Hockey sticks and consultants

Reblogged my StartupNorth post. Comments available on StartupNorth.

Exponential Growth Curve

I’m always giving consultants a hard time. It’s not that I dislike consultants. It’s not that I think that consulting is a bad business model. It’s that a consulting model is very difficult to get exponential growth. You know that hockey stick growth curve, well it’s actually an S-curve but early it looks like a hockey stick, that is so important. I’m talking about real numbers, not projections. Revenue. Users. Customers.  (Need help figuring out what you should be tracking? Go read Dave McClure’s AARRR! Startup Metrics for Pirates). And go read Mark MacLeod about why compound growth changing your funding requirement.

Consulting is a linear growth business. It grows based on:

  • # of consultants billing
  • # of billable hours
  • hourly rate

Unfortunately, all of these are limiting variables. There are examples of very profitable firms and corporate structures that enable a very profitable model. I’m not discounting the profitability of the Big5 consulting firms. Consulting firms are generally limited to the number of consultants. Corporate culture are defined by the people.

The number of billable hours is a limiting factor. There are only 8760 hours in a year. You can’t work every hour. You can’t bill every working hour. It’s just not possible. Billable hours are the currency of consulting and legal firms. Many firms require 1700-2300 billable hours/year. Just think about this: 2300 hours/year =  46 billable hours/week + 2 weeks of vacation. If you assume a 80% utilization rate, i.e., 80% of your time is billable and 20% is on overhead/email/meetings/etc.  To achieve 46 billable hours you need to work 57.5 hours per week.

Hourly rate is generally set by the skill set and the market. Flippa. Rentacoder. 99designs. crowdSPRING. Elance. There are others willing to do it for less.The market determines a consultants hourly rate. 

So for an independent consultant billing at $200/hour on a 57.5 hour work week at 80% utilization would have revenues of $460,000/year. This is an extremely high rate. Looking at the NASDAQ 100 using Cognizant averages $35,892 versus Apple ($1,014,969), Ebay ($551,049), Microsoft ($663,956) and others. This might be a little extreme. Don’t believe me, Hoovers.com suggests that IT/software consulting has average revenues of $160,000/employee (MarketResearch.com has this closer to $100,000/employee). Realistically the easiest way for a consulting firm to achieve exponential growth is to grow to the number of consultants working. And the risk of exponentially growing the number of consultants is that you kill the culture that attracts many people in the first place.

“But isn’t the consulting company itself startup? No, not generally. A company has to be more than small and newly founded to be a startup. There are millions of small businesses in America, but only a few thousand are startups. To be a startup, a company has to be a product business, not a service business. By which I mean not that it has to make something physical, but that it has to have one thing it sells to many people, rather than doing custom work for individual clients. Custom work doesn’t scale. To be a startup you need to be the band that sells a million copies of a song, not the band that makes money by playing at individual weddings and bar mitzvahs.” – Paul Graham

That said, consulting is a great way to take the risk out of a startup. The best consulting projects are the ones where you can build the software you want to sell as a product. This assumes that you have necessary legal agreements where you retain ownership of the intellectual property created during the consulting gig. This is often referred to as “bootstrapping” (read Paul Graham’s Fundraising Survival Guide to understand the tradeoffs).

There’s nothing wrong with consulting. It’s a perfectly viable career. It’s a perfectly viable business model. But do the math, it doesn’t scale like a product company.

Business Models

A business model is a method of doing business. All business models specify what a company does to create value, how it is situated among upstream and downstream partners in the value chain and the type of arrangement it has with its customers to generate revenue. – Michael Rappa

Software+Services and SaaS models have been discussed for while, mostly called utility computing. We’ve started to see the rise of utility computing services like EC2, App Engine and Reddog, along with storage including S3, CloudFS, and SSDS. Less traditionally thought of utility computing options include mapping, contacts, mail, among other services pushed in to the cloud. Michael Rappa described [PDF – 141kb] the characteristics of a successful utility as:

  • users consider the service a necessity
  • high reliability of service is critical
  • ease of use is a significant factor
  • the ability to fully utilize capacity is limited
  • services are scalable and benefit from economies of scale
  • exclusive rights are granted for providing service in a given area

Rappa also provided a detailed breakdown of the different business models of traditional utilities. The models are really great building blocks for startups to think about the problem they are solving, where they fit in value chains and the relationship they have with their customers to generate revenue.  Rappa presents 9 unique business models:

  1. Brokerage model
    Brokers charge a fee or commission for each transaction it enables. Think eBay, PayPal, EventBrite, esellerate. The formula for calculating the fee varies based on the vertical. Models include exchanges, demand collection systems and auction houses.
  2. Advertising model
    The advertising model is an extension of a traditional broadcast model where the broadcaster is the content hub or web site. Sites provide content and essential services like search, email, groups, etc. Think Live, Google, News.com, Yahoo, etc. This mode works best with either high traffic volume or with highly specialized/focused user groups. 
  3. Information-intermediary model
    Data about customers and their consumption habits are very valuable. This is the premise of behavioural analytics aimed at analyzing users to improve advertising targeting. Firms like comScore, Google, Quantcast, Compete, Coremetrics, and tonnes of others.
  4. Merchant model
    Rappa describes merchants as “wholesalers and retailers of goods and services”. Very familiar ecommerce examples include virtual retailers like Amazon, traditional retailers with online storefronts like Chapters or Banana Republic, catalogue vendors like LL Bean, or electronic bit vendors like Gartner or NielsenNorman selling digital products.
  5. Manufacturer Direct model
    The maker of a product or service sells directly to the consumer. This is the most difficult option for me to understand in the context of cloud computing. But traditionally, it is where software developers or hardware manufacturers sell their products to consumers. This can be seen with smaller software providers like ecto, TextMate, TopStyle, etc.
  6. Affiliate model
    The affiliate model provides purchase and transaction opportunities to people on the web. It is a pay-for-performance model used in banner exchanges, pay-per-click, pay-per-transaction, and revenue sharing often seen with carriers and mobile applications. This is often seen with Adsense, Amazon Associates, and can be seen with Mint who earns fees from customer referrals.
  7. Community model
    Rappa describes the community model as based on user loyalty, where loyal users invest their time and emotions in a business, and revenue is generated on the sales of their ancillary products and voluntary contributions. This is the basis of the “open source” computing model with companies like Canonical and Redhat have leveraged the efforts of the community to build desktop and operating systems.
  8. Subscription model
    Users are charged a periodic fee for access to a service. Subscription fees are incurred regardless of usage rates. Most SaaS solutions fit this model, customers pay the developer of a software solution directly. Basecamp, Salesforce, NetSuite and others. This is a very common model that often uses a freemium pricing as a marketing decision to attract customers.
  9. Utility and hybrid model
    The utility model is based on metering usage, it is a “pay as you go” approach. Unlike subscription services the billing is based on actual usage rates. For example, traditional and VOIP long distance minutes that are billed for usage. Storage in the cloud using services like S3 or CloudFS. Often utility models are combined with a subscription model, think cell phones where there are fixed subscription fees for voicemail, caller id, and utility billed services for data and long distance. 

The Business of Sofware by Michael Cusumano

These models are different than enterprise software company models presented by Michael Cusumano in The Business of Software: What Every Manager, Programmer and Entrpreneur Must Know to Thrive and Survive in Good Times and Bad where companies exist on a spectrum between a pure products company to a pure services company.

  • A pure product play
  • A mix of products and services
  • A pure service play

Looking at the business models derived from traditional public utilities, provides a richer classification for both the product end of his description. Cusumano’s services refer to people powered services, not a utility or subscription model. Though you could argue that the services and maintenance mix described is much closer to a subscription model.

The question for all startups is what do you to to create value, where does that value fit in the value chain of your industry, and what type of arrangement with customers do you have to generate revenue? It’s simple really: What problem do you solve? Where does this fit with your industry? Who derives value from your solution? And how do you get paid? Answer these questions and you can get on to the hard stuff.

All business models specify what a company does to create value, how it is situated among upstream and downstream partners in the value chain and the type of arrangement it has with its customers to generate revenue.