriction is the “first right of refusal,” which requires the employee to offer the shares back to the firm or existing shareholders before selling to an outside party. This ensures the firm’s ability to maintain its ownership structure.

In conclusion, while stock options are not the norm in boutique professional service firms, they can be a valuable tool in certain circumstances. It’s crucial for firms considering this route to understand the unique challenges and considerations in their industry and design an option plan that aligns with their strategic objectives.

If you find this article helpful, come join us at Collective 54. Apply here.

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Eight Key Questions to Ask and Answer When Structuring Ownership: A Perspective from Three Co-Founders

Eight Key Questions to Ask and Answer When Structuring Ownership: A Perspective from Three Co-Founders

Starting a boutique professional service firm is an exciting journey. Here, we’ve distilled our collective experiences into eight key questions every founder team should ask and answer when structuring ownership:

    1. Who owns what percentage?

Answer: Ownership stakes reflect the value each founder brings. When deciding percentages, consider factors like capital investment, skills, connections, and previous experience. It is crucial to have candid discussions about these elements and recognize where each founder adds unique value. The ownership distribution should be based on a mix of these attributes and future commitments.

    1. Who is in control?

Answer: Control can be different from ownership percentage. In most firms, co-founders opt for a unanimous decision-making model for major decisions. This way, despite any differences in ownership percentages, each co-founder feels their voice is heard and respected.

    1. Who has contributed money, how much, and when?

Answer: Keeping transparent records is paramount. Document every monetary contribution and link it to specific milestones or business needs. This approach makes it easy to see who contributed, when, and why, fostering trust and clarity among co-founders.

    1. Who is going to contribute time, how much, and when?

Answer: Not every founder can commit full-time initially. Discuss your individual commitments, both present and future, and noted any anticipated changes (e.g., moving from part-time to full-time). Clear agreements prevent potential resentment or misunderstandings.

    1. What is the incentive compensation plan for each co-founder?

Answer: Besides equity, it’s essential to consider salaries or other compensation, especially if founders have varying levels of financial commitments outside of the business. Adopt a model where early salaries are modest but are combined with performance bonuses and future equity vesting.

    1. What happens when a co-founder quits?

Answer: A founder leaving can be unsettling. Agree that if a founder decides to quit, their shares would undergo a vesting schedule, allowing them to retain only a portion of their equity based on the time committed. This strategy ensures that founders are incentivized to stay and contribute to the firm’s growth.

    1. What happens when a co-founder is forced to leave?

Answer: This is a tough but necessary discussion. Establish a framework detailing specific scenarios where a founder could be asked to leave (e.g., misconduct, not meeting agreed-upon commitments). In such cases, a buyback clause at a predetermined valuation would be triggered.

    1. How is a “forgotten founder” handled?

Answer: “Forgotten founders” are individuals who may have contributed in the early stages but weren’t formalized as part of the founding team. Addressing this proactively, Agree to acknowledge any early contributors either with a smaller equity stake or a one-time compensation, ensuring they’re recognized but without long-term firm obligations.

In conclusion, structuring ownership isn’t just about equity distribution. It’s about crafting a relationship framework that will endure challenges and maximize collaboration. By confronting these questions head-on and forging transparent, fair agreements, will lay a strong foundation for your collective future.

If you find this article helpful, come join us at Collective 54. Apply here.

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IRS Section 174: Amortization of R&D Expenses and Why It Matters to You

IRS Section 174: Amortization of R&D Expenses and Why It Matters to You

We are pleased to present a unique feature on our blog today. The following post comes courtesy of a guest contributor, Collective 54 member Robin Way, CEO of Corios, who brings a fresh perspective and expert insight on a recent change to the tax code affecting boutique professional service firms. We are honored to share his knowledge and viewpoints with our readers. Enjoy this unique piece that broadens the horizons of our usual content.

What is this IRS Section 174 thing?

Sure, the title of this article probably made you flip to the next page. Few stories are less sexy than tax regulations and Congressional legislation. But, if you are a professional services firm who invests in research and development of any kind, you should be paying attention.

Greg Alexander, Founder of Collective 54, has shared a lot of perspectives about productizing your services, diversifying your sources of revenue, and creating mechanisms to earn fees that are not dependent on billable hours. If you have done anything with this advice, chances are you have probably made an investment in R&D whether you knew it or not.

Does this apply to you?

If your firm delivers technology, engineering, design, architecture, or IT services, chances are good that you will incur R&D oriented expenses, whether you know it or not. (This little condition will come back around later, wait for it…)

Here is some good news that you have potentially already been taking advantage of, under the federal government’s R&D tax credit program: you can deduct some of these costs from your tax liability as a tax credit.

The US federal government has provided R&D tax credits since 1986, under what is called IRS Section 41 “Credit for increasing research activities”. Corios has benefitted from this program for about 5 years, and it has taken some of the sting out of our federal tax liabilities, depending on how much we spent on qualified R&D.

To meet the standards of a “qualified research and development expense” under IRC Code Section 41, these R&D expenses need to meet all the following criteria:

    • The costs for in-house or (domestic) contract labor and supplies.

    • Associated with experimental development processes.

    • Associated with improving the functionality, quality, reliability, or performance of a business component.

    • Where there was some technical uncertainty about the outcome of the research.

What is interesting about the “experimental” and “technical uncertainty” clauses is that, if your staff are performing fixed price work for your clients, and this work contributes to building a technical product that your firm owns, then you can also take credit for the labor costs of performing that work. Note that this only applies to fixed price contracts, since under that approach, your firm holds the risk of performance, and this cannot be a work-for-hire where the client owns the deliverables and/or the intellectual property. Your auditor will read all the contracts to ensure these projects meet those criteria.

So, yes, those R&D tax credits sound rather good! Stay tuned for the bad news…

What is different this time?

I mentioned IRS Section 41 above, which defines expenses subject to the tax credit. There is another section of the federal tax code, called Section 174. This (previously) defines how firms can deduct their R&D expenses in the year in which they were incurred. For comparison’s sake, other countries offer manufacturers and other companies investing in R&D a “super deduction” that is vastly preferable to what we have here in the US. In China for instance, firms can deduct 200% of their R&D expenses in the current year.

A major amendment to IRS Section 174 was introduced 5 years ago as part of the Tax Cuts and Jobs Act (TCJA), passed in 2017. It amended the way that Section 174 expenses were deducted, by making business amortize those expenses over a 5-year period. When this was signed into law, there was a 5-year delay in its implementation, so it only affected business taxes starting after Dec 31, 2021.

Section 174 is entirely different than Section 41 tax credit. From my vantage point, you can think of Section 174 treatment of R&D expenses as a penalty. Section 174 makes your firm amortize your expenses over a 5-year period, rather than allowing you to deduct these costs in the year in which they were incurred as a normal expense. (If that sounds boring, it should not. I will clarify this with a simple example a little later…)

Section 174 qualified R&D expenses include everything under the Section 41 definition, and now they add on the following additional categories of expenses:

    • Non-qualifying software development and related expenses

    • Non-taxable benefits costs

    • Foreign research expenses (note that Section 41 only gives you credit for domestic expenses)

    • Depreciation

    • Overhead

    • General and administrative costs

    • Utilities

    • Rent

    • Securing (but not acquiring) a patent

You might be thinking, “OK, so the R&D expense category is larger now, is that a good thing?” Nope. The 5-year amortization requirement is going to really be the part you end up hating. Let us compare your new R&D deductions rate (20% per year) with China’s (200% per year). Big difference.

Why should you care?

Usually, your firm pays taxes based on your EBITDA. The more income you make, the more taxes you pay. Well, Section 174 is completely different. It is not tied to how much profit you make, but to the costs you incur. The more R&D costs you incur, the larger the penalty will be, because your effective current-year R&D OpEx costs now go DOWN, and hence your implied (but not actual) income goes up, and hence so does your tax liability.

Here’s a (relatively) simple example:

Before Section 174 phased in, assume your firm earns $100 per year in income, less $40 for COGS (mostly, the salaries and benefits of staff who are not in R&D), leaving $60 in gross margin. Now come the operating expenses. As a tech-investing firm, you have $30 in R&D expenses each year and another $20 in all other expenses. This leaves $10 in EBITDA, and if the effective tax rate (note: Corios is based in Portland, Oregon, the home of high taxes) is 40%, then your annual tax liability is $4.

Now let us run the very same simple scenario but add in Section 174. The only difference is that R&D expenses need to be amortized over a 5-year schedule. Hence you can only claim 20% of the year 1 R&D expenses in year 1. Your actual OpEx is unchanged, as is your actual EBITDA. However, your effective R&D expenses in year 1 become only $6 (instead of $30) because you can only deduct a part of the first year, making your “effective” EBITDA $34, and now your tax liability is $13.60–more than triple your “Before Section 174” taxes! (Yeah, “holy crap!” is right.) Note that you do not actually earn any more EBITDA, and there is not more money in your bank account; actually, there is less of it, namely $9.60 less of it, due to the increased tax liability. By the end of year 5, your amortization schedule has caught up and now your effective OpEx and effective taxes are back to normal, but in the meantime, you are getting screwed. Royally.

What to do about it

There is some promising news on the horizon, but it needs your help to push it into reality. You too can act and make a difference.

The Senate has introduced a bipartisan bill called the American Innovation and Jobs Act (AIJA), which will repeal the previously amended Section 174 to go back to the way it was before the TCJA. Democratic Senator Margie Hassan introduced the bill in the Senate in March 2023, with co-sponsorship from Senator Todd Young of Indiana on behalf of the Republicans. Support is broad on both sides of the aisle, but the bill needs to be attached to an omnibus spending bill to get adopted. There is a corresponding bill in the House, called the American Innovation and R&D Competitiveness Act, which enjoys a similar bipartisan support.

Despite this bipartisan desire to get this bill passed, many Democrats want to pair the AIJA with a reinstatement of the Child Tax Credit. This is where progress on the bill has stalled a bit (do not take my word as gospel, I am not an expert on the back-room conversations here, but I am passing along what I have heard from the lobbyists).

Several weeks ago, through Corios’ membership in the Technology Association of Oregon, I was invited by Yelp and their lobbyist, Dentons, to visit Washington DC and tell our story to several US Senators. Specifically, two weeks ago we visited the offices of four US Senators: Senator Todd Young (Indiana), Senator Chris Murphy (Connecticut), Senator Ron Wyden (Oregon), and Senator Mazie Hirono (Hawaii).

My role was to tell the story of the “little guy”, namely, the pull-up-by-your-bootstraps entrepreneur who is struggling to get by and for whom the impacts of this Section 174 provision are a big punch in the jaw (or insert a more colorful metaphor, which works just as well). The goal of the lobbyists is to build momentum for both bills in each house of Congress and to get them attached to the major spending bills. To reach this objective will take a journey, not a one-day meet-and-greet.

So, here is what you can do, and it is simple: write to your Senator and House representatives, telling them your story. Here was my story:

“I’m the founder and CEO of Corios. We are not a large company like Google, Amazon, or Netflix, but we employ Americans and pay them a good wage and strong benefits. I believe in innovation, and I actively invest in our software products so that we can stay as competitive as possible in a very tough industry. So now, given the implications of Section 174, my tax liability has skyrocketed, and the incremental taxes are equal to an entire month’s cash flow. That means I cannot pass along pay raises or bonuses to my team members or hire more members of our team to grow. Meanwhile my offshore competitors are enjoying tax incentives that dramatically outpace our own, and meanwhile I am being penalized for trying to invest in my company and my team. Bear in mind, our R&D investments are really an investment in hiring Americans to build our products and paying their salaries. We are not hiring ChatGPT or something, these are real jobs and good salaries. But now that I have less to pay for everything else, I am faced with the decision of paying offshore developers to do the work that ought to stay onshore in the US. But when offshore developers cost $30 per hour and onshore ones cost $100 per hour, that is a very tough decision to support. I need you to get this amendment to Section 174 repealed. “

You can put this story however you would like, but I encourage you to tell your story, and do it today.

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Navigating the Nuances of Recruiting Key Talent: The Founder’s Guide to Safeguarding Boutique Professional Service Firms

Navigating the Nuances of Recruiting Key Talent: The Founder’s Guide to Safeguarding Boutique Professional Service Firms

As a founder who’s ventured into the world of boutique professional service firms, I cannot emphasize enough the importance of meticulously handpicking the right talent. However, the hiring process is littered with pitfalls that could jeopardize the very foundation of your enterprise. So, what should you be wary of when bringing on a key employee?

    1. The Danger of Moonlighting

Imagine this: you find the perfect candidate who’s exceptional in their domain but is currently employed elsewhere. They offer to work for you in their free time. Sounds tempting? Proceed with caution. Moonlighting often leads to divided loyalties, stretched commitments, and the potential misuse of proprietary information from their primary employer. What if they use their employer’s resources during your project’s working hours? This can raise serious ethical and legal questions and put your firm’s reputation at risk.

    1. The Significance of Non-compete Clauses

When hiring a key employee, especially in a niche domain, non-compete clauses become paramount. This agreement prevents the employee from joining a competitor or starting a rival business, ensuring your business secrets remain safeguarded. However, ensure that your non-compete is reasonable in terms of duration and geographic scope; otherwise, it may not hold in court.

    1. Safeguarding Secrets with Non-disclosure Agreements (NDAs)

An NDA is a legal contract that prevents the employee from divulging confidential information. For boutique firms, where proprietary methods and client data are sacrosanct, NDAs offer a safety net against information leaks.

    1. Non-solicitation Clauses: Protecting Your Client and Talent Base

A non-solicitation clause ensures that departing employees cannot poach your clients or woo your remaining team members for a specified period post their exit. This clause is invaluable in preserving your business ecosystem.

    1. No Raiding Stipulations

Closely related to non-solicitation clauses, no raiding stipulations prevent former employees from recruiting your staff for their new endeavors. Given the tight-knit nature of boutique firms, losing multiple team members at once can be devastating.

    1. Invention Assignment Agreements: Why They Matter

Imagine if an employee develops a breakthrough technique while working for you, but there’s no clarity on who owns this invention. Invention assignment agreements ensure that any inventions, ideas, or processes developed during employment are owned by the firm. For service firms constantly innovating, such clarity can prevent future disputes and potential financial losses.

    1. Remedies for Breach of Contract

Despite best efforts, breaches do occur. But all is not lost. Two primary remedies are available:

    • Seeking an Injunction: This legal order prohibits the employee from continuing the breach. For instance, if an employee joins a competitor despite a non-compete clause, an injunction can bar them from working there.
    • Monetary Damages: If your firm faces financial losses due to the breach, you can seek compensation. While it might not mend damaged reputations or client relations instantly, it provides some reparation.

In Conclusion:

Navigating the hiring process in a boutique professional service firm is akin to traversing a minefield. However, with due diligence, a thorough understanding of legal clauses, and always being prepared for the unforeseen, you can onboard the right talent without jeopardizing your firm’s sanctity.

Building a successful boutique firm is as much about the people you bring on board as it is about your business acumen. Proceed with caution, arm yourself with the right legal tools, and always prioritize the firm’s long-term integrity over short-term gains. The journey might be daunting, but the rewards are immeasurable.

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Tax Implications for Boutique Professional Service Firms During Acquisitions

Tax Implications for Boutique Professional Service Firms During Acquisitions

Acquiring or merging with other businesses is a strategic decision that requires careful financial and tax planning. For boutique professional service firms, the tax implications can be particularly nuanced given the nature of the assets and client relationships involved. In this article, we will delve into the tax treatment for three forms of acquisition often used in the professional services industry: asset purchase, equity acquisition, and mergers.

    1. Asset Purchase

Definition: In an asset purchase, the buyer acquires specific assets and potentially some liabilities of the selling business rather than its stock or business entity.

Tax Implications: In an asset purchase, the buyer gets a step-up in the tax basis of the acquired assets to their fair market value. This often results in higher future depreciation and amortization deductions for the buyer. Sellers, on the other hand, pay tax on the difference between the selling price of the assets and their tax basis, which could lead to capital gains or ordinary income, depending on the nature of the asset.

Illustrative Example: Imagine a managed service provider, MSP LLC, with assets valued at $1 million but a tax basis of $600,000. If another firm, Tech Ltd., buys these assets for $1.2 million, MSP LLC will pay taxes on the $600,000 gain ($1.2 million – $600,000). Tech Ltd., meanwhile, will now have a new tax basis of $1.2 million for the acquired assets.

    1. Equity Acquisition

Definition: In an equity acquisition, the buyer acquires the stock or the interest of the target firm, thus acquiring all its assets, liabilities, and potential undisclosed issues.

Tax Implications: The buying entity does not get a step-up in the basis of the acquired assets, and the target firm’s tax attributes (like net operating losses) may be limited in their usability. Sellers often prefer this method because the gains are usually treated as capital gains, which are taxed at a lower rate than ordinary income.

Illustrative Example: Consider a software development firm, SoftDev Inc., with a total stock value of $2 million. If another company, Code Masters, decides to buy all the stock for $2.5 million, the shareholders of SoftDev Inc. would pay capital gains tax on the $500,000 gain.

    1. Mergers

Definition: A merger is the fusion of two entities into a single entity. The three types of mergers are:

    • Direct Merger: The target firm merges into the buying firm.
    • Forward Merger: The buying firm merges into a subsidiary of the target firm.
    • Reverse Merger: The target firm merges into a subsidiary of the buying firm.

Tax Implications: Mergers can be structured to be tax-free if specific requirements are met, especially if they are considered a reorganization under the tax code. If not, they can have similar tax implications to an asset or equity sale.

Illustrative Example: A sustainability consulting firm, GreenAdvisors, merges with EcoConsultants in a forward merger. GreenAdvisors becomes a wholly-owned subsidiary of EcoConsultants. If structured correctly under the tax code’s reorganization provisions, this merger could potentially be tax-free. Otherwise, the tax implications for asset or equity sales may apply.

Decision Tool:

To decide the right acquisition structure when selling, consider:

    • Tax Impact: How will each structure affect your tax liabilities? Would you prefer capital gains over ordinary income?
    • Liabilities: Are there potential undisclosed liabilities or issues in the target firm? An asset purchase can help the buyer avoid these.
    • Strategic Fit: How do the companies fit together? A merger might be the right choice if both entities have complementary strengths and client bases.

In conclusion, understanding the tax implications of different acquisition structures is crucial for boutique professional service firms. Consulting with a tax professional before making any decisions is always recommended.

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Contractors vs. Employees: The Right Choice for Boutique Professional Service Firms

Contractors vs. Employees: The Right Choice for Boutique Professional Service Firms

The decision between hiring contractors or employees is a crucial one for founders of boutique professional service firms. Making the right choice can greatly influence the financial health, operational efficiency, and scalability of the firm.

Benefits of Using Contractors:

Financial Savings: Using contractors can translate into significant savings for small firms. Contractors are typically not entitled to benefits like health insurance, overtime, workers’ compensation insurance, payroll taxes, and Medicare taxes. By hiring contractors, the firm can save on these costs.

Operational Flexibility: With contractors, firms can easily adjust their workforce capacity based on the influx of client work. When the workload is heavy, you can hire more contractors, and when it diminishes, you can reduce the number.

Minimal Management Hassles: Employing contractors means fewer management tasks. You don’t have to deal with the intricacies of employee performance evaluations, conflict resolution, or other managerial challenges that come with full-time employees.

IRS Classification Criteria: The IRS uses three primary criteria to determine if someone is a contractor:

    1. Control over Production: If the worker follows your proprietary process or method, they are likely an employee, not a contractor.
    2. Multiple Clients: A genuine contractor typically serves more than one client. If you’re consuming all their available time, they might be classified as an employee.
    3. Contractual Agreement: A formal written contractor agreement should be in place. Paying invoices without an agreement could be problematic.

Misclassifying an employee as a contractor can lead to hefty fines from the IRS, so it’s imperative to get this right.

Additional Classification Criteria:

Unfortunately, the IRS is not the only one you need to worry about. At times, disputes develop between individuals and the firms they work for. If you find yourself in such as dispute, the disgruntled person may use the following as leverage:

    • Supervision: A high degree of supervision suggests an employee relationship.
    • Training: Providing training is indicative of an employee, not a contractor.
    • Compensation Method: Bonuses or non-hourly compensation can be seen as evidence of an employee relationship.
    • Benefits: Offering benefits like vacation time can hint at an employee status.

Lifecycle Considerations:

Collective 54’s framework, shared in the best seller The Boutique: How to Start, Scale, and Sell a Professional Service Firm, describes the lifecycle of a service firm. From launch to exit takes fifteen years spent in three stages- growth, scale, and exit.

Early-stage boutique firms in the growth stage, facing unpredictable revenues, can benefit immensely from the flexibility of contractors. The ability to scale up or down without long-term commitments can be a lifesaver. A rule of thumb is greater than 50% of the labor force is contractors during the growth stage.

However, as a firm matures and revenue becomes more predictable, hiring employees can be more economically sensible. While contractors might appear cheaper in the short run, in the long term, the “renting” vs. “owning” analogy applies. Hiring full-time employees can offer better value through margin expansion. A rule of thumb is 50%-75% of the labor force is employees during the scale stage.

Moreover, when considering an eventual exit or acquisition, having a stable base of employees is crucial. Acquirers look for consistency, commitment, and a reliable team. They want to purchase both the client relationships and the team that serves them. A firm relying heavily on contractors might be less attractive to potential buyers. A rule of them is less than 10-20% of the labor force is contractors during the exit stage.

Checklist for Decision Making:

Here is a quick checklist to help you determine your mix of contractors and employees:

    1. Nature of Work: Is it short-term or ongoing?
    2. Control: Do you need to control how the work is done?
    3. Training: Will the worker require training?
    4. Costs: Have you factored in all associated costs (benefits, taxes, etc.)?
    5. Flexibility: How important is it for your firm to scale up or down quickly?
    6. Relationship Duration: Is this a one-off project or a continuous relationship?
    7. Future Plans: Are you planning to sell or acquire in the near future?

In conclusion, while contractors offer flexibility and cost advantages in the initial stages of a boutique firm, as the firm grows and stability becomes paramount, transitioning to a workforce of employees can be more strategic. By understanding the pros, cons, and implications of each choice, founders can make informed decisions that best serve their firm’s needs.

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