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Choosing Investors For Services Businesses
Professional services businesses are easy to start (compared to many other businesses) without significant capital and can grow successfully using their profitability. Many services businesses hit a point of growth where the founder(s) believe they can grow faster and capture more market share with outside investment. These businesses are often too small or too young to be able to secure debt on favorable terms, so founders often look to outside investment by selling equity.
Does The Business Need Outside Investment?
Before being too eager to take on outside investment, founders need to consider whether it will help them. If the business is already operating profitably, has shown some ability to grow organically, and has proven its ability to deliver for multiple clients, outside investment - used correctly - can help grow faster.
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If the business hasn't yet figured out how to be profitable, hasn't been able to grow organically (finding new customers as well as increasing revenue with existing customers), or has only had success with one or two customers (typically due to founder relationships), an outside investment may not help. In this scenario, the danger of raising capital by selling equity is that it can mask foundational problems in the business by extending your runway at the cost of dilution to founders. Taking an investment in a company in such conditions means the founders have to focus on becoming profitable and proving they can sell to new customers and be very conscious of expenses.
Larger services businesses with an established track record of growth and profitability can be attractive to more sophisticated private equity investors. Those businesses have a different set of considerations than younger businesses still early in their growth cycle. This post focuses on those earlier-stage businesses.
Does The Business Want More Than Cash From An Investor?
Sometimes all the business needs is cash, and raising money from a passive investor without any experience or interest in the business's operations is sufficient. If you are looking for some experienced outside help from your potential investor, you must be deliberate in your selection process. Founders must ensure expectations are clear for the investor and the business and consider what they want from an investor.
Characteristics to Consider
It's unlikely that every investor - would be interested in every possible area of the business. While complete alignment is almost impossible, founders should ensure they're aligned with an investor on the most critical aspects to drive the business' growth.
Ultimately it's the founder(s) and whoever is involved in the day-to-day management of the business who is responsible for decision-making, so both the management and investors need to be comfortable with one another. Some characteristics to consider for importance and alignment:
Experience scaling similar types of services business
It can be beneficial to have someone with experience growing a similar type of services business. Some questions to consider asking a prospective investor:
What was their role in their previous business(es)?
How hands-on were they in the scaling process/phase?
If they were hands-on, ask detailed questions, like: What areas of the business were they involved in specifically? What are some specific examples of problems you had to solve? What did you do in those particular cases? Who else was involved? What did your team look like, and what roles did other key contributors play?
What were some key inflection points in the growth of their business? What went well, and what would you do differently?
What areas do you think you can be most helpful in scaling a business you're invested in? More importantly, what areas are you not interested in or able to help with?
Expectations of return (e.g., a liquidity event vs. cash flow)
Ensure the founder's expectations are aligned with the objectives of the business. Good questions to test alignment are:
Are you expecting a return from this business from an exit by the company being sold or from distributions from profit?
What's a great outcome look like for you? A good outcome? What is the least successful outcome you'd be happy with?
How long are you expecting your capital to be deployed before you see a return?
How hands-on do they want to be vs. what the business needs
Sometimes founders and investors need to be more aligned around how much they want an investor to be involved or if there are specific boundaries around areas where the investor is (or is not) involved in the business. Founders can try to avoid this by asking questions like:
If we want or need your help, how much time can you spend with us in a week (or month, or quarter)?
How would you like to engage? By phone/video or in person? One-on-one or with a broader portion of the company leadership?
Are you able to be involved periodically only when the business has a specific need or involved continuously (e.g., keeping a pulse on the business even if it's not needed)?
Are you willing and able to "roll up your sleeves" to work on specific, detailed problems with us, or are you more focused on big-picture, strategic ideas?
Expectations of where they can and want to help vs. the business needs
Founders may want investors to only focus on specific areas where they want help or may wish for a more open-ended relationship. Similarly, some investors are interested only in helping in particular areas of the business, while others may be looking for the intellectual stimulation of being involved in all business areas. You can test for alignment by asking questions like:
Are you willing and interested in focusing on specific areas of the business, or do you want to be broadly involved in multiple aspects of the company? (e.g., finance, sales, delivery, operations, culture, etc.)
Are you comfortable being "hands off" except in the areas / during the times when we need help?
Expectations related to governance
Investors may have expectations related to the governance of the company. Founders should make sure they are aligned with a potential investor in areas like:
Expectations around reviews and changes needed to operating agreements or corporate bylaws
The frequency and detail expected in updates about the business' performance from founders and management
Expectations around whether there is a formal board and if the investor expects to have some formal role on the board
The level of control an investor or parties outside the management team can exert on the company
The legal structure of the business may mandate some aspects of governance. In contrast, other structures (like LLCs) give management a lot of flexibility in shaping governance through their operating agreements.
Business connections that may be helpful
Founders often want investors to help with business connections that can help in different areas of the business. Often this can be to help with sales, but it could also help with other business relationships, sales partnerships, government or regulatory matters, or future fundraising needs. Founders should make sure a prospective investor is willing to leverage their connections and explore what that looks like (e.g., warm introductions, facilitating meetings, taking a meeting together, etc.).
Things To Be Wary Of
Expectations of a salary or other fixed compensation more than normal board-level or advisory compensation
Occasionally investors will be looking for a formal part- or full-time role accompanied by compensation. Founders should tread very carefully in agreeing to this as it can be a complicated arrangement to reverse, it's often a significant labor expense, and it only sometimes generates the value expected.
If a founder or the business' management is considering agreeing to this, it's essential to set expectations upfront around the following:
Job role expectations, the same way the business would with any other hire, along with management’s expectations about the time commitment
Employment isn’t guaranteed due to involvement as an investor
Job performance will be evaluated the same way for the investor as it is for any other person involved in the business in a similar role - there is no preferential treatment
Mismatched expectations in areas like growth and profitability
Investors usually expect the business to achieve specific performance metrics, particularly revenue growth and profitability. Founders must be aligned and prepared to meet these expectations, or else there will be significant friction in the relationship with an investor. This should be an ongoing conversation with investors, not just part of the "pitch" when raising money.
Investor's abilities to generate sales
Sometimes founders are interested in bringing on an investor because they believe an investor will generate sales. This is often a mistake. Selling services is hard, and while relationships help, it's not a given that strong professional or personal relationships between an investor and a sales prospect will lead to a sale.
Even a well-connected investor doing everything they can to introduce a services business to a strong connection may lead to wasted time in meetings that don't result in closing a sale. Investors are sometimes connected to people too senior in a prospect’s organization to align the services business to a commercial need. Other times, a large organization may be too bureaucratic such that a small professional services business can't make it through the vendor management process. Founders are wise to evaluate terms with a potential investor as if the relationship will not produce any benefit to sales.
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