Sharing The Risk

Dec. 21, 2004
Consulting firms shake traditional fee models.

Call it fad or trend. Whichever it is, there is no doubt that value-, performance-, and equity-based fee structures are becoming more common, especially among smaller management-consulting firms. Although traditional methods of charging for time and expenses, or project cost and expenses, are here to stay, some firms are linking as much as 50% to 75% of their fees to performance. Others are working for stocks or options instead of cash. While potentially lucrative, such approaches can be risky and even potentially unethical, say some consultants. Steve Savia, chairman emeritus of the New York-based Institute of Management Consultants (IMC), says that in a value-based arrangement, a consultant asks a client how much the solution to the problem is worth and, in terms of that, how much he would be willing to pay to get the job done right. "I think there are advantages to that," says Savia, who is a principal with Sage Group, Palo Alto, Calif. "You do get a true sense of how important the engagement is to the client. It helps make sure the resources you need to do your work are available. If a client is willing to pay you $100,000, you have a committed client." A value-based approach will not work if clients are unwilling to say how important projects are to them. Tim Bourgeois, director of Kennedy Research Group, Fitzwilliam, N.H., says value-based pricing works best in operational areas such as accounting. He adds that the top revenue-producing consulting firms often do not use this method because it is difficult to budget for it. One of the disadvantages of offering value-based pricing is that the marketplace is not used to it. "It's not real prevalent in its use, but more firms are doing it," says Savia. "Ultimately it is the best way -- for a client to have that kind of confidence in a consultant." Dudley Smith, president and CEO of the Assn. of Management Consulting Firms, New York, says the consultant increases his own risk by taking a value-based approach. "There is a danger to it," says Smith. "There's nothing like hourly billing." In a performance-based arrangement, where payment is contingent on results, the consulting firm agrees to base fees on a percentage of savings or earnings generated for a client as a result of its recommendations. Thomas Group Inc., Irving, Tex., has successfully used the performance-based model. Calling its team of consultants "resultants," Thomas Group applies its Total Cycle Time methodology to business processes, including product and service development, engineering, manufacturing, infrastructure, and sales. The firm aims to increase revenues and reduce costs for its clients. James E. Dykes, executive vice president-corporate development, says that in some cases up to 50% of Thomas Group's fees are based on quantifiable results. Such results may include various cycle-time reductions, inventory reduction, margin enhancements, profit improvements, or revenue increases. "Our model is 50-50 because that is the level the CEO is willing to accept," says Dykes. Thomas Group's strategy is first to understand what the client is trying to improve. The next steps include an initial analysis to evaluate how the client's business is performing and an estimate of what levels of performance the business should be reaching if it implements the suggested process improvements. "Many times, the people don't believe the numbers are possible," says Dykes. "One of the reasons for the incentives is we believe we can achieve those numbers. We'll risk our profit. It passes the credibility test." In situations in which Thomas Group and its clients are equal partners, both management teams have the same incentive to achieve the desired results. "When they are totally aligned, it is a win-win situation," says Dykes. George Group Inc., Dallas, has been linking its fees to results since 1994. From 1987, when the company was founded, to 1992, the company offered a money-back guarantee for its work. In 1994, however, the firm, which now has 100 consultants, decided to tie its fees directly to results. Now, George Group takes one-half of its fees in fixed payments, and the other half is contingent on getting the results it promises. The firm's objective is to improve the value of a company by improving operating income and reducing working capital. "We are focused solely on results," says Robert Carringer, senior vice president of business development for George Group. "As an investor, you only make money if the value of the company goes up. When you have an investor mentality, you have a different view on the world of consulting." Carringer agrees with Thomas Group's Dykes that it is important for the management teams of both parties in a business relationship to have the same incentives to achieve the desired results. Carringer says the most important lesson his firm has learned from using a results-based approach is to tie the contingent fees to the same objectives on which the executives' bonuses are based. Carringer says that when George Group is competing with a major firm for a client's business, the results-based approach plays well. "Customer service is becoming more important," says Carringer. "Money-back guarantees are everywhere." He adds that other management-consulting firms, as well as businesses in other industries, should adopt performance-based approaches. Tom Rodenhauser, president of Consulting Information Services, Keene, N.H., says a performance-based agreement can work because it is a way for both the client and consultant to share accountability. "It's like they are joined at the hip," says Rodenhauser. But a results-based arrangement carries potential pitfalls. Savia says one of IMC's codes of ethics says members will "serve clients with integrity, competence, and objectivity." By basing one's fees on performance, one could lose sight of the long-term health of a client. "The inclination could be to go the short-term route," says Savia. "Is the consultant making the recommendations based on getting a higher fee or because those recommendations make sense? I am concerned with the ethical consequences of that." Gary Brooks, president of Allomet Partners Ltd., New York, and chairman of IMC, says performance-based fee arrangements create a potential for conflict of interest. "Once you put yourself in that mode, you start losing the most important value a consultant brings to the table, and that is independent judgment," says Brooks. "I'm reading more and more about large corporations using them as a means of reducing the front-end fee." As part of its professional code of conduct, the New York-based American Institute of Certified Public Accountants (AICPA) says its members shall not "perform for a contingent fee any professional services for, or receive such a fee from, a client for whom the member or the member's firm performs." AICPA defines contingent fee as a "fee established for the performance of any service pursuant to an arrangement in which no fee will be charged unless a specified finding or result is attained or in which the amount of the fee is otherwise dependent upon the finding or result of such service." While it certainly is possible for a firm taking a performance-based approach to work in an unethical manner, George Group's Carringer says it is just as possible for time-and-expenses contracts to be unethical. "Objectivity could be a concern if contingent fees were tied to improving your fees but not the client's benefits," says Carringer. Working for stocks or options instead of cash -- an equity-based approach -- is used in situations where an emerging firm does not have the cash to spend on consulting fees. "Options are a great tool for developing companies," says Bourgeois. He adds, however, that the services-for-options approach is less common than value-based pricing. Although taking stocks or options in lieu of cash may be somewhat risky for the consultant, it also can require a high price to be paid by the client. In a typical work-for-stock arrangement where a consultant's total fee is $50,000, the consultant might get $25,000 in cash and $150,000 in options. "It's a great way to get someone interested in the health of the company," says Bourgeois. Parthenon Group, Boston, a small consulting firm that has worked for stocks or options instead of cash, specializes in strategy consulting. Chris Jenny, managing director of the firm, says one-third of Parthenon's clients pay in equity. "Fifteen percent of our revenue was in equity rather than cash last year," he says. The consulting firm's approach has helped its revenues grow 20% to 35% annually during the last four years. Parthenon Group, which was founded in 1991, first accepted stock options instead of cash when it worked with Microcom Inc., Norwood, Mass. Parthenon successfully helped to boost that company's stock by a factor of 10. Since that time, the company has learned several lessons about equity-based engagements. "Make sure you are working on things that can impact the stock over time," says Jenny. And, he adds, "Make sure you are working with a management team that is committed to change." As with the performance-based model, some industry representatives have misgivings about this approach. The IMC's Brooks, for example, says accepting stocks or options in lieu of fees is a potential conflict of interest. Savia counters that the ethical dilemma is not as great as that of the performance-based model because the consultant is apt to look at the long-term interests of the emerging company. "If you're dealing with a well-established organization, there could be the inclination to go for the short term, boost the stock's value, and then get out," he says. "But a more mature company probably would not offer equity in lieu of fees. I think it's more common for the large firms to go the traditional fee route. Smaller firms and sole practitioners have more flexibility." Jim McGuire, national managing partner with KPMG Consulting, New York, says that when accepting stocks or options instead of cash, it is important for both parties to determine whether the payout will be at certain points of the contract or at the end of the contract. George Group's Carringer says his company has offered to accept stock instead of cash as part of its fees, but to date clients have not been amenable to such an arrangement.

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