When I talk to the founders of service companies, many of them express the same desire to me: They want to become software companies. They’re seeing SaaS companies take the world by storm, and they’re wondering if they haven’t made a huge mistake in not choosing this path.
They see ratings of SaaS companies and get drunk with the numbers.
Understandably so, with SaaS companies like Salesforce worth $132 billion and Deloitte, the most valuable professional services company, worth $27.9 billion.
The risk of being an entrepreneur
Some founders believe that service companies are more labor intensive and that somehow building a SaaS company means a better work-life balance. Some founders are driven by the need for fame. They want to be household names the way the Zuckerberg family, Musk, and the Kalanics have made headlines and made great documentaries about them.
However, SaaS companies are twice as likely to fail within five years, according to Professor Scott Shane of Case Western University.
The five-year survival rate for service companies is 47.6 percent, and the five-year survival rate for product companies is 23.4 percent. Founders of both service and product companies take a big risk when they become entrepreneurs, so it’s wise to play the odds and start a service company rather than a product company.
There are three factors to consider before moving to SaaS
In fact, and this is what I say to professional service founders, the challenges and limitations of SaaS life should put you off, perhaps forever. Consider three things before jumping into the world of SaaS:
Evaluate the financial impact of SaaS
The world of SaaS can be very attractive but remind yourself of your company’s potential before you start building your SaaS company for fear of losing it. Founders of professional services firms can create more personal wealth than their product firm counterparts. The reason for this is the effect of capital intensity.
For example, suppose two friends, Soo and Kim, start companies at the same time. Su founded a consulting firm, and Kim founded a software company. So you don’t need to raise capital.
Consulting firms have very low costs and are not capital intensive. Therefore, Sue owns 100 percent of the company. Kim, on the other hand, should raise $5 million from investors. SaaS companies incur product development costs and are capital intensive. Therefore, Kim owns only 15 percent of her company.
A practical example of selling a SaaS company
Ten years later, Soo and Kim sell their company. At the time of the sale, both were making $10 million annually in revenue. Sue is worth 1.5x revenue, which resulted in a $15 million purchase price. Since she owns 100% of her company, Sue makes $15 million.
Kim’s company was valued at 5x revenue, resulting in a purchase price of $50 million. Since she owns 15 percent of her company, Kim makes $7.5 million, which means Sue earns twice as much as Kim does on exit.
In addition, Kim’s investors pay Kim a salary and forbid her to withdraw money from the business. Sue has no investors. She pays herself a salary and distributes cash regularly.
Kim must sell the company to receive a reward commensurate with her efforts, but Sue rewards herself twice, once with regular cash distributions and once at an exit. Effort and rewards are constantly aligned.
Determine the work-life balance you want
Second, founders of professional services firms work less than founders of product firms. The reason for this is that they can control the scale (sterlingwoods.com). Product company investors are forced to grow whatever the cost. This requires a non-stop grueling work schedule.
The founder of a well-run marketing agency, for example, can balance work and life. She can step up when she feels inspired and she can step up when she feels overwhelmed by dealing with clients at will. It controls the company and is not obligated to the venture capital technology investors.
Her cost structure is variable, the talent she needs to serve clients is readily available, and she has the job security that she won’t fire herself when she hits a bump in the road.
Investors and work-life balance
In contrast, the limitations of SaaS companies extend beyond the scope of the business; Product company founders do not have a work-life balance. They lost control of their lives the moment they took the capital from the investors. Their days are now filled with keeping investors happy, and the cost structure isn’t nearly as flexible because investors manage the burn rate.
In addition, the talent SaaS founders need to build the product is hard to find and very expensive. There is a shortage of quality software engineers. Finally, and most worryingly, if the founder of a product company misses expectations, he will lose his job. Investors replace the founders when problems arise.
Determine the best way to expand your company
The promise of SaaS success is rapid scaling, but you can learn that lesson and apply it to your own professional services firm without the risk of trying to raise capital.
There are many professional services firms that have expanded by expanding their reach. Gartner is a $4.7 billion professional services company serving more than 15,000 clients.
The company has established economies of scale for its unique brand; Issues market research reports that customers subscribe to. The cost of producing reports is high but fixed. This means that with each new customer, the cost of the service (on a per unit basis) goes down.
Don’t put your eggs in one basket
Economies of scope mean that it costs less to sell two services together than to sell them separately. Some professional services are not scalable. Services that require specific knowledge of the customer do not have the unit economics of the product.
It would be wise for a service company to create a set of free-to-order service offerings. This occurs when the consumption of one service increases the demand for another.
Your ego doesn’t need SaaS; He needs to succeed
In general, building a SaaS company isn’t all it can be, even if your project has reached peak billion-dollar unicorn status. While the rapid growth of some unicorn companies may be tempting to follow, the realities of raising capital are not as pleasant.
Instead, focus on how you find your niche in the business—areas where you have unique expertise and can build a scalable service company that helps real people solve problems in their lives. Working on creating the best scalable professional services company is likely to reward you, both now and in the future.
Featured image rights: provided by the author; Photography by Dylan Gillis; Unsplash Thank you!
