The Secret Sauce of Valuable Service Businesses

Robert Smith of Vista Equity Partners famously said, “Software companies taste like chicken. They’re selling different products, but 80% of what they do is pretty much the same.”

Service businesses are no different. 

You buy someone’s labor, mark it up, resell it, and spend opex to operate the business. You also spend money on capex to improve the “infrastructure” of the business, and what’s left over is your profit.

Markup – Opex – Capex = Profit

The challenge is that in the long term, the free market is annoyed with your business model.

Customers and labor don’t fully understand the role that you serve, and they don’t particularly care that you have to spend money to operate the business.

Labor doesn’t like you marking up their time, and customers want your markup in their pocket. Many suspect they would be better off if the service were cheaper, and you were removed from the equation. 

To be loved by customers and labor for your middleman role, you must be obsessed with creating more value than you mark up.

Value Provided > Markup = Happy Customers & Labor = Durable Business

You create “excess value” by building value-adding infrastructure (less jargony explanation below), which eventually leads to reliable, growing profits and the option to exit.

Creating Value Through Infrastructure

At the start, almost all the value created in a service business comes from the unique talents of you, the founder. You create trusted relationships and clients happily pay the markup knowing that you are “watching over things”. You use your special magic aura to make everyone happy, and it is a great way to get initial traction.

Unfortunately, businesses dependent on “founder magic” are difficult to scale and have almost no external value without the founder in place. To become something more than a great job for the founder—to become a true asset—the business has to evolve and create more durable, transferrable value through infrastructure.

Value-adding infrastructure :

1. Enables labor to be more efficient and productive. A worker can do more work, more easily because of the tools and structure you provide.

Examples: Custom software matching labor with jobs and helping them efficiently manage their projects, so they can take more jobs.

2. Enables labor to be higher quality and more consistent. A worker can do better work, more consistently because of the tools and structure you provide.

Example: A proprietary process to deliver your services, codified by “How To” guides and training courses for your labor (and often supported by software).

3. Enables labor to be consumed by customers in a more frictionless, more enjoyable manner. The sales and operational process that allows for labor to work with the customer is “lower toll” and has a higher probability of success for all parties.

Example: Digital marketing campaigns that attract quality customers to your business and a website that makes it easier for clients to educate themselves on your services. Training and materials for sales people to improve communication with customers and speed up sales cycles. Elaborate self-service flows that allow customers to solve problems quicker and easier on their own.

Infrastructure creates value repeatedly and reliably. 

But infrastructure costs money, and if you’re bootstrapping or you’ve acquired the company, you’re on a budget. You are paying operational employees who keep the trains running, trying to grow sales, trying to feed yourself, and paying taxes on every dollar the business earns.

You need to be strategic about how and when to invest in infrastructure – the first priority is always survival.

Here is what building infrastructure looks like over the lifecycle of your bootstrapped service business (with some examples in italics):

1. Startup Phase – The First 2-3 Years

You need to survive, scale gross margin, and add talented employees as quickly as possible. Scale and talent begat infrastructure. 

You do not need the same kind of infrastructure that you see in a company ten years old. You don’t need expensive CRM implementations, complicated HR systems, or detailed employee handbooks. It is ok for the business to feel a little sloppy at times and for quality to be inconsistent.

Pay yourself as little as possible, as long as possible, so you have more money to hire people who will help you grow. Hire people who are undervalued and hungry, and build a culture that focuses on improving the business, with no regard for petty ego. 

Example: We hired as quickly as possible, and we didn’t pay ourselves over $60,000 until year 6, when we were up to 10 employees. The excess early capital to hire was critical to the long-term success of the business.

Infrastructure should only by built to resolve massive operational inefficiencies, and should be mostly employee, not vendor, driven. 

Example: The top sales person spends three days creating wonderful email templates for the team that save everyone two hours/day.

Do not feel like you have to reinvent every part of your business – the competition are smart too, and sometimes it makes sense to follow their lead. Bonus tip – avoid anything HR as long as humanly possible – it is like trying to sail a boat with the anchor still in the water.

2. Find “Product/Market Fit” Phase

In the middle years, build infrastructure for what works, but don’t get sucked into big investments for new ideas.

The middle years of your business, roughly years 2-7, are an awkward adolescence. You exist, but you’re not truly excellent (as you might have hoped you were in the start). You are probably selling at least one service well, but you suspect there is a better way that the business could evolve. You’re getting a little impatient that you’re growing steadily, but nothing like a hot startup. You’re still pretty poor. 

You are testing different markets, different services, different customer acquisition strategies, different operating models. You are trying to bring up the average of your employee group and figure out who can lead you into the next decade. You’re actually starting to understand your market and the players involved, and you are exploring the space with earned confidence. 

These middle years are when you’re trying to figure out what exactly the business is, and what flag you want to plant that says “we are the best in the world at XYZ”. 

Example: We started a second brand four years into building the business because we started to realize the limitations of our original model (in-person, academic tutoring focused on LA/NY). We eventually buried the original business and went all in on the new business (online, test prep tutoring, originally focused on international), which is what was ultimately acquired.

Avoid the temptation to really invest in infrastructure for the new ideas until you get some kind of positive market signal. “Fake it ‘til you make it” usually can buy you some time. Stick to building for the old part of your business that pays the bills, even if it is a little boring.

No matter what, you’ll build infrastructure that you have to throw out. Try to avoid the sunk cost fallacy and just let it go. All that matters in this stage is using your earned expertise to narrow and clarify your vision for the business.

3. Scale and Build Infrastructure Phase

Once you have arrived at your supreme focus, “we are going to be the best in the world at XYZ”, then it is time to build the infrastructure that supports that vision and maximizes that process.

Example: Around year 7, we decided we wanted to be the best in the world at one-on-one, online, SAT & ACT tutoring. That meant building a curriculum for this purpose from scratch. Not the norm of adapting a classroom curriculum, or taking in-person curriculum and moving it online, but thinking from the ground up, from first principles: “what is the absolute best way to improve scores in the least amount of time, with a one-on-one, online delivery method”. Building this was a 5-7-year beast of a project, with constant iteration, but the end result was a completely unique piece of infrastructure that added crazy value to our tutors and clients.

You have to improve the infrastructure supporting every single piece of the value chain from the time your labor comes to interview until they finish an engagement with the client. Each step must be codified and optimized. Always try to use software and systems instead of humans.

Create KPIs for your systems and hold people accountable. If you invest in a new CRM, can you demonstrate that salespeople can now handle more leads? Do those new leads convert into gross margin? A great metric for overall efficiency is revenue / corporate employee, or even better, revenue / salary $.

Example: We built custom business management software that helped us double revenue/employee from year 7 to year 12. Caveat, supporting a software development function is very expensive and difficult. Only build software that is absolutely unique to the way that you run your business and will make the business significantly more profitable long-term.  

Building infrastructure is a long term process. You are building a house, room by room. You will have to make tradeoffs and prioritize one pain point over another. Be patient, and try to explain to employees the overall vision.

4. Profitability Phase

It is very hard to rapidly grow a service business, build real infrastructure, and actually make money. There is always something new to invest in. 

At some point, you have to be willing to stop building everything, decide your product is “good enough” (verifying this assumption every year), and consolidate your gains. Transition employees out of infrastructure building and into roles that grow revenue, or gently sunset their projects so they have opportunities to find new work. 

After consolidation, you will have“core profitability” (e.g. true profit margins of 20%+) and infrastructure that can scale. This gives you lots of options – sell the company, step back, or reinvest in new salespeople and other growth areas. 

It is easier said than done—I basically had to step down and deputize my successor CEO to this final task because I couldn’t handle the shift to a profitability mindset.

Happy building!

Build Your Company to Exit

If your long-term goal is to move from labor to capital, then you need to build your business into an asset that you can personally “exit”, not a high paying job.

Assets can be sold or held once you have exited, but they do not require your day-to-day participation. Assets give you free time and capital to invest.

The “gravitational pull” of a service business is to stay small, never let the owner leave operations, and never be acquirable for more than 2-3X EBITDA (if at all).

You have to fight this gravity by:

1) Focusing on a niche and creating actual moats in the business

2) Building the organization and management to be independent from you

Moats and Niches

When you are the driving force of your company, it is easy to be in the “we do stuff for money!” business.

Your relationships and insights drive new opportunities, and your can-do attitude pushes the company to say “yes” to everything under the sun.

Take your time to understand the market and opportunity set, but to set the stage for an eventual exit, make a decision and say “we will be the best in the world at XYZ”. It took us six years to really focus in our first business, and everything was easier after that.

XYZ can be a simple as “providing the most delightful high-end residential lawn care services in North Manhattan Beach, CA”, but you have to plant a flag, say “we will OWN this space”, and relentlessly execute towards the mission.

This clarity will make your company simpler to operate, more profitable, and easier to exit.

You can focus on building a defensible moat, and it will also happen organically. No company in the world will care as much about your customers and be willing to completely align their business around this vision.

You can eventually replace yourself as CEO because the existential issues that require the founder will be resolved, and the focus will shift to operations and efficiency (which employees can often do better).

You have a tight, secure story. You are a solid, hardened entity, built around serving a customer better than anyone else, not the talent of the founder.

You will build something that a competitor would love to own, or a financial buyer would feel comfortable borrowing against to buy. Your business feels like a bond, not distressed equity, and you have the flexibility to sell or own from a distance.

Organization and Management

For every “job to be done”, you need to eventually replace yourself with someone who is better and less expensive (taking into account your equity compensation), until one day 5-10 years later, you’re out of work. Then you can exit.

You learn the job, you build the initial processes, then you hire and train someone else to do it. The people you hire should take those existing processes and rebuild them in a much better way. Each new person you hire should “bring up the average” of the company operations and talent pool.

Each time you take a job off your plate, find a new, harder job that better aligns with your strengths and is needed for long term growth. The challenge is to allow yourself to really delegate, even the hard stuff.

You have to keep pushing, hiring, growing until the company finds product/market/distribution channel fit and reaches a scale and stability that can support a new CEO.

Building an independent organization is a long, slow grind, but it is possible. It pays to be a bit lazy with a middling self opinion, so you’re less attached to completing tasks on your own and more open to promoting other talent. It took four years for my co-founder Tim to be able to exit, and nine for me.   

Some of the challenges:

1) Every time you replace yourself in a job, their salary comes straight from the business profits, and it makes you more poor in the short term. When you are growing and hiring a lot early on, all money conspires to be taken out of your pockets. We made just enough to survive our first five years.

Embrace financial constraints, start young, live your Minimum Viable Life.

2) You have to attract, hire, and retain great people to take over important roles at your extremely irrelevant and mediocre paying small business. 

Offer more than just a paycheck. Offer fun, offer comraderie, offer adventure, offer flexibility, offer opportunity, offer humor.

3) You always feel like you suck at your job. Once you have figured out a job, then someone else can be trained to do it. You move on to the next new thing that needs done, and now you suck at that. At least you can eventually “trade up” to areas of more strength and delegate the parts of your job that you hate.

Be humble, have a sense of humor, and enjoy that you’re growing. It gets better.

4) Eventually, you’ll find a job that you’re actually really good at, and there will be a negative tradeoff required to replace you. The business will be a little bit worse in order for you to exit that role.

This is the price you pay to exit. You have to just let this go. You can’t be a perfectionist and exit your business.



Notes

I talk about a lot of these concepts on Eric Jorgenson’s podcast if you’re interested: https://www.ejorgenson.com/podcast/waitbutwhy-co-founder-andrew-finn-on-how-to-acquire-a-free-company.

He also writes a ton about the concept of Leverage, which is a valuable framework to think about on your professional journey: https://www.ejorgenson.com/blog/category/Leverage.