Hourly Rate or Fixed Price? An Entrepreneur’s Guide to Commercial Contracts
Whether you’re preparing a quote or drafting a statement of work, payment structure is a crucial component of any services agreement. Is it best to go with an hourly rate model, a fixed price, or some hybrid? What’s the difference between these options? And, why choose one over the other?
This article will go over commercial contracting for startups, outlining the pros and cons of different payment structures as well as best practices. While this is meant as a guide for entrepreneurs, the concepts are applicable to all organizations and business models.
Hourly Rate
An hourly rate pricing model is one where the party delivering services charges the buyer a fee that is calculated by multiplying the price charged per unit of time worked by the amount of time worked. For example, if you are a plumber who charges an hourly rate of $100 per hour and works for 10 hours on a particular project, the price of your services will be $1,000.
Any (current or former) lawyer, accountant, or consultant reading would likely be very familiar with the hourly rate model as the “billable” hour is a staple of those industries. It is also commonly used by marketing and advertising agencies.
A typical clause setting out an hourly rate reads as follows:
In full consideration of all Services performed Deliverables provided in accordance with this Agreement, the Client shall pay the Startup at an hourly rate, billable in half-hour increments, of one hundred dollars ($100.00), for each hour worked by every Startup employee staffed on a Project covered by this Agreement (the “Hourly Rate”).
The Pros
Hourly rates are helpful for projects where the amount of time needed to complete a task are unknown or difficult to predict ex ante. This gives some degree of margin protection for the vendor who can hedge against unexpected changes.
This model is also great where changes are anticipated, as it allows parties to continue working ahead without re-quoting. This flexibility makes hourly rate structures very advantageous for non-standard and unstructured projects where scope has not fully been defined.
The Cons
Contrary to conventional wisdom, hourly pricing models are not necessarily a sure-fire way to ensure that you get paid for the time you’ve put into a project. It is a rookie mistake to assume that you’ll get paid for every hour that you bill. Especially when first starting out, the amount of time you spend actually working on a given project may pale in comparison to the time you spend on administrative tasks like tracking time, corresponding with your client, and documenting your progress.
Budget-conscious clients may demand itemized receipts, showing what time you spent on which tasks. Unsatisfied customers may even use the model against you, claiming (with or without justification) that the time you expended on a given task was unreasonable.
There are also ethical considerations regarding hourly rates and the potential for creating conflicts of interest between vendor and purchaser. As a vendor, you should be cognizant of situations that may arise where your business interests run counter to the business interests of your client.
Fixed Price
Also commonly referred to as “lump sum” or “flat fee” agreements, fixed price contracts are agreements where the price that a buyer pays is determined up front. Under this model, both parties must also agree to project scope at the time of contracting. It is best to opt for fixed price when both parties are crystal clear on what a project will entail.
A typical clause setting out a fixed price reads as follows:
In full consideration of all Services performed and Deliverables provided in accordance with this Agreement, the Client shall pay the Startup one thousand dollars ($1000.00) (the “Fees”), upon final receipt of the Deliverables.
The Pros
Fixed prices agreements are simple for both supplier and purchaser. Suppliers like fixed price agreements because scope is pre-defined and they can benefit from the efficiencies of not being “on the clock” as they would be under an hourly model; purchasers like them because the budget is confirmed up front.
These contracts are expedient and benefit parties under a time crunch. If you have a template ready to use and the scope and price set in mind, you can pump out a statement of work quickly and get started.
The Cons
If you’re going to pursue the fixed price route, you need to be certain that you’re getting everything you’ve bargained for. Fixed price agreements typically have less room for adjustments to price and projection direction than hourly rate contracts.
The opacity behind the numbers can also be off-putting for some clients — especially clients with a deep understanding of the market rates for a particular type of project. You should, therefore, give serious thought into the price you quote, knowing that your potential customer may shop around your quote and have an idea in their head what they ought to be paying.
Best Practices for Commercial Contracting
Now that you have an overview of different pricing structures as well as the pros and cons of each, you can focus your attention on ensuring you and your counterparty lay the foundations for a mutually rewarding commercial relationship. Here are some tips to keep in mind both before and after you sign your contract:
- Set your expectations early on. As with any business relationship, it is important to know up front what you’re getting yourself into before you get into it! Is your client or vendor going to be communicating with you constantly throughout the project or will you be responsible for getting a hold of them? Will you have an assigned project manager/point of contact or will the assignments be handled by committee? Will the project be delivered in stages or all at once? Are you buying or providing a turn-key solution or something that is more iterative in nature? These are all important questions to answer before you sign on the dotted line. For more information, check out this well written Forbes article that sets out 10 ways to set clear expectations with clients.
- Out-of-pocket expenses. Whether or not out-of-pocket expenses are included in a fixed price contract and, if not, whether one party can charge an administrative fee for handling out-of-pocket expenses are topics worth considering. Typically, with hourly rate agreements, out-of-pocket are reimbursed. Parties typically negotiate whether the out-of-pocket is charged back at cost or if margin in the form of an admin fee is permitted.
- Track your time so you can find out how much your time is worth. Even if you decide to charge a lump sum for your services, you should track your time. It should go without saying that you should be tracking your time if you’re using an hourly rate pricing model but do so is equally important under fixed price agreements. If you don’t know how much time you’re spending on projects, you won’t have the information needed to help you adjust your prices (and contract structures) with future clients. Moreover, if you don’t track time, you have no way of managing your resources or knowing whether or not you’re making money. Don’t believe it? Check out this Medium author’s opinion on the matter and how it changed his business!
- Know your margins. With the insights you glean from tracking your time, you’ll be able to calculate the cost of your services. This can be done by taking your annual overhead and dividing it down to an hourly level. To do that, first take your total annual overhead and divide it by the number of working days in your calendar year. You now have the daily cost of your services. From there, divide the daily cost of your services by the number of hours in your typical work day. Now, you have your cost base. You should set your rates (whether hourly or fixed) above your cost base by at least 40% and, in any event, never below 30%. Having this information at your disposal is extremely helpful when negotiating prices with clients. Need help calculating your profit margin? Check out this great walk-through by Investopedia.
- Beware of conflicts of interest. While the complexities of conflict of interest scenarios in commercial contracting is a topic for another blog, a simple rule is to be up-front and honest with your counterparty. If you sincerely believe that the standard of care requires you to put in more work than your client may have anticipated (thereby running up their tab), tell them. Let your client decide. If they then choose to take your advice and pay you, that’s great! If not, you’ll know your next steps and will have fulfilled your duties to your client — everyone leaves happy.
- Know when to hire a lawyer. Although commercial negotiations and deal-making do not necessarily require having an attorney present, situations may warrant otherwise. Depending on the size of the project, the dollar figures being thrown around, the risks involved, and the complexities of the proposed terms, a lawyer may be helpful — and prudent — to have by your side. Most attorneys will provide free consultations to help assess whether your situation warrants hiring them. Some may even be willing to charge below their standard rates if you have a compelling story. In any event, while commercial lawyers are a dime-a-dozen, finding the right counsel for your situation can be a time-consuming process. Be sure to shop around.
Just Remember: Be Honest, but Firm, with Your Client and Be Honest with Yourself
This article, while helpful in illustrating the benefits and pitfalls of different pricing structures, is no substitute for the experience you will gain as an entrepreneur.
Savvy business folk love to negotiate. They also know when to trust their instincts and stand by their decisions. If you’ve done your homework and know your margins, you should feel comfortable explaining your pricing to your client. You can articulate your value proposition — your client should appreciate that and, if they don’t, maybe they’re not the right fit for you. As the old Kenny Rogers song goes:
You’ve got to know when to hold ’em,
know when to fold’em,
know when to walk away,
know when to run.
The Gambler certainly knows how to play the game — you should too.
And while bluffing is an essential skill for poker players, bluffing in business is a fool’s errand. It’s important to always be truthful not only with the other party but also with yourself. It goes without saying that you should enter into all business dealings in good faith, looking out for the other party as you both work towards achieving your goals. It is equally important to remember what you’re in it for.
As you begin pitching your work and entering into discussions with potential clients, take note of where you think you may need some assistance. While every entrepreneur should have some basic knowledge of how services contracts work, not everyone who works in a startup will be comfortable drafting agreements or negotiating them. Self-awareness is an entrepreneur’s virtue.
