Something of Value

A strategy for building equity into a professional-services business

They had a problem familiar to most owners of professional-services companies. When Larraine Segil and Emilio Fontana started the Lared Group in Los Angeles two years ago, they wanted to build equity into their company so that they could eventually sell it for a good price and walk away. But how could they do that when the main asset of their business was the consulting services that they themselves delivered?

Professional-services companies are easy enough to start, but building value over and above the daily efforts of the principals is another matter. Some owners do it by converting their service into a product, putting out computer programs, audiotapes, or training seminars that generate an independent revenue stream. "Most people who provide service for a fee are only as good as the hours they work," Fontana says. "We wanted to move away from that. The idea of earning money while we sleep is very attractive."

The first check that Segil and Fontana earned while asleep is already in the bank. It arrived in February, the initial installment of what could amount to as much as $100,000 during the next three years. They received the money under a "success-sharing" arrangement with one of their clients; instead of charging an hourly rate or a flat fee for the project, the usual methods of billing, they take a percentage of the additional sales their client realizes as a result of their recommendations.

While almost all of the Lared Group's revenues come from fees for services provided, Segil and Fontana have targeted success sharing as a major source of income in the future. Over the next five years, they want to strike 10 to 20 such deals. That could mean about $2 million in annual revenues, or up to a third of the Lared Group's sales, by the mid-1990s.

Though veterans at business, neither partner had ever before faced the problem of building value in a professional-services firm. Both had worked for companies that built asset value the old-fashioned way, by making a product or by delivering a service that didn't depend on the people whose names were on the door. Fontana had spent his career working for large companies. The Lared Group was his first new venture. Segil had run a metals-distribution and manufacturing company and founded a financial-services company and a medical-services firm. She is also the founding chairwoman of World Technology Executives Network (WorldTEN), an international network of executives of high-technology companies.

Partly through her work at WorldTEN, Segil saw an opportunity to help small and midsize companies extend their reach to new markets at home and abroad. The tools she and Fontana use include strategic alliances, partnerships, joint ventures, and equity participations, put together through the Lared Group's partners in three U.S. and four European cities.

Whenever possible, Segil and Fontana want to be compensated for these services through success sharing. "It was part of our original thinking," Segil says. "We wanted to build a portfolio containing streams of income for the company. The continuous income would give us a valuation that wasn't just based on goodwill."

Achieving that higher valuation, though, involves some risk taking. For a new professional-services company, or one struggling with profitability, stretching receivables over a period of years could invite severe cash-flow problems. Before trying success sharing, a company would need a healthy flow of fee-for-service business to back it up.

What's more, those receivables could turn out to be nonexistent -- even the most brilliant consulting work can't guarantee that there will be any success to share in subsequent years. A client could bungle the implementation or suffer financial reversals that would prevent it from making its success-sharing payments. That puts enormous pressure on Segil and Fontana to choose their clients carefully -- both for the quality of their product and their management.

The two partners found that marketing their concept wasn't easy. Large companies had always paid the conventional fee for service and weren't interested in changing. Some new and small companies, on the other hand, found the financial terms attractive; success sharing would enable them to conserve cash up front. "It's difficult for these companies to pay for services they receive unless there's some certainty of success," Fontana says. "We've found that by offering success sharing, we decrease the clients' resistance to doing business with us."

The first company to close a deal with Lared matched the profile of the likely candidate. DigiVision Inc., in San Diego, is a medical-electronics company with $3 million in sales. As an offshoot of its military and industrial research, it had developed a $25,000 device that enhances X-ray images used in cardiac surgery and other procedures. But DigiVision lacked the contacts it needed to market the product.

Segil and Fontana, though, knew of a company that would make a good strategic partner for DigiVision: Medrad Inc., a $35-million medical-products company in Pittsburgh. Without revealing Medrad's identity, Segil told John Cambon, DigiVision's chief executive officer, that she could introduce him to a company that had 85 marketing and services employees out in the field and could operate as a sales, marketing, and service arm for the product. Segil asked for out-of-pocket expenses plus a success-sharing agreement for helping to forge an alliance between the two companies; Cambon readily agreed.

"I've always been inclined toward performance-oriented deals," Cambon says. "If we put a consulting company on retainer, it could go on for months, and we might not get anything out of it. A small company like ours doesn't have the resources to gamble on that. So I was willing to negotiate something based on the future."

But Cambon negotiated the arrangement with Medrad himself, in part to avoid any potential conflict of interest on the part of the Lared Group. Some success-sharing agreements can put the interests of the clients and the consultants at odds. For example, if the consulting company is to be paid over a three-year period, it might be tempted to recommend short-term strategies when the best interests of the client might demand long-term considerations. "If the consultant is heavily involved in the deal," Cambon says, "there could be a problem. It's my responsibility to structure the agreement so that it's proper for the corporation."

The success-sharing deal will last three years, with Lared Group receiving 2% of DigiVision's sales of the imaging devices to Medrad. The cap was set at $100,000 -- more than what DigiVision would have paid under a conventional fee-for-service arrangement, reflecting the risk that Lared Group is taking that the product will be a success. With initial sales recorded at the end of 1988, the Lared Group has just received its first success-sharing check.