Customers sometimes ask about the success fee settlement model. The more often the questions on the subject arise, the greater the pressure on the current business model of the company. Those who were present at these conversations start asking their bosses: How many more transactions would we make if we offered solutions based on a success fee? How much more could we earn from the same project? Some of you know these questions too well.
From my experience, the success fee can be a very profitable model of cooperation – under certain conditions. In every model of this type, however, it is very difficult to run a business on an appropriate scale. There are several reasons for this.
Success defined wrong
The contractor has a limited ability to define success before the start of the project. Is the success in working with an SEO agency to increase brand recognition, get 100,000 subscriptions to the newsletter, make 1,000 purchases, win over 800 new customers, generate $100,000 in revenue, or $30,000 in margins? And if we already define success as generating $100,000 in revenue, why is it 100,000 instead of 95,000 or 105,000? The contractor’s business is to set the bar as low as possible, the customer’s as high as possible.
Usually, the information advantage is on the client’s side because they know their business better. The competence advantage lies on the contractor’s side because they know SEO. In practice, most of the success fee transactions that I have researched were based on badly defined success criteria.
Time spent on defining success
The problem is the time spent on defining success. Let’s assume that the agency devotes an average of 5 hours on defining success criteria. Of the 100 success fee inquiries, they present an offer to every other, of which they win as much as 40%. This means that 250 hours per month is devoted to the valuation of the projects. And these are not the cheapest hours, because valuations are usually carried out by senior employees who are competent and more expensive, often managers. As a rule, the cost of selling projects in the success fee model should be drastically falling. In practice, they don’t go down as they are replaced by project valuation costs.
For this reason, the contractors don’t want to dedicate time nor money to define success accurately.
Conflict of interest
Success fee models generate a conflict of interest between the client and the contractor. A contractor who works in a success fee model wants to achieve big success as soon as possible. This is due to the fact that a large and fast commission on success is better than a small one, for which you have to wait longer. Unfortunately, the client is usually unable to cope with large-scale rapid success and wants a “tiny success” or many “tiny successes”.
Imagine the chaos that arises in a warehouse, that to this day has been selling 6,000 orders per month, when someone doubles sales in three weeks. How many new warehouse workers does this require? It may be necessary to move the entire operation.
This conflict of interest costs the time you spend on its mitigation which puts further pressure on the contractors’ margin or simply ends the cooperation. The second source of conflict of interest is the time horizon. The client wants to achieve success today, but also tomorrow, and in 5 years. The contractor wants to achieve success as soon as possible because they bear the costs here and now. So, why should a contractor who is rewarded with a commission on income, not apply a radical discount deepening?
It is not their problem that after a few months customers will get used to low prices, and will not want to buy products at previous price levels. If the client secures themselves and decides that they want to pay the contractor’s commission on the generated sales margin- this may also cause conflicts, because then the contractor (following the example of search engine marketing) will reward traffic sources that generate quick profitability instead of a long-term relationship with the client, which is worth much more (but it requires patience).
Risk bonus and cost of unsuccessful projects
As you know, projects settled on the basis of a success fee are divided to those that work and those that don’t. Customers who work this way and succeed must find two things in the contractor’s commission, apart from the price of a normal service: a risk bonus for project failure and the cost of your failed projects (which don’t generate revenue but generate costs).
Customers are smart, so the moment they succeed while cooperating with you, they will ask for a new deal and switch over to permanent fees, so that they don’t pay for these two elements. Customers who aren’t successful don’t want to switch to another model, still generating costs. With time, contractors stay with customers who generate costs and are not successful, and customers who are successful and don’t want to work in a success fee model. So contractors are systematically at risk, but rarely get a risk bonus that lasts long enough to balance costs.
We won’t run away from talking about money in this post. Here lurk the biggest risks of running projects in the success fee model. Let’s assume that it takes you a month from the start of the project to generate the first effects of success. You get the money after 14 days, but you get the cost right away. This, combined with the costs incurred on the valuation, generates a lot of pressure on your company’s short-term cash-flow. It would still be bearable, if not for the fact that customers in success fee models often forget to pay contractors on time.
This happens more often than in traditional business models. It is especially so in the case of cooperations that aren’t continuous, only one-off. And that means that the cash-flow pressure in your company will be added to the cost of debt collection and the cost related to the difference between the invoices nominal and real payment dates.
If your organization lives on more than 50% of this type of projects, the pressure on cash-flow can simply put you out of business, unless you have a powerful working capital loan (which involves other types of risks, especially during economic breakdowns) or a pile of cash (which could give returns instead of lying around and giving only a sense of security).
The last risk associated with cooperation settled in this model is responsibility. In the best companies with whom we work, sales are the responsibility of the entire organization, and every team in the organization strives to support salespeople in their own way in achieving their goals. Unfortunately, in the case of models focusing on the success fee on revenues or margins, the responsibility for the result is pulled from the organization to the contractor, which means that the company stops focusing on clients and starts on secondary things.
Whether we like it or not, sales and marketing are the key competencies of a B2B company, and should never be the responsibility of anyone who isn’t employed in it. This leads us to the conclusion that smart managers do not delegate their key processes and competencies. And since they delegate non-key competences, they cannot be associated with a large success fee. In practice, therefore, the contractor working in success fee model is doomed to work in key areas with stupid companies (because the smart ones don’t delegate the key ones) or smart in non-key areas (but for a small success fee). And this isn’t a good dilemma for building a company that will be on the market not only today but also in 5 years.
If you are a freelancer, all this can have zero meaning to you, and it’s quite likely that you will live well with your success fee based business. But you won’t have a multi-person company this way.