Consulting Math vs. Software Math

Post by
Scott Francis

Jason Cohen, a local Austin startup hero, paints a bleak picture for consulting in "The unfortunate math behind consulting companies."? The basic thesis is that it is really hard to ramp up from a single-person consultancy to a bigger company that makes money.? He's right. It *is* hard.? But it is also harder to be an individual consultant than he lets on:

  • Most independent consultants have a hard time relaxing when they're "off".? They get enough time on the bench or on vacation to live a good life, but when they're on the bench they're worried about when the next project starts. It makes it hard to truly enjoy time off.
  • Lack of camaraderie.? There's no team as an independent.? At first that is liberating, but later on it is frustrating for those of us that are more social.
  • Lack of vision.? Being an independent consultant does lack a certain vision.? What are the goals? What are we building toward?? What gets me excited about getting up in the morning to do this work?? You know, besides paying the bills?
  • Not to mention, your income is clearly a function of hours worked * billable rate.? Not everyone likes that.
  • You have to do it all: sales, contracts, insurance, delivery of the project, project management, QA, etc.

Most happy independents that I know offload at least a couple of these things:

  • Having a spouse with insurance.
  • Having another company produce most of their leads/business, while they just focus on delivery.
  • Paying other independent consultancies to do things like accounting, benefits, and other bits that aren't in the sweet spot.

So this leads to the question:? should you hire?? Should you try to grow your consulting firm to a bigger practice?? Jason writes:

Consulting can be a great way to fund a startup or make a bunch of cash. It?s easy to start; Just pick an hourly rate and jump in.

But someday soon you?ll notice there?s only so many billable hours in the day, and you?ll be tempted to expand. Maybe hire an employee for $30 per hour and re-bill them at $60. Easy money, right?

Unfortunately the math doesn?t work that way.

Jason is right. It isn't that easy.? But it isn't quite as bad as he makes it out to be either.? First, let me lay out some of the ground rules you can use as assumptions if you're building a consulting company.

  1. Base your budgeting on 2000 hours in a year.? It is a nice swag (2 weeks off), and it also makes the math easy!
  2. Expect 80% billable as your realistic maximum, though some of your people will do better than this.
  3. A good rule of thumb is that your minimum billable rate is 2x the hourly cost.? At 80% billable this is better than break even.? But at 50% billable you're losing money. This isn't a good billable rate, but it is the minimum billable rate. Because you do have costs: Medical benefits, 401k contributions, office space, vacation, downtime, sales & marketing, etc.? But there's no reason to settle for the minimum rate.
  4. If you are using a contractor (1099) in the US, you shouldn't expect to markup their rate by more than 50% (ie, 33% margin for you at most).

So, even with all that, Jason paints a pretty bleak picture for your prospects of making money as a consultancy.? The primary issue is scaling the size of your business so that you can (a) reduce risk, and (b) make more profit.? If you talk to friends at startup software companies, they'll spend lots of time discouraging you about the scalability of consulting companies (something investors and software folks are pretty convinced of).? Here are my thoughts about how to address scale, risk, profit:

Start with a co-founder.? If you don't have one, find one who is also a specialist in the same area, or who has a tightly complementary specialty.? Make sure that you have enough skills overlap that you can cover for each other in a bind, but that you also have some different skills to augment each other in unique ways.? Starting as a company of two partners is easier than being the sole founder with one employee.? (Who wants to be your first employee, anyway?).? It allows you to reduce your risk - and if you charge correctly you can be break-even if one of you is billing.? And you'll have more flexibility to chase leads, take vacations, etc. - without company revenue declining to Zero while that is happening.

If you're going to grow, you're going to forgo profits.? The independent consultants I talk to don't want to admit that, but it is true.? At BP3, Lance Gibbs and I certainly could have had a more profitable first 3 years of operation if we just ran a two-man shop.? But we saw an opportunity to grow a bigger business.? We hired great people - and held on to the team through lean times in 2008 and 2009 - taking lower salaries ourselves and paying people when they were on the bench for long periods of time.? That scrappiness and determination got us into a great position to grow our team in 2010 and 2011 - from a bigger base.? But remember - every time you hire, you're investing profits - reducing your cash flow for 60-90 days (or longer if training is required).? A good way to think about it is that people you hire in 2011 will add materially to your business in 2012 - it makes you plan conservatively around what you can afford.?? Now that we're a little bigger, it is easier for us to hire when we come across the right person - we don't have to work as hard to time each hire just right.

This also means that it is better to not grow, than to hire the wrong people.? If you take this approach, when you can't find enough talent to grow, you'll be more profitable.? When you can find those people, you'll grow the business at a little lower margin, and with a little tighter cash flow - but with your future baseline performance at a higher level.

Those early hires are really important.? See the previous point.? Early hires in a consulting firm set the tone: culture, discipline, follow-through, work-ethic, reputation, skill.? Don't hire someone on reputation alone - better to hire someone whose reputation hasn't caught up to their real performance than to hire someone whose reputation exceeds their real capability. If you hire the right people at the beginning, it actually gets easier to attract the right talent later on.

Forecast next year's revenue based on your current staffing.? Don't fall into the trap of building a consulting-based business plan that depends on hiring people in the same year that they contribute to your bottom line.? I've seen a lot of these "plans" before: "we'll hire 3 people in Q1, 4 people in Q2, 6 people in Q3..."? To which my response is typically "which 3 people? which 4? which 6?"? If you don't know who they are, take that out of your plan.? A better way to write it would be:

Based on our forecast we can afford to hire 3 people in Q1, 4 people in Q2, 6 people in Q3.

Point being: there's a difference between what you can afford, and what you can actually execute.? Given how important each person is to the growth of your company, are you going to hire the best 3 people you can find in Q1, or will you only hire 2 if you can only find 2 you're excited about?? Intellectually we all know what the right answer is but it is important to actually act on that knowledge.

Get Financing.? You may not think you'll need it - but as soon as you can, get it.? When you're a small consulting company, usually one customer has an outsized influence on your cash flow.? Having a line of credit or a loan can give you some cushion against the vagaries of their accounts payable.? Word of warning: it is very difficult to get a traditional bank to do this until you have 3 years of history as a business.? Second, you'll be referred to operations that do receivables factoring, but I would recommend steering clear of those companies because their contracts are horribly one-sided and may make it difficult to get traditional financing later on. If you and your partner have the capital for it, it may make sense to put some money into a corporate savings account - to be tapped only in certain situations that all the partners agree upon.

Have a sharp focus.? You have to know how to say no to work that isn't in your sweet spot.? Saying yes to all the opportunities that come your way will cause the following problems:

  • You won't build the necessary depth in your chosen area of expertise, or any particular area at all.
  • Your win rate will be a lot lower - because you'll be competing with people who specialize in each area, whereas you are essentially presenting yourself as a generalist.
  • You can't effectively partner with other people or companies because you always feel like you could be competing with them for business.? Ask yourself what kind of work you would refer to the partner firm, and what kind of work the partner would reasonably refer or sub to you.? If you can't answer that question, one or both of you is lacking focus.
  • You won't build a reputation in your niche.? Reputation in the age of twitter and blogs is really powerful.? Lack of one is similarly powerful in its absence.? Start blogging, get on twitter, and learn your niche and who the experts are.? Those experts are rarely wanting for work.

Back to Jason's Post:

Jason terms it "unfortunate" math for consulting... but the real problem is that consulting is an EQ business, rather than an IQ business.? It requires more emotional maturity and awareness, and the smartest guy in the room is not necessarily the best consultant.? Ideally you're both high IQ and high EQ.? But don't forget which one will get you further in consulting - EQ.? If you don't have a high EQ, partner with someone who does!? There's no one "right answer" to how to succeed as a consultant.? But there are definitely higher or lower risk plays on the business.

Jason points out in his post a series of problems a small consulting firm will face.? There are remedies to the problems Jason points out, and he offers a few himself.? But as you ramp up your team, in my experience when the firm is ~5 people is the hardest phase in growth.? At that stage you need everyone billing as much as possible, you can't afford to pay for overhead (a non-billable person working for your company), and somebody (hello, founder) has to work a lot of extra hours to get things like invoicing, sales, and recruiting done - because customers don't pay you to do that work with billable time, you don't want to pay someone else to do it for you, and it has to be done right.

As you head north of 10 people, the math starts to work more in your favor.? You can hire non-billable help with administrative or sales work, or one of the knowledgeable billable people on your team can explicitly spend less time billing.? Another thing I've often heard from bigger companies is that getting past 15 people is a tough barrier - that you run out of "people you know" to hire, and have to get your operations in much better order than you required as a smaller company. I agree that somewhere between 10 and 20 people, the nature of your firm changes and you need to change with it.? I'm sure that is true at many inflection points further on as well.? If you just look at this as another interesting business problem to solve, you're in good shape.? If someone tells you there's a glass ceiling to how big your services business can get, just ask them if they know how big IBM's professional services business is.

Jason's thought on running the business at smaller sizes:

  • None of these new tasks are fun or creative. It?s drudgery, and it?s on you. Congrats, you?re a business owner.

Well, don't go down the path of building a business unless you enjoy being a business owner and running or building your business.? If you enjoy doing this sort of thing, it won't feel like drudgery - it will feel empowering and gratifying*.? If you don't enjoy this sort of thing... partner with someone who does, or get a job!

His other recommendations are in bold, my comments in regular typeface:

Recommendation: Charge more.? Well, this one is a bit obvious.? If you have too much demand for your services, you generally need to raise your rates or hire more people (increase supply).? Figure out which one you can do.? The basic issue is, pricing is incredibly important in consulting businesses.? Mimiran is a great resource for better pricing techniques.? But regardless, you have to understand that your consulting value is worth more than the hourly wage you put in.? You have uniquely differentiating value.? You're likely committing to provide your customer with an outcome or else lose your "job" (contract) - which is something their own team may not be putting at risk.? An hour is not what you are truly charging for, you're charging for the output you produce, and dividing it by the # of hours. There is a difference.

Recommendation: Bill more hours.? Generally consultants bill more than what Jason was describing in his post. While this is true, so long as you bill by the hour, I'd phrase this differently:? provide more value.? That might mean billing more hours.? Or it might mean that you will either raise your rate or the demand for your services by providing "better outcomes".? Focus on the value.

Recommendation: Build a product.? I'd be very careful with this one.? Most consulting companies don't make the transition.? The product you're going to build has to be something that will get a lot of your attention and TLC - and likely something that earns money for you right away.? What you don't want to do is take a profitable consulting company, plow the profits into a product that isn't profitable (most products aren't), and then find yourself with a less valuable enterprise overall.? Make sure the product is truly something you want to invest in, and make sure you understand how it will yield revenue.

Recommendation: Use subcontractors instead of employees.? This is lower risk, but lower reward - and I don't just mean financially.? This choice comes down to what you want to be when you grow up. Is this a business or a body shop? There's a difference.? If you're building a business, you use contractors as a minority of your business or to augment specific skill sets or deal with variability of demand.? But if you're building a business, it is your team, your employees, that will really build it with you.? You need to hire those people - contracting them won't cut it.

Concluding Thoughts...

Jason's conclusion:

It?s always hard. Most consulting companies don?t make much profit, and it?s one in a thousand that has the discipline to launch a successful product during off-hours. If you?re going to make it happen, you yourself need to be serious, disciplined, and relentless.

The idea that small consulting companies don't make much profit doesn't ring true.? A well-run consulting business is a good business. ?? Of course, for many consulting companies their margins may look lower because they do certain things:

  • Provide generous benefits, from vacation to medical insurance, to 401k or profit sharing.
  • Pay generous salaries & bonuses.
  • Buy the latest and greatest hardware gadgets and software tools.
  • Keep overhead (non-billable head count) low.

These tend to reduce margins in the short run, but retain top contributors in the long run.? Usually a tradeoff worth making.? But the biggest question for the independent consultant moving toward a small consulting firm:? What's next?

Is the goal to build a big consulting firm?? To make some money?? To solve a particular problem in your industry or specialty?? To have a boutique firm of good friends and rock star specialists?

It really is up to you.? But the answers will help dictate what makes sense as you build your business...? For BP3 it is to be the best business process firm we can be - which is compatible, for now, with being a growth business.

*? Author's note:? One of the things I enjoy about building the business, as a consultant, is the opportunity to practice our craft (BPM) internally.? As we get bigger, there are real payoffs to improving processes. And we have time to actually think about our business and improve it.

** Another note:Perhaps the title should just be "Consulting Math" since we didn't discuss Software Math... but I think the prevailing public opinions about consulting businesses largely come from people with a software background - primarily that they don't make much money and can't scale, and are inherently riskier.? But, most people don't mention the fact that these days, most software companies are probably less profitable than consulting companies.? There are really significant exceptions (e.g. Google, Microsoft) which is what people focus on.? But in enterprise software most of the money is in consulting these days.

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