Effectively Managing Operating Risk in Digital Product Studios / Services

After the creation of a sustainable new business pipeline, managing operating risk is the most important thing you can do to ensure the success of your professional services company. It’s a foundational pillar of professional services co. design.

One of the biggest problems that I’ve seen professional services (digital product studios, consultancies, and agencies) struggle with is maintaining growth. The cause is threefold, suboptimal org design, lackluster sales pipeline development, and the business model, or the modus operandi to sell one-off project work. For clarification, one-off project work is an engagement that lasts a definite amount of time, has a finite budget, and ends on delivery.

As the studio grows, the “one-off project” model becomes largely unsustainable and relatively quickly.

The primary focus becomes covering payroll and fixed costs, structured growth takes a back seat, and the services business will more often than not find itself cash strapped and overextended; this then negatively impacts project deliverables, company morale, and unoptimized margins. Moreso, the quality of new business the company takes on suffers due to increased fiscal pressures.

While it’s true that efficiencies will typically decrease as you scale, the services business is so much more susceptible to this phenomenon, and I believe the primary cause to be the inability to forecast costs and revenues accurately.

Let me know if this sounds familiar.

You close a new client and now have to staff that project. Your current team is at capacity, so you hire three new people. It’s a good quarter, and you close another project, now you have to staff against that as well. You can move some people from a project that just ended, but you’ll have to hire two more folks to staff this second project.

Your headcount just increased by five, and it runs you an additional 500k/annually to keep these people, that’s another ~ 45k/mo, but it’s cool because business is up and you’re doing well, and have a healthy pipeline of SQLs (sales qualified leads).

This process repeats, and pretty soon, your agency is staffing a team of 30 which, averaging 100k annual salary, that’s a payroll of ~ 265k/mo after benefits and taxes. You’ve got an office, perks; you’re burning through 300k a month. But:

You increase the hustle, and you sell a deal that’s a little smaller than usual because it’s cash coming in, but you still need to staff it. Your top-line revenue keeps growing, but this vicious cycle keeps repeating itself, and the underlying problems become more substantial.

Management (you) get more stressed, efficiency and work output suffer, employees become more discontent, your once amazing creative shop is now a massive shitshow, but somehow the machine keeps working, even if there’s some smoke coming off it.

A new executive gets appointed into one of your key accounts and dumps your company; then different client project gets canned because management moves to a new model, and now you’re stuck carrying a team. Maybe two of these things happened in succession? Perhaps you lose three clients sequentially who made up 40% of your revenue stream, or client budgets tightened because there’s a recession on the horizon.

The next thing you know that 1.5 months of runway is gone, and you’ve got to let a big chunk of your team go. It isn’t a matter of if – but when it will happen to your agency. Read my friend Rick Webb‘s book Agency, it occurred to him, and it happened to me, it happened to a lot of other agency founders I know.

It’s a reality, but the good news is, there are ways in which you can mitigate a lot of this risk that will keep you from firing half your tram and killing your culture for an indefinite amount of time.

Without going down a risk management rabbit hole, your operational risk is the sum of internal systems, processes, people, and external events. While you can’t control external events like new executives being appointed and bringing in their own people, you can mitigate the risk associated with those types of events. The other thing I want to touch on is that we’ll be looking at risk as it directly ties into day to day operations of the services business and for simplicity tie this risk to the business’s expenses.

The biggest single line item in any services business is your people. Human capital is expensive, and the more people you bring in, the bigger the risk from this line items becomes – a large team that isn’t generating revenue will quickly dry out your cash reserves. It’s also important to address that revenue-generating employees need to cover payroll for all administrative personnel.

To mitigate this risk, you have to bring in revenue, which comes from Inbound Growth Activities, Upsell and Referral, and Sales (new business development, network).

While the development of these channels is a must in any professional services org, the problem lies in that even if you know your close rate, projecting revenues for any longer period of time will prove difficult if not impossible in a project-based model. One month you sell two projects, then for two months, you don’t close any, then there’s a windfall. There’s also the issue that this business is cyclical in nature, with most sales happening from September to December and secondary uptick from March to May. The summer is dead, as is the beginning of the year.

Be it from misfortune, or a sub-par sales cycle, there will come a time when your utilization rate (# of employees on project / # of employees who can be on project) will fall below a number that no longer makes keeping those persons on financially sound, and at this point you’re faced with a handful of options — debt financing, investment, or letting people go. Either way, morale is going to suffer, and you’ll be faced with rebuilding.

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As someone who’s gone through this first hand a couple of times, I can honestly say that this is one of the most emotionally debilitating experiences for management. Letting people go en-mass is horrible, and while I can’t promise you that it won’t happen, there are strategies to enforce, which will at least mitigate a good chunk of your operating risk.

Solving for operating risk comes down to two things:

⁃ Establishing predictable, sustainable revenues. ⁃ Scaling team efficiently

Your sales cycle will mostly follow the above curve, some years you’ll hit more projects some less. But the problem with selling contracts is you’re selling one time engagements, likely coupled with obscure payment agreements. 30% upfront, 30% once engineering starts, 40% on completion. Stop this immediately and start moving to a monthly recurring revenue model with all your clients.

If a client has a 1.2MM budget and the engagement is a year, then charge them 100k/mo., if they have a 90k budget, and the project will take three months – charge 30k/mo.

Spreading out billing systematically lets you plan your cash flows and identify when you’re expected to be cash poor. It will also help you determine when you need to scale up growth, or seamlessly scale down team (we’ll get to this in a bit).

Billing your clients monthly during your engagement also sets a significant precedent. Billing “seems” like it’s on retainer, even though it may be a one-off project, during which time you, your engagement manager, and/or your accounts people ought to be working to establish a long term relationship with the client. As a services business you don’t want client engagements to end, so if you’re selling product innovation services, reinforce the message that product, design, engineering, etc.… is a living thing which needs nurture, which ongoing and continuous support, and deliver a product roadmap beyond the initial scope. If you’re a growth agency, you know marketing is continuous. Communicate that to your client, and you’ll both be better off for it. Unsupported projects die, and revenue is always good. It’s also a lot easier to sell 100k/mo than $1,200,000 annually.

Do this with every client, not all clients will go for it, and that’s fine, but eventually, you’ll get to a place where revenue and cash flow become predictable. For you, this is awesome, you’re mitigating operational risk, and can move onto part two.

We went over how the biggest line item in any services business is people, and when clients drop for whatever reason, revenues disappear, utilization rate falls, becomes unsustainable, and you need to trim payroll. It’s terrible for morale, bad for your brand, and all-around well… bad.

So often, professional services companies will scale up by bringing on full-time staff to cover new projects, and while growth is excellent, it also causes problems. These folks will require time to get versed in your processes. They may not understand the corporate culture, or you may have made a poor hire. It happens. Alternatively, managers may take the position where they throw too much work at staff because margins are already thin, which causes the quality of deliverables (output) to suffer. Your overworked employees get stressed, tired, and morale drops.

Ensuring superior delivery results should always be priority one with any services business. To accomplish this, staffing a new client team is incredibly important. Excellent service is defensible, and will often lead to long term engagements.

But how do you staff appropriately, while also keeping your operating risks (payroll) controlled?

Use hybrid team models – a combination of in house (fulltime) and freelance or contract resources. On an average team of six that would comprise what I refer to as a product engagement cluster, you would have a product manager/lead, a project manager, a product marketer, two designers, and two engineers for the duration of the engagement, with perhaps a QA person being brought on.

In this cluster, up to 50% can be freelance talent. The product marketer’s involvement is a few weeks, one or both of the designers can be freelance as well if you’re fully utilized, and theoretically so can engineering and QA. Your lead has to be internal as they’re carrying the project forward, as would the project manager.

But in a scenario where the project lasts 3-6 months, ends prematurely, or you don’t manage to sign a long term engagement, your project risk is minimized by the percentage of contractors you have on it. The client ended the engagement. “Ok. I get it; I’m a freelancer.”

Should you manage to close the account for a long term engagement, then is the time to bring on the full team to staff against the project based on the client’s needs. If, for example, they require little design, keep the freelancer, and hire the two engineers. Just make sure that knowledge is transferred appropriately and that the work remains AAA.

The argument against this is that freelance talent can often be more expensive per hour, but in my experience, this model provided superior financial performance every time.

The goal, however, is to minimize operating risk while providing the best service imaginable, so use your best judgment. It’s a process that requires you to have a list of great freelancers you can tap into, and that is only built over time and by working with great people.

A healthy company is a happy company, and a healthy company is cash-rich.