PS Margin Myths

I read a blog entry today from a venture capitalist that made me wince:

One of the Biggest Mistakes Enterprise Startups Make

In the post, he is making the argument for why software startups need to invest in Professional Services. I am in line with the majority of his reasons. Until his last point:

And finally, the most obvious argument is an economic one.

It’s true that professional services have a lower margin (say 45-55% gross margin) than software (typically 85-95% gross margin) and professional services business are inherently less scalable.

So I’m not endorsing your building your entire company around professional services (although I think that’s a fine strategy for many non VC-backed companies) but rather not to avoid it.

Let’s say you can do $1 million in software sales in your first year of selling delivering $850,000 of gross margin. Let’s say you can supplement that with $1 million in professional services revenue at $500,000 gross margin.

Need I point out that the $500,000 is still profitable revenue that can contribute to your central costs of running your business?

I have been involved in benchmarking embedded PS organizations for the past seven years. I know exactly what best in class financial performance looks like for PS organizations within software companies. I can tell you that both project margins and overall PS profitability have been steadily improving year over year. But I can also tell you, that on average, embedded PS organizations are not generating 50% gross margin on projects. And they surely are not dropping 50% of their revenues to the bottom line to cover other company expenses.

The logic in this blog entry is based on grossly inaccurate assumptions–and that is what makes it so dangerous. I pity the poor manager put in charge of PS for a company that this venture capitalist has invested in. The expectations of the economic role of PS will be based on napkin math, not financial realities.

Building and scaling a project based human capital intensive business is hard. Having investors that do not understand the financial realities of the PS business model make success almost impossible.




2 Responses to “PS Margin Myths”

  1. David Shimberg Says:

    Embedded professional services contributions should not be measured in margin contribution alone. The driver for customers to purchase more software is realized value. The life cycle of customer investment and returns is dependent on effective implementation and solution adoption. PS is a key contributor in the value chain. Where is that measured?

    • Thomas Lah Says:

      David: I agree with your observation that embedded PS organizations contribute more than simply margin dollars. There is a body of work we did five years ago titled “Economic Impact Analysis.” We created a set of frameworks for measuring the total economic impact of embedded PS organizations on a product company. However, we have found VERY FEW cases where the PS organization is actually attempting to measure any economic impact metrics beyond project margins and PS profits. If embedded PS organizations want to claim larger economic impact they need to measure it. Otherwise, it sounds like they are making excuses for anemic project margins.

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