So pervasive has this thinking become that on several occasions startup companies with profitable and fast-growing services businesses have wanted to show me the product businesses they created internally to see whether they would be financeable or whether they might be able to create “spin outs” that could be financed.

A great recent example of this was a successful group of entrepreneurs who had created a company that will do $10-12 million in revenue at their system integration business (read: services business) in 2011 after having done $5 million or so in 2010 and $2-3 million in 2009. They feel very confident they can hit $18 – 20 million in 2012.

They have created two internal technology “products” and wanted to figure out how they could turn their services business into a product business that could be financed. This team is talented. They wanted advice. And probably some money. I gave them advice I don’t think they were expecting from a VC:

“Don’t raise venture capital for this business. Ever. And stop effing around trying to create a product company.”

It is advice I give entrepreneurs often as I have written here on why most businesses should never raise VC.

Why Shouldn’t Most Services Businesses Raise VC?

Well, let’s look at this exact situation:

• I don’t have access to their actual financial statements but let me make some reasonable assumptions. It would not be a big stretch to image a well-run service business like this making 15-25% net profit margins. Early in a services business there is usually no profits as the company reinvests in hiring people to grow, but by $20 million in sales the company should at least be pulling in 10% profits (if not more) depending on how much is reinvested.
• So assume that in 2012 the company would do $20 million in sales and $2 million in profits (10%) and 2013 they would do sales of $25 million and $4 million in profit (16% net margin) and then slow growth in 2014 to $30 million and $6 million in profit (20% profit). That is $12 million in profits over 3 years.
• The founders could reinvest this in growth (0% tax, focus on future equity growth) or take the profits of $12 million and divide amongst the founding partners. Assuming there are 3 founders and they own an equal amount (33%) then they’ve just taken $4 million each in profits and note that this is at a qualified dividend tax rate (currently 15%) versus an income tax rate (35%). True, the 15% rates will likely go up in the future, but I doubt they will approach the income tax percentage level.
• The thing is – even if your services business is a smaller scale than this – you have complete control over the decisions about where to take the business. There is no shame in making a few million dollars in profit and paying yourself dividends while still owning a large percentage (if not all) of your business. It’s how things are done across the country outside of Silicon Valley.
• The minute you raise VC you have one option – try to become big. No VC is interested in dividends – they want growth. That’s the right answer for VCs. It may be the right answer for you. But it might not.
• Trying to turn a successful services business into a product business is getting the cart before the horse. If you really want to do a product business then hire a professional manager for your services company, quit that job and focus 100% on your product company.

Why build a service business in the first place?
There are at least two types of tech services businesses in my mind:

1. Service as a bridge to a product business. One of the best ways for young startups to finance its business without any dilution is what I call “customer financing,” which is mostly only possible in businesses that target businesses rather than consumers. Customer financing often comes in the form of your company agreeing to build a product with a “sponsor” customer or two and helping them with the rollout/implementation. Often in this strategy you end up giving them the product for free and bill them only services fees. You own the IP you create.

The benefits for the customer are: A mostly custom-built product addressing one of their internal needs, the focus of a very talented young startup focusing on their business need & free product – potentially for life.

The benefits for you are even more clear: You get to build a product raising significantly less external money (if any at all) and therefore no dilution, you get a customer who will help you figure out the real requirements for your business and you have your first real reference client lined up, which should help with future funding and with future sales.

If you set out to build this kind of business you just need to be sure you don’t become a permanent consulting business by default. The “customer-financed” type of tech service business is never frowned upon by VCs – unless you’ve been doing it for 2-3 years with no product business to show for it, by which point they assume you’re the second type of services business.

2. Services for services sake. The type of business that is generally shunned in Silicon Valley is the “pure services” business like consulting, system integration, value-added resellers (VARs), customer support businesses, outsourcing companies, etc. I have already outlined some of the economic reasons these can be good businesses as well as the one of the most important – retaining full control in you business.

But the broader reason that I often suggest them to entrepreneurs is that they’re much easier to build than product businesses even though they’ll never become Google, Twitter or Facebook. Trust me – it is far easier to persuade a business to pay you for your services (a concept they readily understand) than it is to persuade them to buy a totally new product concept and pay for that product.

“How much is that software really worth? Who else is using it? How much did they pay? Wait, I’m only paying “X” for my Salesforce.com licenses – and you want me to pay “Y” for your product? Who are your competitors – how much do they charge?”

I could go on-and-on with all of the sales-blocking messages you will hear when you try to charge for a product. I’ll repeat: Everybody understands paying for services. It’s pure irony. At my first company we would have a product sale of $80,000 where the customer would grind us to get the fee down to $70,000 but would readily pay $25,000 extra for “implementation & post-sales support.”

We were building a VC backed software business so I had to focus on the product business. But this lesson in business was never lost on me. And some of my former teammates are now building really awesome services businesses in the exact same field and they own 100% of their companies.

Even tech blogs know this. You struggle to get advertisers to pay your CPM rates and get your page clicks up in a business where you become a near commodity to ever other website out there. Yet you can run a conference and mint money. If it’s well run, people readily pay for conferences and sponsors readily pay to become platinum, gold or silver sponsors. Tech blogs can theoretically scale, tech conferences are pure service businesses.

But how do service businesses grow?
I’m not saying the scaling a services business is easy – it’s not. One big challenge is how to grow the company. You end up needing to add staff and take on more risk without knowing what your future demand will be. There are a couple of ways to think about this growth.

1. Start with a network of independent contractors. When you’re a young company with 3-4 people and you land work that requires 7-8, it can be daunting. You don’t necessarily want to take on the extra employees and risks. I recommend that you establish a network of contractors who want to do similar work to you but don’t know how to sell projects or to build a company. They’ll be glad for the occasional extra work.

2. Vendor financing. When you start to win business – let’s say as an implementation arm for tech/business products or as an ad sales team for large tech/media businesses – you can often get financed in a small way by your vendors who are all to happy to have a bigger ecosystem of implementation houses. They won’t do this before you prove yourself but once you hit a minimum scale this is always an option.

3. Angel financing. Just because VCs won’t back this kind of business doesn’t mean angels won’t. If you can show a few million in sales and the ability to return dividends in the near-term there are always smart businesses professionals who will consider financing this. What are there other choices these days – money in a bank at 0.5% interest?

4. Bank financing. OK, so this isn’t immediately likely to come from Wells Fargo, but there are tech banks like Silicon Valley Bank or Square1 Bank that are in the business of financing startups. If you can show regular cashflow and are willing to put your profits into their bank you can often fund expansion this way.

Final message on financing – just be careful not to let your fixed costs get too high as a young services business. In a booming tech market like 2011 it’s easy to think your business will always expand. The problem with service businesses is that when the economy turns revenue & profits take a really big and quick hit. Those companies that have a largely variable cost base and make the tough decisions survive for the next boom.

Why shouldn’t service businesses become product businesses?
If you build a true “technology services for services sake” business, at some point you’ll likely build technology products where you either own the IP or you own in jointly with your customer or business partner.

This is where many service businesses make mistakes and go pear shaped. They get “product business envy” because they read too much TechCrunch about their product brethren raising money at crazy valuations and getting sold at even crazier ones. So they set out to build a product business within a services company.

A few problems arise. Firstly, they don’t realize how hard product businesses are. They mistake their successes in selling services as a competency in selling products. Second, they often ramp up their cost base to accommodate these costs, which when a down market hits they are more effed than those that stay focused. Finally, the focus on the product (envy) means that they take their eye off of their core business, which is services. So the core business suffers.

I saw this first hand. My first career was at Andersen Consulting (one of the largest services businesses in the world). We built a hugely successful global services business yet we never got over our product envy from watching our tech clients. So we created internal software projects and all of the internal consultants on those projects became blowhards who thought they knew how to create software product businesses.

We stunk at every product we ever created. We had no sense for gathering real customer requirements. We over-spec’d products. We built for our over-intellectual selves. I can’t think of any great software tools ever created internally by Andersen Consulting. We were a great services business. Period.

What should services businesses do with their product businesses?
So back to my advice to the company I recently spoke to about spinning out their tech business or raising VC. My advice wasn’t to shut down all product / IP initiatives but rather to be clear on their purpose and how to monetize them.

1. Products as a service sales machine. My dear friend Franck Meudec in Paris knows this best. He has built some internal technology products to support his services business. They are “loss leaders” for his core business. In stead of going in and trying to hold the line on how much to charge for these products he can tell customers, “Sure, we’ll give you our planning software at cost if you decide to work with us.”

His business is booming. These products help him win his core sales. He is not confused about which is the horse & which is the cart. He is building a services business. In stead of owning 1% in options to join a startup tech company he created his own tech services business. He is the majority owner. Higher risk, higher reward than joining as a junior employee somewhere else.

2. Products as a key differentiator. Another important reason for having internal IP in your services business is as a key differentiator against other services businesses. If a customer is faced with two equal choices for companies who can implement Salesforce.com – how do they choose one other than references & price? Imagine if you had build a few modules on top of Salesforce.com that made that product more effective? Even if you didn’t charge for these it would sure increase your sales hit rate.

Tech services business in booming markets are mostly about how fast you can sell, implement, manage quality, hire and sell some more. In a down market IP can become a huge differentiator.

3. Products as a gross margin bump. Finally, it should be said that in a services business often your implementation rate becomes a commodity relative to others in the market. If you can make an extra 10% on each sale by selling your “ad on” products that are at 90% gross margins not only will you increase your win rates but you’ll also add valuable profits to your bottom line.

In summary: I’m not advocating that companies are crazy to try and be product companies. In fact, that’s all that I fund as a VC. But I don’t want the narrow world of venture-backed companies and the trade rags that report on them to dissuade the overwhelming masses of potential entrepreneurs from building meaningful businesses that are both fun and economically rewarding.

Mark Suster joined GRP Partners in 2007 as a general partner after selling his company to Salesforce.com. He focuses on early-stage technology companies. He blogs at Bothsidesofthetable.com