One of the challenges that comes with design services is the cyclical nature of the services business. When the economy tightens and corporates are watching their operational expenses, the first step will be to halt any external contracts/contractors which are not deemed absolutely essential. For customers in the strategic segment this usually means that the activities will continue although sometimes throttled down somewhat. For the lower two segments it typically means activities will be halted or significantly reduced. It is important to note that the right mixture of customers within the segment is also important. Startups and growth-stage companies will often continue to execute their roadmap and will not reduce their spending as time-to-market is more important to them.
Frequently we encounter design services companies without a proper CFO as part of the Management Team. Understandable in the startup phase of the company but even then, it is prudent to include a CFO as a part-time MT member to ensure strategy is not discussed without a proper financial perspective, both short- and long term. Using an accounting office is usually not equivalent to having a CFO in the team. Accounting offices are typically of a generic nature (handling all kinds of customers and their businesses) and tend to have little specialist insight into the semiconductor eco-system.
In our Strategic Advisory services, we in general recommend that several instruments are used to provide some level of buffering when adverse market conditions are encountered. The first one is the creation of a financial buffer. The size of the buffer depends on the availability of other instruments; without any other revenue streams it is typically between 3 and 4 months of the company’s operating budget. However, companies must establish a few other instruments as well. One instrument which can be triggered once the company has built a larger team, and a financial track record is the use of R&D projects and the related grants that come with it. We’ll cover this instrument in a follow-up post as it merits more discussion. Another relevant instrument is the use of a “breathing layer” of contractors. These contractors need to be selected carefully and, despite their “flexible nature”, tied into the company so that they can easily be brought in and work within a project team. At the same time, when a project is finished or put on hold, they can step back. This breathing layer of contractors provides flexibility for the company, not just where it concerns its operating expenses but also in its ability to quickly ramp-up in case of a new project. It is not uncommon to have about 10-15% of engineering resources available as contractors.
One of the challenges that comes with design services is the cyclical nature of the services business. When the economy tightens and corporates are watching their operational expenses, the first step will be to halt any external contracts/contractors which are not deemed absolutely essential.
Whereas the earlier (staircase) model is a good approach in scaling up revenue and creating new revenue streams, the foundation of the company is still based on the service model: headcount continues to be the main driver (typically up to 60-70% of revenue). In terms of (enterprise) valuation the additional revenue streams, however, will already make a significant difference.
Design services companies typically start small (some exceptions when it concerns management buy-outs) and natural growth is a slow process as it requires hiring and training of engineers based on/driven by the revenue stream of the company. Growth of business is tied to growing the team and it is not always easy to find the engineers.