Here's where you are: balancing on a razor's edge. You are juggling competing needs:
- Capitol for product development
- Cash flow to pay for sale effort
- Attention required to staff two different models:
- Traditional consultants for your cash flow business
- Developers and support staff
- Sudden need to build an infrastructure to support a growing business
- Finance guys, admin staff, human resources/recruiting
You're enormously attracted to the rush of 90% profit margins on each product sale but you are starting to miss the simpler days, when you had half a dozen guys out doing consulting and a one-room office that you and your partner shared. And if you were both out consulting, you answered client calls at the Homewood Suites at night.
Why is Your Profit Margin Dropping?
You may note that in our earlier piece on the transition from Product To Consulting we'd started with a 30% (gross) margin on consulting and a 100% margin on 'the product.' Well, that was true when the product was client financed and improved by salaried bench consultants. But now that you have a few developers, a server room, bigger offices, etc, etc it starts to eat into your profit margin. So it's down to 90%.
Oh, wait, your new finance guy just completed an ABC (Activity Based Cost) on your organization and found that your consulting margin has dropped to 20% due to turnover and higher bench rates and that the cost of sales you calculated did not include sales shows and the taxes you now need to pay in California on your sales office in the valley. Ok, product margin is now down to 70%.
But it is still a lot higher than consulting, and the requirement for capital for expansion is even more necessary.
Persevere
You don't get to a $3M/year company employing 30 people without having some drive, so you make a plan. A business plan. A real one. With expected, best, and worst case scenarios. And a spreadsheet showing how you'd use $1M to take your business to $15M in 18 month.
Reality check: $1M a year with six guys to $3M a year with 30 guys in a year. Can we go to $15M with 60 guys? Yeah, we can do that again. Make the powerpoint and hit 'send' on the email.
Enter the Venture Capitalist
You are lucky and your product enables web 2.0 enabled mobile social enterprise marketing. (Please feel free to add or subtract buzzwords here.) So you're hot enough to get into four or five VC's and one of them thinks you 'fit into our portfolio' and wants to do a deal.
Fitting Into A Portfolio
Just a quick note - this means that quite aside from anything else the VC thinks of you, he is expecting you to provide (at best) at cost services to other companies with cash crunch issues. At worst they will expect you to take over struggling product/development/sales issues for dying startups.
Your salesguy is already calling on their core customer base, it'll be a synergistic sell. Yes, I know that your product is a back office enterprise solution and theirs is a front office spam mail filter, but he's already on site!
Right. Let me give you a hint: this is bad.
Before you go to bed every night, practice looking yourself in the mirror and saying: No. You may need to add juicer words to the front of "no" to make it work. At the end of the day the VC can fire you and take your company, but it's the last thing they want to do, especially before you are in trouble. So you can start early on and get them used to going to find someone else to push around.
The Deal
We've already talked about what to look out for in a VC contract, and we've already talked about how the VC will probably wipe out your Mom's investment. And you know to watch out for those salesguy's Amex cards with your personal guarantee, the phone system with your personal guarantee, the copier with your personal, well, you get the drift.
We have not mentioned the absolute necessity of using a real payroll provider like ADP (small is fine, may not save you any money though) and ensuring that they are escrowing all your payroll taxes and unemployment insurance, etc. Because no matter how nicely you're incorporated, the feds will come after YOU for that money, and if they don't get it you are very likely to end up in Federal Pound You Prison.
So go read those back posts and come on back, because this is where the VC kills your business.
Consulting is Dead, Long Live Product Specialists
To the VC investing $1M to ramp your company up to $50M (Remember that excel sheet? The numbers got bigger.) the $1M you're making in consulting is not worth it in:
- Cash flow: they want you to spend their money to get to the second round to own more
- Your Attention: product has the multiples, leverage, and profit margin
- Market Confusion: Are you a product or services company?
To give them their due, aside from the ulterior motives of the first point, they are right. You have a thin management team and you are fighting to get recognized in the market, so you have to focus on the future.
So the core of your business goes away - you dump 8 of your 12 consultants and keep four around to test, install, and write custom reports. There are always custom reports.
Because your typical bag carrying billable consultant is terrible at this, you eventually have more turnover, which feels good at first because the new guys cost less, are more compliant to doing this kind of horrible scut work, and the probably don't have any expectation of equity.
The Money Is Gone
You burned through your VC money, probably on schedule, and while sales have been good they aren't making up the burn rate. Two things can happen:
Thing the First: - A Down Round B
Your previous pre-money was $3M and you gave up 1/3 of the company for $1M. Now your pre-money is $750K and you give up 75% of the remaining company for $500K. I could do the math, but it would depress you. Suffice it to say they will take your net profit margin on trailing 12 month sales and use that as the market cap value.
And your boss sits in San Jose. Almost all non-essential staff is laid off, but your're paying $10K/week for two hours a week of CFO time from another portfolio company. Plus your development guys are "taking a look at" some "other interesting technology products."
You ever heard of LinkedIn or Monster? Get familiar. I have been doing startups for a long time and have seen this zombie phase a lot. And I've yet to see a company come out of it.
Thing the Last: Retrenching With Consulting
If you decide to stop taking the Devil's Money and you've been very successful in saying "No" a lot and very loudly, you can probably bull your way into trying to resurrect your consulting business. But you find that the consulting market has moved on, you don't have any more consultants on staff except you, and, frankly, it's hard to get too excited to going back to six guys and a cube. In my mind this is just another type of zombie.
The Moral Of The Story
There isn't one. There is nothing wrong with transitioning from consulting to product, but it is darn hard, for reasons we've discussed. And there is nothing wrong with VC money if you're in a hurry and you are willing to take the risks. Me, personally, I can't imagine taking VC money in today's highly leveraged global human resources market, with cheap high quality hosting, powerful tools, and ready access to millions of particular customers. But your product may have different requirements, so good luck to you!
ageRank and Live Count
It's always great to get a new tool like the 
Filter Options
We're taking down the downloadable list of 2,162 social bookmarking and networking sites and replacing it with an interactive analytical tool that gives you a lot more information and display control. It will let you see the heartbeat for any social bookmarking or networking site. Thus, in a fit of imagination, we called this the
In one of this week's hottest Sphinn stories, 
And sells the next day at 2. Bam! Billions of shareholder equity lost. A year ago this would have been unimaginable.
