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The Five Tool Player: Service Provider Financial Considerations

The Five Tool Player: Service Provider Financial ConsiderationsThe great thing about this country is that you can grow up to be whatever you want to be. Obviously, few of us spend our youth dreaming of the day that we can become a data center provider or operator—I wanted to be a secret agent—but as we get older things change and new opportunities open up to us. Lately it seems like more and more folks are looking to embrace these new opportunities and become data center providers. I guess if you can’t get the latest gizmo from Q, it’s not a bad second choice. Now that you’ve decided to become a service provider the first thing you need to do is to understand that unless you are independently wealthy, you are going to have to ask people to give you money so you can get started. This in itself isn’t so bad. People ask people for money all the time. Don’t we all have someone who regularly reaches out to put the “touch” on us? Unfortunately, the people that have the volume of money that you need speak just a little different language than the rest of us so its important for you to understand “financial speak”.

The first thing to understand is that you are seeking to enter an asset based business. This is a little different than say, running a 7-11. Although both require the use of capital, success is judged differently for each. In our 7-11 example, your capital is spent on inventory—those Slurpees and Big Gulps don’t just make themselves—and the sale of that inventory is what generates your revenue (and if you’ve ever purchased a box of cereal at midnight from your local purveyor of 24 hour convenience you know what I mean). As a service provider, capital is the lifeblood of your business. Even if you gather enough to begin operations you can’t grow without more of it. Since the people that you will ask to provide you with capital (a much more sophisticated term than “money”) aren’t going to give it to you for nothing, they will be asking you about what they are going to get for letting you use their funds. Since we’re all being sophisticated here they won’t ask you “how much am I going to make” but they will ask what you expect your return on capital to be.

A simple way to think about the concept of return on capital is like the mortgage on your home. When a bank grants you a mortgage they agree to give you a sum of money that you will pay back over time. The fees and interest that you agree to pay is where the bank makes their money. This is their return on capital. As a provider, this return rate is what you are paying your investors for the use of their money. This principal amount of capital plus return rate is what you owe investors before you begin to receive your first dollar of profit. Although this seems like an obvious point, it is often overlooked by many providers. Not recognizing that return on capital consists of both the principal and the earned rate of return has left more than one service provider with an unprofitable business model. Too many service providers talk in terms of “margin” while neglecting to note that a good bit of that margin is the return of the original capital invested.

To structure a profitable business model, a service provider has to develop a cost structure that effectively amortizes the repayment of the capital principal and its rate of return (interest). The optimal structure would be similar to our mortgage example with both being paid over time. Despite the familiar nature of this model, many providers in an attempt to reduce their start-up costs elect to use a “bullet” payment model. Under this structure, only the return rate (interest) amount is paid regularly with a single “bullet” payment for the principle to be made at a pre-determined future date. As many in the recent sub-prime mortgage crisis found out, in this type of arrangement very often the bullet shoots you. In other words, revenues have not reached the level necessary to make the final large lump sum payment. As you can imagine this tends to make all involved very unhappy.

One of the primary reasons for success for many colocation companies was that they were able to start by taking advantage of “10 cents on the dollar” facilities. When the playing field is level (everyone has to build new), it requires much more expertise and discipline to make the model work.

Naturally, the financial considerations for becoming a service provider are deeper than we can be covered in a single blog post, but this covers the primary area of confusion faced by many providers. Hopefully this will help some of you future providers out there. And for you secret agent wannabe’s, let me close with this ideal funding strategy, “Bonds, cheap bonds”.