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.
Lared's work wasn't completed with the negotiation of the alliance. It has a vested interest in assuring that things work smoothly. "They're regularly in touch with Medrad and with us, so if there's any unhappiness, they will intervene," Cambon says. "They'll get us to sit down and talk."
Medrad, too, agreed to a success-sharing deal with Lared Group last year. Serendipity in the research lab had brought it a new product it was unprepared to produce and market on its own. The company designed prototypes for two radon-detection devices, one of which could be developed into a $150 instrument for home owners. Unlike products now on the market, Medrad's device would remain inside the house and give continuous readings.
The Lared Group began looking in Europe for a manufacturer that could take worldwide rights outside North America. Its work proceeded in three stages, each tied to a separate fee. The first stage was a quick analysis of the European market to determine demand, for which Lared received a set payment. The second stage, also for a set fee, involved a deeper analysis and the identification of a Swedish company as a potential partner.
The final stage, still going on, is the negotiation of a strategic partnership between Medrad and the Swedish company. If the alliance goes forward, Medrad will pay the Lared Group 5% of sales the first year, 4% the second year, and so on until payments cease following the fifth year. "I wanted them to be looking at the size of the deal," Medrad's CEO Tom Witmer says. "Their reward is directly parallel to our reward: the bigger it is for us, the bigger it is for them."
Life in the success-sharing lane isn't always so agreeable. One of Lared's deals, with a biotechnology company in California, went bust at the last minute. Lared had found an Italian company that agreed to distribute the biotech firm's new medical-diagnostic tests. A few days before completion of the agreement, some investors on the company's board decided to sell the company instead, voiding the deal.
It was a bitter lesson for Segil and Fontana. "Some silent interests on the board don't come out until the deals are on the table," Fontana says. Adds Segil, "We don't evaluate things anymore on only the rational issues of the deal. We want to make sure the venture capitalists and other board members are on the same track."
If that sounds like a big risk, Segil says it is preferable to another type of risk -- that, after years of building a company, she won't have many assets to sell in the end. "You can never really have a secure business when you're only on a fee-for-service basis," she says. "Success sharing gives security and stability to your company."
How to judge a long-term deal
Instead of billing all of their clients by the hour or with flat fees for particular projects, the Lared Group's Larraine Segil and Emilio Fontana are experimenting with "success-sharing" arrangements. They take a percentage of the additional sales their clients make as a result of their recommendations, and this income stream is for a set number of years. Segil and Fontana have discovered a few things you should consider with such deals:
* Cash flow. Be sure you have a healthy flow of fee-for-service business to back up success sharing. Otherwise, stretching receivables over a period of years could give you cash-flow problems.
* Quality of client's business. Choose your clients carefully -- their success is what ensures your own. And don't look at their product alone; their skill at managing is just as important.
* Size of client. You're likely to be wasting your breath if you try to convince large companies to buy into success sharing. New and small companies, however, are apt to be attracted to such deals.
* Top management's view. Be sure those at the top in your client's business, including the board, are amenable to the idea. Otherwise, the deal could collapse at the eleventh hour.
* Your costs. To protect yourself if the deal does fall apart, build in guaranteed payments for expenses and minimum retainer fees.
* Future relationship. Build a continuing relationship into the agreement, so you can get involved in the future to help resolve problems.
What the experts think about Lared's success-sharing strategy
Partner at Calfee, Halter & Griswold in Cleveland, specializing in succession planning.
Receiving a client's fee over time isn't necessarily a good thing. If the option is to get the same amount -- the $100,000 fee -- now or over three years, the Lared Group would be worth less to an acquirer if it received the money over a three-year period. The money will be worth less in three years, and there is always the chance that the Lared Group won't get the money at all. After all, the creditworthiness of a client can deteriorate over that long a time.
On the other hand, I can see two circumstances in which success sharing would raise the value of the company. First, if it can get a significantly larger fee through success sharing than it could through a fee-for-service arrangement and, assuming the risks are reasonable, the increased revenues will be attractive. Second, if success sharing enables it to reach a market that couldn't afford its services otherwise, then that too will add to the company's growth and hence its value.
JEFFREY C. WALKER
Managing partner, Chemical Venture Partners, a $300-million buyout and venture capital fund.
From the standpoint of someone thinking of purchasing the Lared Group, it's comparable to buying a venture capital portfolio. You have to evaluate every success-sharing deal they've done and see how each of their clients is doing. Two consulting companies with different success-sharing portfolios could be worth very different amounts, based on the quality of their portfolios.
The success-sharing revenues will tail off in future years, so a prospective purchaser still must rely primarily on the continuing efforts of the principals when figuring out a fair price for the company. But if the success-sharing portfolio is strong, that should make it a more valuable company.