CM: Consultancies tell us the reason they are pursuing consulting-for-equity arrangements is because dot-com clients often can't afford their fees.
Nanda: But that's only half the story. If the clients don't have the money to pay you right away, that doesn't mean that equity is the only means of deferred payment. They can also pay you through bonds. The other half of the story is that the consultancies, seeing how successful the dot-coms firms were, began to tell them, "We're prepared to share in the risk for the bond which will be based on your performance."
CM: Can we say consultancies are today a leader in this area of exchanging fees for equity?
Nanda: Some consulting firms, Parthenon, for example, have been doing this for some time. Consulting firms have also learned from professional firms offering other services, such as law firms, some of which have been quite aggressive in taking equity for advice. Venture Law Group in the Silicon Valley, for instance, insists on compensation partly in equity in return for professional advice.
CM: As Wall Street seems to be taking a more conservative view toward the dot-coms and they seem to be losing their luster, venture capital funding seems to be evaporating. Should the established consulting firms take a more conservative view as well?
Nanda: We have been through the phase of huge investments chasing dot-coms, where any idea that had a dot-com behind it got venture funding. That era may be coming to a close, but I do not see venture funding evaporating. It's just that the go-go days that existed a year or so ago are probably drawing to a close. But I expect a huge amount of funds to continue to be channeled into the New Economy.
Will the end of the "every dot-com is successful" era have an impact on consulting for equity? Yes. Consulting firms will realize that equity is a risky payment. Some of those risks will begin to hit home as consulting firms discover that the equity received from some of their client firms is not particularly valuable.
CM: What will happen in the event of a market downturn?
Nanda: If the dot-coms begin to perform poorly, consultants' willingness to accept consulting for equity will decline. However much they may say they are keeping in mind the higher risk component of taking equity, the fact is that most consultants are thinking of equity compensation as a winning proposition because many have the attitude that the possibility of stocks that they are getting in exchange for their advice falling to worthlessness just does not exist. That perspective, and the attendant willingness to accept equity in exchange for advice, can change quickly in the event of a downturn.
CM: There are two schools of thought out there. McKinsey says that they will do consulting for equity but only in the short term. It seems like a necessary evil for them.
Nanda: I don't think there's a right or wrong way. The tension here is between independence and alignment. If you are paid fee for advice, the consultant's interests are not aligned with the long-term interests of the firm's shareholders. There is no reason why independence is inevitably superior to alignment for a consultant unless we begin to look at what particular type of advice the consultant is giving. Should a lawyer giving advice on what laws to follow be independent? Yes. Should someone advising on risk be independent? Yes. Should somebody who is advising on what strategic policies to choose in order to get a better competitive position? Not necessarily. You may want the consultant to be aligned with the shareholders' interests. The ethical issue here is whether you are up front about your long-term relationships, that is, do you disclose your long-term relationships to all existing and potential clients. Suppose you are aligned with a firm and a second firm seeks your services. There should be disclosure to the second firm about your long-term relationship with the first.
CM: When should independence be the goal?
Nanda: Independence is important in two circumstances. One, when you are observing a company but are responsible not to the company's management but to another set of people. For instance, auditors are not responsible to the management of the company, but to the shareholders and to the public at large to verify that the management is following accounting rules. Similarly, you don't want the analysts to be aligned with management. You want the analysts to evaluate management independently and advise investors.
Secondly, suppose you have been hired as an advisor to give judgment related to what is permissible or legal. So, for instance, you have been hired as a tax attorney. If you are too aligned with management, then rather than advise management on the legality of particular tax practices, you might assist in management's pursuing tax avoidance policies that are perhaps wrong and unethical. Another example where independence is important would be risk consultants. If you have been hired to advise on managing risks your firm might be exposed to, you should not be paid on the basis of expected returns on the firm, because then you are likely to underestimate the low-probability events that you have been hired to focus on. Aligned advice is particularly helpful when the client needs strategic advice. If your interests are aligned with those of the client shareholders, you will offer advice that works for the client shareholders' best interest. Also, the problem of "management capture" — management using consultants to satisfy their own goals to the detriment of shareholders — gets reduced if consultants are being compensated in the form of equity.
CM: What happens when consulting firms take ownership in businesses within concentrated industries?
Nanda: Having established long-term relationships that tie the few firms providing particular professional services to specific clients hurts other potential clients who do not have these long-term relationships but need professional service. Because the few professional service providers are already tied up with their clients, the newer clients risk being foreclosed out of the market of conflict-free service. They are focused to accept professional service tinged with potential conflict. The net result is reduction in competition in the market and accumulation of market power with the few providers.
This was not much of an issue in the past because the consulting industry tended to be highly fragmented. But it has become a very real concern in consulting today because of the consolidations that have been taking place in different segments of the profession.
CM: What would the profession look like if everyone engaged in consulting for equity?
Nanda: If everybody engaged in consulting for equity, strategic consulting would be strengthened. The other kind of consulting, aimed toward improving operational effectiveness through best practices transfer, would be hindered. The marketplace would become less transactional and more relational, with the clients and consultants tied through long-term relationships. The boundaries between consulting firms and client firms would be more blurred.
Every consulting firm taking equity for service would lead to fragmentation in the industry. Over a long period of time, if the existing consulting firms had long-term relationships with a few clients, clients that did not have such relationships would seek new sources of advice, and new consulting firms would crop up to serve the unserved clients.
Fragmentation has two effects — competition increases but efficiencies of scale are lost. A fragmented industry is highly competitive because every service provider has a competitor. On the other hand, it is inefficient as well, because everybody is reinventing the wheel and firm sizes are too small to be able to serve effectively large global clients.
I don't think that the best of all worlds is one in which everybody is offering consulting either just for fee or just for equity. I think that the best situation for both the consulting profession and the clients is one in which both offers — consulting for fee and consulting-for-equity — are on the menu, there are laws about full disclosure of long-term relationships, and there is some restriction in using the consulting for equity option in concentrated industries.
Sidebar: Ashish Nanda says that consulting firms which have decided to do consulting for equity should think about five issues:
1. How does the consulting firm reinforce its role as a passive investor rather than an active manager of the client? Should there be a cap on how much of a share of a client firm a single consultancy owns? Should there be a norm on the equity-fee split the consulting firm is willing to accept from the clients? How does the consulting firm think about its professionals taking directorships on client boards?
2. Should there be a sunset provision, i.e., should the consulting firm have some rules on existing ownership positions in the clients?
3. How diversified should the portfolio of equity investments be? What should be the guidelines on the number and variety of firms to invest in?
4. What fraction of the equity should be directly apportioned to the particular professionals who are dealing with the client and how much should be pooled in a shared fund?
5. What are the processes of disclosing the consulting firm's long-term relationships to existing and potential clients? What are the processes of reviewing potential conflicts before accepting clients?
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