The following are some common characteristics that apply to most types of professional services companies.

These are People Businesses

Professional services firms are extreme versions of “people businesses”. A people business is one in which the revenue is generated directly from the labor of the employees. Unlike a product business, a people business must grow headcount to scale revenue.

With a people business, the quality of the services delivered to clients is entirely dependent on the team of people assigned to the work. Within the same firm, a project could have wildly different outcomes depending on the specific people assigned to the project roles. This is why effective resource allocation is one of the most vital tasks within a professional services company. The wrong combination of people on a project will yield a dissatisfied client and often a poor economic result for the firm.

Easy to Start, Hard to Scale

Professional services businesses tend to be easy to start and hard to scale. They are easy to start because you only need to possess an in-demand skill and a client or two willing to pay you for that skill. This has become easier than ever given the numerous job boards available and the prevalence of digital freelance marketplaces. More and more professionals are “hanging out a shingle” and starting their own services business.

Unlike product businesses, you can begin to capture revenue almost immediately with a professional services business. You don’t have to wait for a long research and development effort to finish before you can start generating cash. In fact, you may not need to raise any capital at all to get a services business off the ground. You can incorporate the business, start working for clients, and begin invoicing those clients all within the first month.

But, as easy as these firms are to start, they are fairly difficult to scale. Why? Because they are people businesses. To scale a people business well, you must possess an entirely separate set of skills than the ones you use to deliver the underlying service to clients. In order to grow your firm, you must create an appropriate organizational structure, hire the right employees, develop and document repeatable processes, train and manage employees, leverage the right operational tools, track dozens of metrics, and so forth. The majority of professional services firms remain small simply because of the compounding complexity that comes with headcount growth.

Firm Structure

There are two common structural models for professional services firms. The first is the “guru model”, in which the firm is comprised of seasoned experts who need very little training or direction in order to deliver high-quality services to clients. The most classic example of the guru model would be a management consulting firm with 20-30 partners who are all experts in their area of focus. The second model is the “leverage model” in which the firm is comprised of all levels of experience, including hires directly out of college. Some firms start out with the guru model and then migrate toward the leverage model over time.

The guru model firms often remain smaller and are easier to manage. Since all of the employees (or partners) are highly experienced, they don’t need much in the way of training, managing, process documentation, and the like. They understand that their job is to sell engagements and then deliver services on those engagements. In many ways, each partner in a guru model acts as the CEO of his or her small portion of the business. With a guru model, bill rates tend to be very high and so are the salaries of the team members.

With a leverage model, the firm hires all levels of employees and needs better process maturity. Since it hires college graduates (with no experience), the firm must have a robust training program and well-documented service delivery practices. While a guru model could have a 100% remote workforce, the leverage model likely requires office space so that junior personnel can learn more easily from senior employees.

The key to success in a leverage model is to get the new hires trained and highly billable as quickly as possible (ideally within the first year). Since those employees will still have relatively low salaries, the company can generate high profit margin (leverage) over those first several years of employment.

There is no “right” model, but there are major implications of each. It is important that the founders of the firm are clear about the type of company they are building and the model they wish to pursue. Accidentally wandering down the leverage model path with a team that is only comfortable operating under the guru model will not work out well. We have a dedicated topic on leverage later in Compass.

Billing Models

The vast majority of professional services firms bill their clients on either a “Time & Materials” or a “Fixed Fee” basis.

Time and materials billing (or “T&M”) simply means that the firm will bill the client for all hours worked on the project. The firm likely provides some type of time and cost estimate in the project proposal and, as hours are worked, they are billed to the client (often on a monthly basis). The “materials” part of T&M simply means that any materials purchased or expenses incurred by the firm in the delivery of the services will be charged back to the client for reimbursement.

With fixed fee billing, the client is usually charged a predefined amount of money upon specific milestones or dates. With these types of engagements, it doesn’t matter how many hours the firm works to produce the services and deliverables. If the firm can complete the engagement in fewer hours than planned, its profit margin will be better than expected. But, if the hours run over, the profit can disappear quickly.

With both T&M and fixed fee billing, it is common for professional services firms to bill incurred expenses back to the client. The types of expenses that can be charged back and the total expense budget are usually defined in the legal contract.

Staff Augmentation versus Project Work

Most professional services engagements fall into one of two macro categories: project work or staff augmentation. With project work, the firm is hired to deliver a specific scope of work and produce one or more defined deliverables. Projects are finite in length and have a clear set of objectives that must be accomplished for the project to be considered complete. With staff augmentation, a client procures the services of one or more employees from the firm for a longer period of time and often without much scope definition.

These two categories of services work are quite different. Project work tends to be shorter in length and requires specialty skills in certain roles. Given this, the bill rates for project work tend to be much higher than staff augmentation work. With staff augmentation engagements, the client is often looking to expand the throughput and skills of their existing team without having to recruit and hire full-time employees. The rates for staff augmentation are lower primarily because the contracts tend to be for longer periods of time (a year or more). Some employees of professional services firms prefer the challenge of working with several new clients every year (in a project model) while others prefer the stability of being able to focus on a single client (in a staff augmentation model).

Since the bill rates of project firms are much higher and the work is sometimes more cutting edge, many services firm founders gravitate toward the project model. But those high bill rates don’t always correlate to a better business. A staff augmentation firm with lower bill rates but near constant billable utilization can easily generate more gross profit over the course of the year than a similarly-sized project-based firm with higher bill rates.

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