Entrepreneurs expect professional investors to be practically frothing at the mouth to fund their ventures – since, as we all know, every concept for a new business is original, innovative, and guaranteed to generate profit! Of course that isn’t how professional investors see it and why they have a reputation for being somewhat jaded. They can be downright cynical when it comes to funding service-based business models.
As founder, president and CEO of such a company, I have lived the perils faced by entrepreneurs who wish to charge forward with a service-oriented business. I started TriNet Group, Inc. in 1988 to provide an online and in-person solution for outsourcing payroll, employee benefits, and other human resources services – and over the last 13 years, I have raised equity financing from angel, corporate, and venture capital investors. As TriNet’s customers include many companies that pursue equity financing, I’ve also witnessed the struggles fellow entrepreneurs have in getting investors to open their wallets.
In a sense, service businesses are stigmatized as those that won’t grow quickly and yield an acceptable return to equity investors. Founders of such companies need to understand that stigma, so they can develop a model that counters objections, builds confidence, and ensures a solid foundation for the business itself.
Assess Your Service Model
The first step is to consider the service business as a “customer-value proposition.” I feel there are three types: those based on expertise, those based on a method for enabling transactions, and those that effect an exchange. Let’s take a closer look at these three propositions. In an expertise-based business, the principal benefit to the customers is derived from the personal skill or knowledge of the individual providing and delivering the service. While professionals such as lawyers and consultants are the most typical example of this type, the model also holds for expertise in a range of fields, from the ability to design a custom database to the skill of cooking a gourmet meal for sale in an expensive restaurant.
Next are transaction-based models, which leverage infrastructure by delivering a consistent product or service in high volume. Here’s a classic example: a Starbuck’s coffee shop. While each cup of coffee doesn’t contribute much to the bottom line, the enterprise as a whole generates revenue and profit from the sheer volume of coffee sold across a vast number of stores. The model works because company brand and infrastructure are used to great effect without incurring high labor costs.
Finally, businesses based on the trading model bring together buyers and sellers, thus acting as middlemen that offer the advantages of convenience and better pricing. An online auction site – say, eBay – is the quintessential example. Another would be the specialty store that receives goods from a wholesaler, marks up the costs, and sells the items for a profit.
In some cases, a service business model might involve all of these value propositions; however, one of the three usually determines a company’s strategy and profit potential. Given the speed of change today, a business can also shift allegiance from one model to another over time. Both Amazon.com and eBay began as traders bringing together buyers and sellers; now, after devoting resources to infrastructure, customer service and the user experience, they fall more into the realm of the transaction-based business.
Know Your Model’s Weaknesses
Although these business models might appear reasonable, each presents a concern for investors, who must decide whether companies built on such models can grow fast enough to create an investor liquidity event, such as an IPO or merger or acquisition.
In the case of the expertise-based model, the limiting factor is scalability. Such firms are beholden to the number of billable hours that their professionals can invoice. In other words, when their staff doesn’t have a paying customer lined up to cover the overhead for each professional, the business is absorbing the cost of nonproductive talent.
Sullying the reputation of the expertise model even further has been the recent collapse of the publicly traded Internet and technology consulting firms. In the wake of the dot-com bust, with the stocks of such companies now trading at pink-sheet levels, the lesson has been that demand for such expertise-based businesses is only as good as the market that supports it. If the demand for intellectual capital dries up, the business can implode.
For transaction-based service models, it is not difficult for an early stage company to find itself losing money on each transaction. While this sounds like an obvious problem to avoid, it takes both realistic expectations and a finely honed strategy to achieve the right balance between anticipating growth and implementing new technology. In my own industry – online human resources – I’ve seen competitors spend madly on new technology, assuming continued fast growth, only to see their customer bases expand at a less-than-hyper-speed pace. With slow growth and a huge computing and service infrastructure to support, they were unable to charge enough to cover their basic cost of service delivery. If they can’t snare a new infusion of equity capital, firms in this situation fall victim to a gut-wrenching death.
In the exchange-based model, the need to add value – continually – to support the existence of the middleman can become problematic. In the recent past, more than a handful of service companies peddled the ability to enable clients to conduct transactions faster and cheaper on the Web. Those same companies watched with dismay as their corporate clients created their own online transaction systems, eliminating the need for the Web-savvy go-between. As a result, many high-flying B2B exchanges landed in the trash bin.
Now that I’ve convinced you that entrepreneurs who start a service-based business should be committed, let me also offer the good news. You can counter objections by scrutinizing your company for its strengths and weaknesses. Whether yours is an expertise-, transaction- or exchange-based model, you can make a compelling argument for its existence by stacking it up against the following criteria.
How is your proposed service more enticing than any and all existing alternatives? It isn’t enough for a fledgling service-based company to provide an incremental improvement; rather, it must offer an idea that is a quantum leap forward, a service so different and innovative that customers will gladly change entrenched buying habits. The service you plan to provide should be the equivalent of manna from Heaven.
How will the service be marketed and sold? Once a market is identified and quantified, it is critical to devise a realistic and cost-effective strategy for finding prospective customers, following through on steps in the selling cycle and closing sales.
How will production be scaled? A commitment of investment to create and sell X begs the question of how to multiply X by a factor of 10, and then 100, and then 1000 to satisfy the need for increasing revenue. As a corollary, consider the need to get to 1000 times X while also forcing down the cost of production.
What indirect revenue streams are possible? As important as the structure for setting fees is the need to examine sources of passive as well as negotiated revenue. In other words, are there ways to generate additional revenue without having to negotiate directly with customers? Interest income, for example, might derive from cash balances that customers are willing to trade for an increased level of convenience or service.
What are the barriers to entry for competitors? In other words, determine how hard it would be for competitors to eat your hard-earned lunch. If creating and running your business isn’t difficult, why isn’t everyone doing it? What would stop a deep-pocketed competitor from jumping in and duplicating your service?
In sum, when creating your service-based business models, think about doing what comes naturally to investors, founders and partners: gravitating toward a promising business only after poking it full of holes. By developing a pre-emptive strike against the most common objections, you will successfully identify the service-based model that makes the most sense for your venture. After that, all that’s needed is passion and luck – and as an entrepreneur, you, of course, already have those qualities in spades.