In my previous article, I received a question in response to “Myth #1: I need to get VC funding to make my company successful.” I was asked to explain what it really takes to get a consulting company off the ground. How much money does it take to start a consulting company? How much constitutes a “little bit of money“? This is a great question, so let’s start at the beginning.
Starting a consulting business is no different than starting any other software company until you get past the paperwork stages. You file with the state, open a bank account, get a domain name, and do all of the typical software startup things. In fact, on paper a software company and a consulting business are exactly the same. You’re going to need hardware, software, developers, time, and a little bit of money. There’s that phrase again. How much!
I don’t think many people realize how easy it is to start a software consulting business. I started Moon River Software with about $5,000 and a couple of credit cards which I barely used. The plan was to start out consulting while writing software products on the side. When software sales exceed consulting revenue, it’s time to switch from consulting to full-time product development. That hasn’t happened just yet, and it will not happen for quite a while, but the software sales are slowly growing. The money that I had saved up didn’t go to software, hardware, or many of the other things that you might think. It went into my pocket. So, I put $5,000 into the company and promptly started giving myself paychecks.
Does that seem strange? Of course it does. That money should have gone toward resources that the company needs. Something important. Not back into my pocket. Right? Not so fast. For a consulting business, the lifeblood of the company is the incoming business, measured by the hourly rate times the number of billable hours. Guess what? You don’t get paid until the work is done. So, just like switching jobs, you need to have some money in the bank to help you get through what I call the paycheck gap. What schedule did your old company pay on, and what schedule does your new business pay on? Some companies withhold one full paycheck, which depending on the schedule could be 2-3 weeks. If the company pays on a monthly basis (and some of them do!), you might not see a paycheck for quite a while. Even if you want to pay yourself every week, chances are that you can’t because the business hasn’t made any money yet.
The Paycheck Gap
The Paycheck Gap is the time period when you must perform a careful balancing act between cashing incoming checks, writing checks for your own payroll, and sending money to pay business credit cards or other debts. The biggest problem with a consulting business is that there is a net terms payable agreement. That means that after you bill the company you do the work for, there’s still a lag between when you’ve done the work and when you get paid. Let’s say you start a job on June 1. On June 14th, you’ve done two weeks of work and you bill them. If the net terms are 2 weeks, you might expect a check around June 30th. That means an entire month has gone by and your company has had no income until you get that check. That’s hard.
To make matters worse, net terms of 15 days are not very common. Most companies use net 30, net 45, or even net 60. That means that even after you’ve done 2 weeks of work, it could be an additional 4, 6, or even 8 weeks before you see a check. That puts you into late July or even early August! The larger the company, the longer the net terms tend to be. This means that from the time you leave your old job to start consulting, it will likely be 6-8 weeks before you see a check. I’ve done work for companies that only allow you to bill them the last 3 days of the month. I did a two day job for a company the second week of last December. In addition to not being allowed to bill them for another 3 weeks, I had to wait another 4 weeks on top of that to receive my check. Total time from work complete to receiving a check: 7 weeks.
Let me make one thing perfectly clear before we go on: Do not expect your clients to pay early. Period.
You might get paid a day or two early. If there are quarterly or yearly accounting audits going on, you might expect a more timely payment. But there is only one situation I know of in which they will pay significantly early, and that’s if you start giving them discounts for doing so. In that case, you’re offering them an incentive, and are cutting their costs. If you’re desperate for the money, offer a 1%-2% discount for paying early and 9 times out of 10, you’ll be paid quickly. Otherwise, you’re going to have to wait.
Why does a 2% make a difference? Say you’re charging them $2,000/week. A 2% discount will save them $40. And for what? Writing a check a little earlier than it needs to be written. Accountants are penny pinchers for a reason. That’s what they’re paid for. Cash on hand is great, but if they can save $40 by writing a check a week early, they’ll do it. Because over the course of a year, saving 2% each week on your invoices alone could save the company more than $2,000 total. Arthur Anderson, eat your heart out.
Back to my example of not being paid for 7 weeks. That’s almost two months before you see any money for your business! Not only is that timeline typical, but who is to say that you’re going to be paid on time? What will happen to your business (and you) if you aren’t paid on time? What happens if you aren’t paid at all? Don’t think this will never happen to you. It happens to a lot of people and it very nearly happened to me, so be on your guard.
The Paycheck Gap ends when you are receiving checks from your clients on a regular basis.
Catch Up Mode
Once you have cleared the Paycheck Gap you are on your way to being successful. What happens is that your business will turn from being forced to survive on peanuts in the short term to what I will call ‘Catch Up Mode’. This is the time during which your business must issue back paychecks to you on a regular basis, typically for work done anywhere from three to nine weeks ago. Moon River Software’s Catch up mode period was six weeks of back paychecks.
Many people will be tempted to start paying off any business credit cards they have accumulated balances on, just to prove that their business has no debt. Take my advice. Don’t. Give yourself a paycheck and try to catch up on your back paychecks. Not paying yourself first is seriously demotivating. It seems like everyone is getting paid except you. Forget about the fact that you’re going to be paying interest on some purchases. Forget about the fact that your balance sheet could be closer to zero liabilities. Your salary is a big liability, and receiving paychecks is a huge morale booster. You start seeing the profits of your labor, and the fact that your efforts are actually paying off. Pay yourself first is typically a strategy used for retirement savings, but it works extremely well when growing your business. If you are constantly paying everyone else first, there will be very little or nothing left for you.
During this time period for Moon River Software, I had more than enough money in my bank account to pay the credit card bills for the equipment I was buying, but instead let the bills linger while the cash sat in my account and instead went to my payroll. Why? Well, my business credit card gave me a 0% interest rate on all purchases for one year, starting in October. Guess what? I had no incentive to pay them off early. Instead, the money went to me in the form of paying off the money I loaned the company to get off the ground and in terms of my payroll. In fact, I just paid off a $10,000 balance that I’ve accumulated over the last year because in October, interest would have started to accumulate. Had they offered me a discount to pay it off early, I would have.
At this point, if you’re running your consulting business properly, then you’re making a profit every week, and will slowly catch up with your payroll. In the case of MRS, every two weeks that went by I caught up by another week or so. Once you’ve caught up and are writing checks for payroll every Friday for work completed the week before, you will start logging a legitimate profit. Now you can put money away for those times when you will not be working, be it because you have taken a vacation, or are between clients.
Just to be clear, the billing cycle between you and your business is different than the billing cycle between your clients and your business.
It should go without saying that being profitable is a bare minimum requirement for running your business. If you’re not profitable, you’re going to go out of business, plain and simple. At the end of every quarter, you read about companies who log tens of millions of dollars in losses every quarter. The first quarter of this year, GM posted a $323 million dollar loss. That’s a lot of money, by any standard. How do they keep going you ask? How could they possibly stay in business while losing $323 million in a single quarter. That doesn’t even count the previous five quarters where they also logged losses of more than $1.3 billion the year before. Yes. Billion with a ‘B’.
Let’s switch gears and talk about the profit stage of a company. I think here is where a lot of people get confused about the long term goals of a company. As soon as a company is profitable, the owners start thinking about all kinds of things that they can do. Buy more equipment, hire more people, get a bigger office space, increase corporate benefits, buy gadgets and gizmos for employees as rewards, etc. These people have lost sight of the true goal of the company, and there is really only one.
Your primary goal is to stay in business.
Now repeat those words with me. “My primary goal is to stay in business”. The single best way of ensuring this is setting up a rainy day fund. Financial planners the world over recommend that individuals should have no less than a 3 month safety net. This is money in the bank for you to pay your bills, your mortgage, car payment, meet your monthly expenses, live a little bit, and still be able to make ends meet for at least three months with no income. You need to do this for your business. And not just for the founders. For every employee in the company, founder or not.
Rainy Day Fund
Moon River Software recently crossed the six month Rainy Day Fund threshold. Right now, in the business bank account I have enough money to cover all corporate expenses, including the office lease, payroll, internet access, colocation server costs, phone bills, and several thousand dollars in additional ‘surprise’ expenses for six months with zero additional income. The business has zero debt beyond this months’ credit card bill and upcoming payroll expenses. It’s been said that running your own business is one of the most stressful things in the world. With this Rainy Day Fund behind me, running my business is one of the least stressful things in my life. I know that I can screw up all kinds of things and still be in business. Here’s why.
Let’s go back to the example of GM and figure out how they’re still in business. Their loss of $323 million in the first quarter of 2006 was on revenues of $52.2 billion dollars. Let’s assume they did the same thing that I did, and could theoretically operate for 6 months with no income. That would mean they had over $100 billion in the bank. Losing $323 million is a mere 0.3% of that. For arguments sake, lets triple that loss and say they instead averaged a $1 billion loss every quarter for the next X years.
With a $100 billion Rainy Day Fund, even losing $1 billion every quarter, they would still be in business for the next 25 years. Yes, that’s correct. 25 years! Isn’t that impressive? Between you, me and the engine block, GM doesn’t have that kind of money to spare. They’re in pretty poor shape. I think that untrained monkeys could do better by flinging poo against a ‘Corporate Strategies’ mat on the wall, but that’s why I work for myself instead of GM.
The point I’m trying to make is that once you get a 6 month Rainy Day Fund under your belt, you’re in good shape. Now is the time that you should start looking to expand your business, hire more employees, buy more equipment, and do all those other things with your money. While large corporations measure success on a quarterly basis, I would recommend measuring it every other week. Every day or every week is too often, and once per month is probably not often enough. Here’s why every week is too short.
If I bought a new laptop this week because my old one died on me, it would set me back about $3,000. By spreading out this expense over multiple weeks, my profit margin will be much lower for those weeks, but longer term, the profit is still there. If I were measuring my corporate progress on a weekly basis, adding $3,000 worth of expenses in a single week could kill my profitability curve. Depending on how much my consulting income is, it could put me into the red that week. Measuring every other week tends to smooth out the wrinkles in the curve. When you start hitting millions of dollars in revenue every year, that’s when you can measure every month or every quarter. Until then, stick to every other week.
No matter what niche market you’re trying to serve with your consulting business, you don’t need a lot of money to get started. All you need is enough income to get you through the next six weeks or so, and the willpower to not melt down into a steaming pile of mental ward biomatter. If you make your situation clear to your first couple clients that you need a reasonably fast turnaround on the first couple of invoices, most of them will be willing to help out a little bit. Push for 10 or 15 day net terms. If you negotiate well, this won’t be a problem.
The hardest part about the process is having the willpower to make the leap into being self employed. After that, it’s really not that hard.
Special thanks to Rob Walling for reviewing drafts of this article.