To Make More Money, Take More Risk

LinkedIn Article by Tim Williams 
May 31, 2016

When creating an investment portfolio for retirement, no reasonable person would put all their money just in gold, just government bonds, or just stocks (especially in today’s economic climate). In a professional services firm, your client compensation agreements are your most important financial asset. If they are all based on the same remuneration system — just fees based on hours, for example — it means you’re not diversifying your portfolio, and by definition not maximizing your firm's profitability.

Wall Street portfolio managers are trained to optimize returns through a combination of different types and classes of investments characterized by different levels of risk. Seasoned financial advisors know that prosperous investing is dependent on assessing, leveraging, and mitigating risk. 

Peter Drucker taught "All profit is derived from risk." If you want to make more money, take more risk. If you want a low-risk existence, low-risk client engagements, and low-risk compensation agreements, guess what kind of margin you'll get in return? On the other hand, if you take a conscious, deliberate approach to risk, you stand to gain in the same way you would in the way you save for retirement. 

The concept of a compensation portfolio

The unfortunate truth is most firms have unconsciously followed a low-risk approach to pricing, meaning their compensation portfolios reflect a steady diet of just one thing: cost-plus agreements based on hourly rates, labor-based fees, time of staff, etc. Firms with this type of single-approach compensation portfolio operate under the illusion that if they “manage their hours” they will achieve their target profit of 20% on each client. 

Firms with a more balanced approach to risk have the confidence and foresight to experiment with diverse types of client compensation agreements, however. These firms know they can expect much more variety in their margins from projects and clients, but they also know this creates the potential for above-average profits overall. Instead of obsessing over the monthly profitability of every individual project and client, they view the financial health of their firm like the health of the human body. What counts is that you're fit and healthy overall, not that every individual part of your body is in perfect condition (which of course it never is).

The idea isn't to run your pricing program like a riverboat gambler, but rather to take some calculated risks; to experiment, test and learn. The principals of the marketing firm Anomaly think of it as making a series of small bets on themselves. Partner Jason DeLand says his firm often doesn't know where 30% of its year-end revenue will come from. Not because they're poor forecasters, but because they have injected enough innovation into their various revenue agreements they don't know exactly which ones will pay above-average dividends. But it's precisely this type of compensation diversification that helps firms like this consistently earn above-average profit margins -- sometimes two or three times the industry average.

Costing is not pricing

The joke inside advertising agencies is that they should apply creativity to everything except the way they do their accounting. True enough. But accounting (a science) is not the same thing as pricing (an art), and devising creative compensation agreements is something every firm should aspire to. Merely counting your costs and turning it into a price isn't pricing; it's just costing.

Professional pricing means crafting compensation agreements based on the value you create rather than the hours you work. Once you decide to stop selling your costs and start selling your value, it opens the door to almost unlimited revenue models. The tech industry developed the concept of "technology stacks," which refers to arrays of software solutions. Professional firms can develop "compensation stacks," a variety of ways that they can derive revenues from what they really sell: intellectual capital, not hours.