Understanding the Use of Debt in Boutique Professional Service Firms

Understanding the Use of Debt in Boutique Professional Service Firms

As the founder of a boutique professional service firm, one of the essential yet challenging aspects of business management is navigating the financial landscape. The question of funding and cash flow is crucial. Why might a founder consider taking out a loan? The answers are multifaceted.

For starters, external funding, especially in the early stages of a firm, can be the lifeline that ensures smooth operations, facilitates growth, and bridges the cash-flow gaps. While there are various sources of funding, loans often emerge as a preferable choice. But who might a founder borrow from? Traditional banks, credit unions, online lenders, and sometimes even professional acquaintances can offer loans, depending on the founder’s network and firm’s credentials.

Interestingly, debt financing (taking loans) often holds an edge over equity financing (giving away company shares). The reason is control. With debt, you remain the primary decision-maker, not having to dilute ownership or accommodate the interests of external shareholders. However, borrowing comes in various flavors, each tailored to specific needs.

    1. Term Loans Term loans are fundamental in the lending world. These are typically loans of a specific amount for a specific purpose. The funds can come as lump sums or in installments. Repayment generally commences from the inception of the loan and can be structured over various tenures, either being fully paid off on the maturity date or through an amortized schedule.

When is it best to use? Imagine you’re expanding your firm’s services and require new talent. A term loan would be ideal, offering you the required large sum upfront, allowing for the acquisition of the new talent.

When should it be avoided? If the firm’s cash flow is inconsistent, repaying a term loan might become a burden. In such cases, a flexible repayment structure might be more suitable.

    1. Revolving Loans Often synonymous with a line of credit, revolving loans grant founders’ access to funds up to a set limit. The magic lies in the flexibility—borrow only what’s needed and repay, usually with interest on the drawn amount.

When is it best to use? Let’s say your firm is waiting on payments from big clients, but you have immediate operational costs. A revolving loan offers the liquidity to manage such working capital requirements without borrowing a massive lump sum.

When should it be avoided? If not managed judiciously, a revolving loan can lead to perpetual debt, with the founder perpetually drawing and repaying, leading to hefty interest payments over time.

    1. Secured Loans These loans require collateral, i.e., an asset (like property or accounts receivable) that the lender can seize if repayment falters.

When is it best to use? Suppose you’re investing in cutting-edge software or technology for your firm. Given the substantial cost, a lender might seek assurance in the form of collateral. With a secured loan, you could potentially get lower interest rates due to the reduced risk for the lender.

When should it be avoided? If the risk of non-repayment is high or if the asset is indispensable to firm operations. The danger of losing the collateral can be detrimental to the firm’s functioning.

In conclusion, while loans can be a lifesaver, they come with their own set of risks. Debt is a double-edged sword—it can bolster growth but can also lead to financial distress if not managed prudently. The key lies in understanding the firm’s needs and aligning them with the right type of loan. As founders, we must recognize that every type of debt has its pitfalls, which become exacerbated when the wrong loan is opted for in an unsuitable scenario. Making informed, strategic financial decisions is vital to ensuring the firm’s sustainability and growth.

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.

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

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.

Master the Art of Forecasting Revenue, Profit, and Headcount in Your Boutique Service Firm: A Strategic Guide

Master the Art of Forecasting Revenue, Profit, and Headcount in Your Boutique Service Firm: A Strategic Guide

Ever wondered how to create a bulletproof forecast for your revenue, profit, and staffing needs in your professional service firm? It’s a critical task that can make or break your business growth, sale potential, and overall scalability. In the world of boutique firms, precision is everything. This post presents a hands-on guide to nailing these forecasts, with steps tailored to different scenarios: quarterly, annually, and multi-year.

Here is a guide to forecast revenue, profit, and headcount. 

Forecasting Revenue:

    1. Data Roundup: Your past can predict your future. Collate your historical revenue data, zeroing in on overall revenue and specific client or project revenue. For example: in 2020 the firm did $8 million, in 2021 $9 million and in 2022 $10 million.
       
    2. Identifying Revenue Influencers: What moves the needle in your firm? Client contracts, project pipelines, retention rates, market demand, and pricing strategies can all be key players. For example, in 2022 client #1 extended the contract by six months, but in 2023 the contract ended. 

    3. Reading Market Signals: Stay attuned to market conditions and trends. Wallet share, macro-economic indicators, and emerging opportunities can impact your revenue significantly. For example, the share of wallet inside your top 10 clients is 80% but you just invested in sales so new client acquisition should be up. 

    4. Revenue Modeling: Shape your data into something that speaks. Use techniques like trend analysis, regression analysis, or time series forecasting. For example, descriptive analytics describes what happened, diagnostic analytics tells you why it happened, predictive analytics will tell you what is about to happen, and prescriptive analytics tells you what to do to alter the future outcome. 

    5. Testing Your Assumptions: No forecast is complete without a sanity check. Engage your team, peers, mentors, and Collective 54 members to validate your assumptions. Pro tip: bounce your forecasts by your Collective 54 Leadership Board.

    6. Risk Assessment: Risk is a reality. Consider potential challenges like win rates, project delays, or employee turnover in your revenue forecast. For example, you are running at 100% utilization and time to fill an open req is 90 days.

    7. Refining Your Forecast: Stay nimble. Adjust your forecast to accommodate seasonality, cyclical patterns, or one-time events, and keep updating it as new information emerges. For example, the week between Christmas and New Years is dead.

Profit Forecasting:

    1. Counting the Cost: Your services come at a price. Calculate both direct and indirect costs associated with service delivery. For example, $20,000 to acquire a new client, ~20% of project fees go to cost to serve, 10% of firm revenue on overhead etc.
       
    2. The Drivers Behind Costs: Identify what’s causing your costs. The relationship between revenue growth, costs, and scaling can reveal a lot about your firm’s efficiencies. For example, the leverage ratio of senior to junior staff’s impact on labor costs. More seniors and less profit.

    3. Crafting Profit Models: Subtract your projected costs from revenue forecasts to build profit models, track profitability trends over time. For example, Collective 54’s benchmark data says best-in-class margins are 80% gross margin, and 50% EBITDA margin. How does your forecast stack up? 

    4. Sensitivity Analysis: Revenues and costs can change. So, how will this affect your profit? Test the waters with sensitivity analysis. For example, margins from your ideal clients are 65% but from non-ideal clients is 35%, and yet half your clients are outside your ideal client profile. What would happen to the profit forecast if you stopped selling shitty work?

    5. Financial Goals Alignment: Your profit forecast should match your financial ambitions. Pro tip: see what your firm is worth by using Collective 54’s Firm Estimator tool here.

Headcount Forecasting:

    1. Productivity Ratio Analysis: Profit and headcount are closely tied. Compute productivity ratios to better understand this relationship. For example, revenue per head in 2022 was $400k. 

    2. Staffing Need Assessment: Identify your staffing requirements based on projected revenue growth. For example, with 20% revenue growth, we need 4 juniors for every senior to keep our leverage ratio at 4:1. 

    3. Turnover Rate Consideration: Employee attrition can be a pain point. Use historical turnover rates to estimate future staff changes. For example, your historical turnover rate is 15% per 100 employees so to stay headcount neutral you need to recruit 15 people per year.

    4. Hiring Plan Development: Align your hiring plans with your revenue and profit forecasts. For example, you need 75% of the headcount expansion in the first half of the year if you are to hit the full year revenue goals.

    5. Monitoring and Adjustment: Always keep an eye on your actual headcount and adjust hiring plans when necessary. For example, revenue is softer than expected so reduce the hiring plan by x%.

Time Horizons and Their Impact on Forecasting

The forecasting processes outlined above may vary based on the time horizon involved.

    • Quarterly forecasts: Focus on short-term revenue and profit projections, considering specific sales pipelines, ongoing projects, and immediate market conditions. Headcount forecasts should align with the short-term workload. 

    • Annual forecasts: Incorporate a broader view of the market and consider long-term trends. Revenue and profit forecasts should account for annual cycles, market fluctuations, and strategic initiatives. Headcount forecasts should align with the anticipated workload for the year. 

    • Multi-year forecasts: Consider long-term market trends, industry developments, and strategic goals. Revenue and profit forecasts should reflect growth objectives, market expansion plans, and potential risks. Headcount forecasts should align with the long-term growth trajectory and strategic initiatives.

Conclusion

For any boutique professional service firm, forecasting revenue, profit, and headcount can be a make-or-break endeavor. With the above guide and by regularly updating your forecasts, you can make strides towards your wealth, income, and workload goals. Start your forecasting journey today and steer your firm towards continuous growth and prosperity.

Episode 17: The Boutique: Where to Find the Cash to Scale

Boutiques run on cash. They do not run on net income nor EBITDA. Some boutiques neglect the management of cash flow. Take a moment to understand how you can improve the flow in and out. In this podcast episode, we look at where you can find cash flow when scaling a business.

TRANSCRIPT

Sean Magennis [00:00:15]: Welcome to the Boutique with Capital 54, a podcast for owners of professional services firms. This show aims  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 on this episode. I will make the case that boutiques run on cash-flow. They do not run on net income or EBITA. I’ll try to prove this theory by interviewing Greg Alexander, Capital 54’s chief investment officer. Greg is an expert at helping firm owners boost cash flow. Greg, good to see you. Welcome.

Greg Alexander [00:01:03]: Hey. Good to be with you. Do you remember the movie Jerry Maguire and the famous line, show me the money? Let’s start with that. So on the count of three, let me hear your best “Show me the money.” Are you ready?. One, two, three.

Sean Magennis [00:01:19]: Show me the money.

Greg Alexander [00:01:24]: Awesome, you’re a great sport. I think we’re ready to begin.

Sean Magennis [00:01:27]: Yes, we are, funny enough. I just watched that again recently. It’s a great movie.

Why is Cash Flow So Important When Scaling a Business?

Sean Magennis [00:01:32]: Okay. So why is cash flow more important than net income and EBITDA for a firm trying to scale.

Greg Alexander [00:01:41]: Sure. And when I say casual, I mean simply cash coming in and going out of a professional services firm. And it is different than net income. Net income is a profit a firm makes for a period and is often calculated for tax purposes. Whereas cash flow comes from daily activities, and cash flow is also different from  EBITDA because EBITDA does not consider capital expenditures, which are most definitely cash outflows.

Greg Alexander [00:02:06]: As to why it is more important to boutiques trying to scale, its firms run on cash. They are scaling a business, which means they are pouring the cash back into the business. They would rather invest it than give it to the government or a potential acquirer.

Sean Magennis [00:02:22]: Completely understood. And it’s often said entrepreneurs often seriously mismanage cash flow. Do you agree with the statement? And if so, is it relevant to our listeners?

Greg Alexander [00:02:34]: Yes and yes. In my capacity as Chief Investment Officer at Capital 54, I see our listeners, a.k.a. owners of boutique service firms, trying to raise capital when they don’t need it. They think they need X amount of capital to scale when in fact, they’re often generating enough cash from operations to fund scaling.

Sean Magennis [00:02:57]: And Greg, why does this happen?

Greg Alexander [00:02:59]: This happens because sometimes owners do not know how to boost cash flow because they are not measuring it properly.

Sean Magennis [00:03:06]: Please explain that to our listeners.

How to Scale a Service Business: Ways to Boost Cash Flow

Greg Alexander [00:03:08]: The best way to find ways to boost cash flow is to measure it correctly, and  the best way to measure it is at the project level. Measuring cash flow in the aggregate hides waste. Here’s a recent example. My team recently performed due diligence on a public relations firm seeking to raise growth capital, and they used the following formula. I wish I was on a whiteboard but bear with me here audio audience. 

So cash flow per project equals cash flow divided by fees times fees divided by staff times, and staff divided by project. This revealed a healthy six hundred and fifty thousand dollars per project in this instance. This told me the firm was generating plenty of cash to fund it’s  aggressive expansion plan. Yet they were on a Zoom with me looking to raise money, claiming they did not have enough cash. I’m not sure where the cash was leaking, but it was leaking like an old faucet.

Sean Magennis [00:04:14]: And Greg, the point is to measure cash flow at the project level, not at the firm level.

Greg Alexander [00:04:19]: Yes, exactly.

Sean Magennis [00:04:23]: And now a word from our sponsor. Collective 54 is a membership organization for owners of professional services firms. Members join our mastermind group to work with their industry peers to grow, scale, and someday sell live firms at the right time, for the right price, and on the right terms. Let us meet one of the Collective 54 members.

Nish Parikh [00:04:49]: Hello. My name is Nish Parikh. I owned Rangam Consultants, where empathy drives innovation every single day. We serve Fortune Global 500 companies for their I.T. and all business professional leads. We serve customers in the United States, Canada, Ireland, UK, and India. 

These customers turn to us for help with their disability and autism hiring programs. Every one of us is connected to someone on the autism spectrum or with a disability. The challenge is finding autism-friendly  jobs and matching them to the right candidate where they can be successful. We solve this problem by building a connected community in the workplace through technology. 

We build a formal, structured, and scalable program that seamlessly integrates with our clients’ existing hiring practices. If you need help with your disability and autism hiring program, reach out to me at [email protected] or visit sourceabled.com.

Sean Magennis [00:05:53]: If you are trying to grow, scale or sell your firm and feel you would benefit from being a part of a community of peers, visit the Collective 54 community page. .

Sean Magennis [00:06:10]: So this takes us to the end of this episode, and as is customary, we end each show with a tool. We do so because this allows a listener to apply the lessons to his or her professional services firm. 

Our preferred tool is a checklist. And our style of checklist is a yes-no questionnaire. We aim to keep it simple by asking only ten questions. In this instance, if you answer yes to eight or more of these questions, your cash flow is not your obstacle to scaling a business. If you answered no a lot, you are not generating enough cash to scale.

Sean Magennis [00:06:48]: So let’s begin. Question number one, will you run out of working capital if you double the size of your firm?

Greg Alexander [00:06:56]: So this happens all the time. You go sign up a bunch of work. You got net 30 terms, which means they pay net 60, and you’re literally growing yourself out of business.

Sean Magennis [00:07:07]: Yep. Got it. Number two, will you need short-term debt if you double your firm?

Greg Alexander [00:07:12]: So, in that instance, now you’re borrowing money just to make payroll.

Sean Magennis [00:07:18]: Number three, will you develop a collections problem if you double your firm.

Greg Alexander [00:07:24]: Here we go.

Sean Magennis [00:07:24]: You said it, right?

Greg Alexander [00:07:24]: Right. So all of a sudden, now you’re, instead of selling projects, you are  chasing bills.

Sean Magennis [00:07:28]: Yep. Number four, will your cash payments exceed your cash income if you double your firm?

Greg Alexander [00:07:36]: Payroll is going to kill you there. Right.

Sean Magennis [00:07:38]: Right. Number five, will you have a hard time getting enough cash on the balance sheet to double your firm?

Greg Alexander [00:07:45]: Right. So the way to handle that, if you’re going to have this cash flow problem, meaning you get paid after you do the work instead of before the work, is you get to build up cash reserves on your balance sheet to carry you through those times.

Sean Magennis [00:07:58]: Number six, when growth has spiked in the past, did your cash flow ever turn negative?

Greg Alexander [00:08:05]: Yep.

Sean Magennis [00:08:06]: Number seven, will payroll growth exceed accounts receivable growth when you double your boutique? 

Greg Alexander [00:08:13]: Yep.

Sean Magennis [00:08:14]: Number eight, will cash flow problems be hidden due to lack of forward visibility?

Greg Alexander [00:08:20]: That happens all the time.

Sean Magennis [00:08:22]: Number nine, will it be hard to generate yield on your cash deposits? Specifically in today’s day and age.

Greg Alexander [00:08:30]: Yes, exactly.

Sean Magennis [00:08:31]: And number ten, will you be at risk of paying your future obligations if you double your firm?

Greg Alexander [00:08:37]: Right. So, I mean, literally, if you think about it, if you’re one of these high growth businesses, which is our listeners, you can grow yourself into a lot of cash flow problems. So you got to be aware of that by asking yourself these ten questions. And there’s so many easy fixes here.

Sean Magennis [00:08:54]: Yes.

Greg Alexander [00:08:54]: And that’s probably content for another episode. But the easiest one just to give you the silver bullet is to get paid in advance. If you get paid in advance, you don’t have these issues.

Sean Magennis [00:09:04]: Love it. So, in summary, boutiques run on cash. They do not run on net income or EBITDA. Do not run out of cash as you try to scale.

Sean Magennis [00:09:16]: 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.” Greg, thanks for being here. I’m Sean Magennis, and thank you, our listeners.

Episode 13: The Boutique: A DIY Approach to Raising Growth Capital

Scaling a boutique takes money. This type of money is called scale capital. There are three primary sources of scale capital. Each has a set of advantages and disadvantages. Which is best for you is highly situational.

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TRANSCRIPT

Sean Magennis [00:00:15] 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. On this episode, I will make the case to scale your firm requires capital, and that not all capital is the same. I’ll try to prove this theory by interviewing Greg Alexander, Capital 54’s founder and chief investment officer. Greg has been on both sides of this. While the owner-operator of consulting firm SBI, he raised capital and as chief investment officer of Capital 54, he invest capital into boutiques like yours. This makes him uniquely qualified to help boutique owners think through the need for capital during your scale stage. Greg, great to see you, and welcome.

Greg Alexander [00:01:25] Hey, pal. Good to be with you. I’m looking forward to our discussion today. By the end of the show, we will be reminded that it takes money to make money.

Sean Magennis [00:01:34] It sure does Greg, why don’t we start right there? Why do firms need capital when trying to scale?

Greg Alexander [00:01:41] So scaling usually means entering new markets, launching new service lines, adding more headcount and many other strategic initiatives. And these things take money.

Sean Magennis [00:01:52] Yes, I agree. And at the top of the show, I suggested that not all capital is the same. What sources of capital are available to boutique owners during the scale stage?

Greg Alexander [00:02:05] These days, capital is abundant and there are many kinds. You only have 10 minutes or so, therefore I would focus on a do it yourself approach, which has three types of capital. First, there is free cash flow from operations. This comes from increasing revenue and driving down costs using the spread to scale. I mean, why give it to the government in taxes. Number two is debt. It comes from banks and private lenders. There is a way to do this without mortgaging your soul. And third, we have equity partners. This is when an investor puts in cash in exchange for a piece of the action. Watch out for predators. But the right equity partner can add a lot in addition to capital.

Sean Magennis [00:02:52] This is simple enough. But what are the pros and cons of each of those?

Greg Alexander [00:02:58] Well, free cash flow from operations is the best. The reason this is the best is because it’s cheap and in unlimited supply for well-run boutiques scaling with free cash flow. Preserve the preserves the owners equity. It does not add a debt service burden to the peno in the best of the best boutiques. Know how to allocate intelligently, which acts as a flywheel throwing off more and more of this free cash flow. There are some disadvantages to relying on free cash flow to scale.

Greg Alexander [00:03:34] For instance, instead of putting the free cash back into the business to fund scale, many owners pull it out of the business and pay themselves. This retards growth and adds years to the firm’s timeline toward an eventual exit. This is a difficult temptation to resist. Debt is the next best alternative to free cash flow. In my view, it is not cheap, but it is reasonable as lenders charge modest rates and loans to boutiques and it is also readily available in the two to three times, even arrange the negatives to debt are obvious. But let me quickly point them out. It does add an expense to the PNL as a loan payments need to be made. This will reduce the owner’s income. However, it does preserve the owner’s equity. So this can balance out over time. Unfortunately, young firms cannot secure it unless they personally guaranteed a loan. In some cases, this still does not work because the owner’s personal assets are not enough to act as collateral. Lastly, there is taking on an equity partner. This is cheap in the short term, but expensive in the long term. There is no loan payment to be made, meaning more cash is available. However, the owners stake in the firm is diluted as the equity partner is taking a piece of the business. And when an owner of a boutique sells, the equity partner gets his piece of the pie.

Greg Alexander [00:05:08] And one more thing. It is difficult for a processor firm to attract an equity investor. Many equity investors simply do not invest in people driven businesses. So it is in short supply. But that was a lot. Let me stop talking here.

Sean Magennis [00:05:24] Greg, this is excellent. How about sharing a little from your personal journey to to make sense of this?

Greg Alexander [00:05:31] Sure. So my firm, SBI, used free cash flow from operations as its source of scale capital. In retrospect, this was a mistake. It took 11 years to start scale and sell my firm. If I had taken on some debt, I think I could have cut this time in half. We were able to deploy capital effectively. Each investment resulted in more clients and each initiative resulted in lower costs. More capital would have resulted in even more clients and even lower costs. During my run, the cost of debt was much lower than the return we were generating. I will say, however, I am grateful I did not take on an equity partner. We were able to sell for nine figures. If I had taken on an equity partner, my share of the price would have been much less and I would have had sellers regret.

Sean Magennis [00:06:26] That’s a great personal example Greg. Thank you for bringing this to life. Well, I can’t think of a more important strategic decision for our listeners to get right. This one comes with very high stakes.

Sean Magennis [00:06:43] And now a word from our sponsor. Collective 54, Collective 54 is a membership organization for owners of professional services firms. Members join to work with their industry peers to grow scale and someday sell live firms at the right time for the right price and on the right terms. Let us meet one of the collective 54 members.

Matt Rosen [00:07:09] Hello. My name is Matt Rosen and I’m the founder and CEO of Allata. Allata serves large enterprise clients in the financial services, healthcare, retail distribution and professional services spaces. Our clients are centered around our offices in Dallas, Phoenix, Provo and Boise. Clients like the Frieman companies and brinks some security turn to us for help with strategic initiatives in the business and digital transformation space, typically creating new revenue streams, building seamless customer experiences and streamlining operations. We help with these initiatives by building digital strategies and roadmaps, assisting with enterprise architecture and design, working with data as an asset and customer, developing solutions which help our clients reach their strategic objectives. If you ever need help with digital strategy data and customer development initiatives, please reach out to me at www.allata.com Or [email protected]. Thank you.

Sean Magennis [00:07:57] If you are trying to grow scale or sell your firm and feel you would benefit from being a part of a community of peers, visit Collective54.com.

Sean Magennis [00:08:13] So this takes us to the end of this episode. And as is customary, we end each show with a tool. We do so because this allows the listener to apply the lessons to his or her firm, our preferred tool as a checklist. And our style of checklist is a yes, no questionnaire. We aim to keep it simple by asking only 10 questions. In this instance, if you answer yes to eight or more of these questions, all three of these capital sources are available to you. If you want to know to questions one to three, do not pursue funding scale with free cash flow. If you answer no to questions, four through nine do not rely on debt to fund scale. If you answer no question, 10 do not take on an equity partner. Get it, Greg?

Greg Alexander [00:09:06] I got it.

Sean Magennis [00:09:07] So let’s begin. Number one, are you generating enough free cash flow to fund scale? Number two, do you know where to deploy this extra free cash flow? Number three, are you willing to go without today for scale, tomorrow? Number four, have you been in business for at least five years? Number five, are you generating stable EBITDA every year? Number six, Would two to three times EBITDA be enough to fund scaling your firm? Number seven, can your PNL handled a debt service burden of a loan? Number eight, are you willing to personally guarantee a loan? Number nine, do you have enough personal assets to secure the loan, if you’re open to a guarantee? And number ten, are you willing to dilute your ownership take for the right equity partner?

Sean Magennis [00:10:26] In summary, it takes money to make money. Scaling a boutique takes money. There are different funding sources, each with their own pros and cons, all work well. Which is best for you is highly situational. Take your time to consider this very important strategic decision.

Sean Magennis [00:10:51] 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. Thank you for listening.