Value-Based Fees Don't Work For Most Consultants
They sound like an amazing idea - but they're not practical for most consultants when we consider the challenges in estimating value, risk imbalance, and competitors.
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One of my biggest bugbears is the concept of value-based fees.
Like many, I devoured Million-Dollar Consulting when I was getting started.
A significant lesson from the book was to use value-based fees vs. hourly rates.
The process is relatively simple.
You collaborate with the client to determine the value you will create for them, and then you charge a percentage of that value as your fee.
For example, imagine you’re a sales consultant who will help a client increase the conversion rate of prospects by 20% by bringing in best practices and improving the pipeline. You estimate this will result in an additional $15m in value over three years. Charging just 10% of that figure ($1.5m) sounds like a bargain to all involved.
The client captures 90% of the benefits, and you get a fee that reflects your value. Everyone’s happy!
Can you spot the problems with the above?
Before you read on, consider why this won’t work.
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Problem 1: You Can’t Measure Most Consulting Projects By Dollar-Value Return
It’s challenging to estimate the actual value of the project.
Even using the sales pipeline example at the more accessible end of value estimation (more on that later), it’s difficult to determine the project's value.
The vast majority of consultants don’t support functions which are as directly linked to revenue as sales. IT, HR, Marketing, and leadership consultants are rarely able to make a reasonable estimate of their value. That’s because many business functions aren’t held to dollar-value measurement.
Developing a reasonable figure is still challenging, even when working on projects where dollar-value measurement is possible. Even if that were the case, we’re still plucking far too many numbers from thin air.
In our example, why did we use 20% improvement as the basis of estimation? Why not 5% or 50%?
Likewise, we estimated our work would generate an additional $15m over three years.
But why three years? Why not one year or ten years? We can increase the number of years to infinitely increase the project's value. Where can we reasonably draw the line? There are no rules around this - even if you use a discount rate to zero.
You will also notice we charge 10% of the project’s value to estimate our fee.
Why 10%? Why not 50% or 1%? I’ve seen no principle or rationale that helps determine what % of the project’s value we should charge. We’re still in the ‘charge clients as much as you feel they will pay’ territory.
Problem 2: Big Fees Become RFPs
Even if you could reasonably estimate the value of the project, clients are unlikely to spend the fee you’re asking for.
Once you start charging more than $50k, most projects enter a competitive bidding process to ensure the client can evaluate the bids from a range of organisations and to put some safeguards in place to prevent bias and fraud.
And once an RFP is issued, you will find yourself competing against larger firms with a lot of experience in responding to an RFP.
It’s VERY HARD to tell an organisation it’s good value for money to spend $1.5m on a single consultant vs. a larger firm with a team of people.
Problem 3: You Have Competitors
Imagine you have a terrible leak in the upstairs bathroom. The water is coming down, so you call a plumber. The plumber explains that the entire floor will crash if he doesn’t fix the leak. He does some research and estimates fixing a collapsed floor will cost $110k to $170k.
So, he conservatively charges you $11k (10%) as ‘fair value’ to fix the leak.
Would you pay $11k for him to fix the leak?
That’s a value-based fee!
If he’s the only plumber in town and you don’t have time to find another option or figure it out yourself, you'll have no choice but to pay that fair figure (you would feel you were getting good value, right?)
This highlights the problem with those who believe in value-based fees. They assume you’re the only option, and clients have no idea what they should spend. The reality is we’re all part of a market.
»» [People who believe in value-based fees assume you’re the only option, clients have no idea what to spend, and you have no competitors. If your fee is far above the market rate, you will lose business to your competitors.]
You would expect to pay a plumber a few hundred dollars to repair the leak in a few hours. Any more than that is a rip-off.
The same is true of most organisations. If they feel your fee is far above their market expectations, they will source options from your competitors, which will soon become a problem.
When your competitors quote $30k to $50k as a flat rate, and you charge $450k as a ‘value-based fee’, it’s hard for the client to feel they’re getting value.
You can’t ignore the client expectations and going market rates and expect to win the business. Your fees will be determined by:
Project scope.
Competitor fees.
Your distinctiveness within the market.
If you want to increase your fee, you must change one or more of the above.
Problem 4: Shifts All The Risk Onto The Client
A significant problem with value-based fees is they shift almost all the risk to the client instead of the consultant. The consultant might help scope out a project worth $15m, but that’s not what they will be held accountable for in the contract (with good reason).
The consultant will be held accountable for achieving deliverables that lead to the outcome. This creates an obvious problem: What if that outcome doesn’t happen?
The consultant still gets paid (or at least 50% in a 50/50 payment terms split), but the client is disappointed and out of pocket.
There’s a vast difference between hoping and thinking a project will achieve a $15m return and actually seeing it. A client can do all the due diligence in the world but still be disappointed. Every organisation and every set of circumstances is unique, and things can change incredibly quickly.
How confident can a consultant be about the degree of improvement we will have on the client? If a consultant is confident, they could be paid by the outcome (you can probably charge even more if you’re only taking a % of the difference) - but no consultant wants that (for good reasons).
Better Approaches Than Value-Based Fees
While reading this post, which favours value-based fees, I was struck that the experts quoted at the bottom of the article don’t recommend them.
This doesn’t mean you should charge by the hour instead; that’s a bad idea.
The right approach is almost always to charge by the project. Every industry is different, but you can find some broad guidelines for fee ranges here to help you get started. Then, you can zero in on the correct fee for your project.
Thanks for reading.
p.s. If you want to learn more about fees and selling consultancy projects, sign up for my Proposal Mastery course.
Great write up! Take a look at my stuff a lot of synergies! tanya.seda@substack.com
Definitely agree. The only scenarios I have seen consistently favorable for value-based pricing are when firms with a massive brand power apply it. Hard as a smaller firm.
Otherwise, I would always recommend a fixed-price, outcome-based commercial model when it's very clear what your scope is, otherwise charging by the hour (yes! Charging by the hour) is the way to go when the scope of the work is too unclear (sometimes it happens).