Episode 6: The Boutique: Transform Income into Wealth
All revenue is not good revenue. In this podcast episode, Sean Magennis and Greg Alexander discuss the different types of revenue and which create more wealth for owners of professional services firms. You will learn what good fees are and why they increase the value of your firm and improve your business exit strategy.
Episode 6: Transform Income into Wealth
All revenue is not good revenue. You will learn that some types of revenue create more wealth for owners than others.
Various Speakers [00:00:01] You can avoid these landmines. It’s a buy versus build conversation. What’s the root cause of that mistake? Very moved by your story. Dive all into the next chapter of your life.
Sean Magennis [00:00:16] Welcome to the Boutique with Capital 54, a podcast for owners of professional services firms. My goal with this show is to help you grow, scale, and sell your firm at the right time, for the right price, and on the right terms.
I’m Sean Magennis, CEO of Capital 54 and your host. In this episode, I’ll make the case that all revenue is not good revenue. Some types of revenue create more wealth for owners than others. I’ll try to prove this theory by interviewing Greg Alexander, Capital 54’s chief investment officer. Greg is an expert in converting income into wealth. Greg, hi. What types of fees are considered high-quality fees?
How Can Professional Services Firms Increase Fee Quality?
Greg Alexander [00:01:09] Yeah, and that’s really important because we’re trying to convert income into wealth, and the way that you do that is by having high fee quality. OK. So what does this really mean? So it’s a very deep topic.
Greg Alexander [00:01:22] I know lots of professional service firms, leaders, and owners who make a great income, but very few are wealthy. This is disappointing and unfortunate because they’ve built great firms, and they should have their cake and eat it, too.
Sean Magennis [00:01:41] Yes, indeed.
Greg Alexander [00:01:42] They should have a big balance sheet and lots of net worth, and they should also have a great annual income, but unfortunately, that’s not happening. I’m reminded of the phrase, “it’s not what you make that matters, but what you keep that counts.”
Sean Magennis [00:01:55] Great phrase.
1. New Versus Existing Client Revenue
Greg Alexander [00:01:56] Yeah. So there are lots of ways to convert annual income into personal net worth, and it’s worth this time here to talk about that. So let me share four easy-to-understand ideas.
So the first analysis of fee quality, which is the active ingredient in wealth creation, will focus on new versus existing client revenue. Boutiques that depend heavily on new client acquisition have poor fee quality. Yes, all firms need a steady stream of new clients, and I’m not suggesting otherwise.
However, this type of revenue, new client revenue, is very expensive to generate, and it’s usually not very stable. It requires heavy investment in business development in the BD dollars, and the non-billable hours could be deployed elsewhere, generating a high return.
Also, boutiques are addicted, and that’s a keyword, addicted, which I think many are to new client fees often are hit and run specialists. Or some call them churn and burn boutiques. They perform well for a period of time, but eventually, they stop growing because word gets out that the sales pitch is better than the product delivery, and this hurts new client acquisition, which is the very thing that they are dependent on.
Professional services firm boutiques that depend heavily on revenue from existing clients also have poor equality. It is true that firms generate fees from existing clients. However, this type of revenue eventually disappears. The nature of boutique work is that it is temporary. Clients are renting your expertise. At some point, they stop paying the rent. They no longer need the work to be reformed, or they take it in-house.
So boutiques that are over-indexed to existing client fees forget how to hunt. They wake up one day needing new clients, and they cannot generate them. These boutiques often devolve into lazy lifestyle businesses. So we’re talking about converting income into wealth.
The key to making that happen is high fee quality, and that comes from a proper balance of fees generated from new clients and existing clients. To give the audience a rough rule of thumb, I would shoot for about a 60/40 split: 60 percent of fees sourced from existing clients and 40 percent of fees sourced from new clients, and that’s a healthy balance.
Sean Magennis [00:04:39] Got it, Greg. So a 60/40 split: 60 percent from existing and 40 percent sourced from new clients. So you mentioned you have four ideas to share. We’ve gone through one. What is number two?
2. Length of Contracts
Greg Alexander [00:04:55] OK, so the next analysis of fee quality is the length of your contracts. Potential investors want to see long-term contracts with clients. So, for example, a management consulting firm that performs a 30-day strategy assessment would be labeled a firm that has poor fee quality because it’s only a 30-day contract.
However, the professional services boutique that performs the strategy assessment, then engages in solution development, and then engages in the implementation might have a contract length of, let’s say, 12 months. That type of firm has very high fee quality because of the length of the contract.
Sean Magennis [00:05:37] Got it so simple. The longer the contract, the higher the fee call.
Greg Alexander [00:05:41] Yes.
Sean Magennis [00:05:43] Very, very good. What is number three?
3. Fee Predictability
Greg Alexander [00:05:47] OK. So after analyzing new versus existing clients and taking a look at the length of a contract, investors will look at fee predictability. So a boutique whose services build on one another is very attractive. These boutiques often produce high feed quality due to the predictability of their future feed. So let me give an example.
Greg Alexander [00:06:11] An estate planning attorney is going to have very high fee predictability. Why is that? State plans often need updating. The attorney, the professional service provider who writes your estate plan, is very likely going to update it for you. The future fee is highly predictable.
An estate plan written, let’s say, for a 50-year-old changes when the parents pass away or when grandkids arrive on the scene. Therefore, that estate plan attorney has a very high fee quality. He can see how his service is going to be consumed well into the future, and you can see in that example how fee predictability is built right into the service offering.
Sean Magennis [00:06:55] Yeah that makes complete sense. Really interesting. So I understand the predictability of the fee that is made is more or less valuable. However, I didn’t consider increasing predictability through service offering design. So will you address that in number four?
Greg Alexander [00:07:17] No. Number four is going to be around cash collections. But let me address it here, if that’s OK.
Sean Magennis [00:07:21] Yeah, absolutely.
Greg Alexander [00:07:21] So very often, you know, it’s an obvious thing that you want to follow on fees from your current clients. But the way that most boutique owners address that is through their business development process, you know. They modify their sales… a marketing campaign, and I define that as a push approach, and that’s more difficult.
A pole approach is if you design the service offering so that when someone consumes the service, they’re going to want to consume more of it for a logical reason. So I gave you the example of the estate planning attorney.
Sean Magennis [00:08:03] Yes.
Greg Alexander [00:08:04] I also gave you the example of the management strategy consulting firm. So let’s think about that. Let’s say I’m a strategy consulting firm, and I start off every project with an assessment. Well, my assessment should be delivered back to the client in such a way that encourages them to ask me to develop solutions to the problems that were identified, and then so that’s project number two.
Sean Magennis [00:08:25] Yes.
Greg Alexander [00:08:26] And then when I deliver those solution recommendations, it should be obvious to the client that I would be helpful in executing or implementing those solution recommendations – that’s project number three. And if you add all three of those up, that’s probably a 12-month gig, right?
Sean Magennis [00:08:42] Yes.
Greg Alexander [00:08:43] And it wasn’t me selling the client. It wasn’t push.
Sean Magennis [00:08:46] Got it.
Greg Alexander [00:08:47] It was all pull.
Sean Magennis [00:08:48] All pull.
Greg Alexander [00:08:48] Yeah.
Sean Magennis [00:08:49] Makes a lot of sense. So let’s now go to number four. What is number four, Greg?
4. Cash Collections
Greg Alexander [00:08:53] OK. So investors often examine for quality, also based on cash collections. So boutiques that have aging accounts receivables have poor quality, and obviously, in contrast, firms that are paid upfront have high fee quality. Investors love firms that can use free cash flow to grow.
Sean Magennis [00:09:13] Yes.
Greg Alexander [00:09:14] If your boutique gets paid in advance, you’re unlikely to need cash infusions down the road to fund your growth initiatives, and that’s very attractive to financial buyers, people like private equity firms.
So, as a rule of thumb, firms that rely on short-term debt to run are not attractive. So the way that you might action that is even if you’re a project-based firm, the way that you write your contracts and the way you handle your payments, you should be trying to collect payment in advance of doing the work.
So let’s say you’re writing a one hundred thousand dollar contract that’s going to take three months to complete. Ask the client to pay 50 percent upfront, 25 percent at the midpoint, and twenty-five percent of that at the conclusion. And just by doing that…
Sean Magennis [00:10:00] Yes.
Greg Alexander [00:10:01] As opposed to sending the traditional invoice with Net 30, it improves cash collections substantially and solves your AR problem.
Sean Magennis [00:10:09] Outstanding advice, Greg. From experience, listeners. So excellent. Greg, thank you for unpacking four things that we can do to increase fee quality and, as a result, convert income truly into wealth.
Sean Magennis [00:10:27] We will be right back after a word from our sponsor. Now, let’s turn the spotlight on Collective 54 members who are making an impact in the professional services field. Collective 54 is the only national peer advisory network for owners of professional services firms who are focused exclusively on growing, scaling, and maximizing business valuation.
Today, we have the pleasure of introducing you to Jeffrey Pruitt, who is the CEO and chairman of Tallwave, a business design and innovation company that helps organizations build, bring to market and scale great products.
Jeffrey Pruitt [00:11:10] Thanks, Sean. It’s great to be part of such a strong organization. I founded Tallwave with partners in 2009 with the mission to help clients transform ideas and businesses in the digital age. I also serve as a general manager of Tallwave Capital, which raised $13.2 million in seed funding in 2014, earmarked for the technology sector.
It’s been the most active Arizona Fund, funding 28 companies in the western region who raised over 56 million in total capital. As an Arizona native, I bring nearly 20 years of technology-focused leadership to the post. Over the past eight years, we have led Tallwave to exponential growth or exchange acquisitions, which has helped earn Tallwave a spot in the INC 5000 list of fastest-growing companies over the last three years.
I recently was named… Business Leader of the Year by the Arizona Technology Council and a most admired leader and tech titan finalist from the Business Journal. This is a testament to the great leaders, employees, and client partners of Tallwave. I also serve as an executive leader of the IDEA Enterprise, a program developed by Arizona State University that connects leading-edge teams with senior business leaders. Thank you.
Sean Magennis [00:12:25] Please get to know Jeffrey and other business owners who are leading innovation in the professional services industry by visiting us at Collective54.com. Learn more about how Collective 54 can help you accelerate your success.
Sean Magennis [00:12:43] In an effort to provide immediate takeaway value for you, the audience, I’ve prepared again a ten question checklist. Please ask yourself these ten questions. If you answer yes to eight or more of these, you have high fee quality.
Number one: Did you generate about 60 percent of your fees from existing clients?
Number two: Do you generate approximately 40 percent of your fees from new clients?
Number three: Is the average client contract longer than 12 months?
Number four: Do your projects naturally build on top of one another?
Number five: Is your service built to pull through on the upsell?
Number six: Is your service designed to pull through cross-selling?
Greg Alexander [00:13:49] So let’s distinguish between those two.
Sean Magennis [00:13:51] Yes, please.
Greg Alexander [00:13:52] So upsell means selling more of what somebody has already bought. So instead of them buying three, they buy ten. Cross-sell is to get them to buy something different than what they’ve already bought. So the greatest cross-sell question of all time was, do you want fries with that?
Sean Magennis [00:14:09] Love it, yes, and you know who makes the best fries in the world, by the way?
Greg Alexander [00:14:14] Who’s that?
Sean Magennis [00:14:15] McD.
Greg Alexander [00:14:15] Yeah, I agree.
Greg Alexander [00:14:17] So at the moment of purchase, someone’s buying a Big Mac, and somebody says you want fries with that. You know, the conversion rate there is really, really high, and they obviously designed their product offering in that case in such a way, and then they came up with the bundle and the coke and all that.
Sean Magennis [00:14:34] Yes.
Greg Alexander [00:14:35] So that’s a difference between upsell and cross-sell. I just wanted to clarify that.
Sean Magennis [00:14:38] Thank you, Greg. So number seven: Are your fees predictable? Number eight: Do you collect your fee in advance of performing the work?
Greg Alexander [00:14:52] You know, just a comment on number seven, if I can. In terms of fee predictability, another way to think through that- and I’ll use the accounting industry as an example – we all have to file our taxes on April 15th. Okay. So if you’re somebody who’s going to invest in a accounting firm, you know that there is this kind of natural, compelling event, right?
Sean Magennis [00:15:11] Yes.
Greg Alexander [00:15:12] So now that was dictated by the federal government mandating when your taxes were due, so there’s a natural advantage there. So if you’re an owner of a professional services firm right now and you’re saying, “Well, I don’t have the law on my side, you know, how can I establish dates upon which business has to be completed?”
Well, one way to think about it is your client’s fiscal year, and in most fiscal years, there’s the planning process. And if you’re on a calendar fiscal year, meaning January through December, most companies start their planning process, let’s say, in late Q3, early Q4. So let’s say August to October, and many times during that planning process, there is a need for external assistance and this is just one example of many.
The way you can increase your fee predictability is you can build service offers in in packages that are relevant to clients at certain moments of their fiscal year. So, when you start getting people used to buying from you, especially existing clients that way, then you have some fee predictability which will make yourself very attractive to a potential buyer.
Sean Magennis [00:16:20] Excellent. Thank you, Greg.
Sean Magennis [00:16:24] Question number nine: Can you fund your growth from free cash flow. And finally, question number 10: Can you pay your bills without using debt? Very key.
Greg Alexander [00:16:37] Yeah. You know, a lot of times, growing professional services firms have a hard time hitting payroll every month.
Sean Magennis [00:16:43] Yes, indeed.
Greg Alexander [00:16:44] The reason why that is, is that their clients are delaying their payment, but yet, payroll can’t be delayed. So they go to short-term lenders to bridge the gap on payroll, and obviously, that is expensive and risky. So you want to get away from that, and the way you get away from that is you get paid in advance.
Sean Magennis [00:17:01] Thank you for that, Greg. So as we’ve learned from today’s podcast, all revenue is not necessarily good revenue. There are good fees and then there are bad fees. Good fees attract buyers. They increase the value of your firm and they improve the odds of exiting. Bad fees push buyers away. They decrease the value of your firm and they will likely prevent you from selling your business.
Sean Magennis [00:17:31] If you enjoyed the show and want to learn more, pick up a copy of Greg Alexander’s book titled “The Boutique How to Start Scale and Sell a Professional Services” Firm. I’m Sean Magennis. We thank Greg again, and thank you for listening.