PEO Valuation: Leadership and Financials

Netprofitgrowth.com is releasing a five part series which will cover helpful topics regarding contributing factors to the valuation of a PEO. A new section will be released weekly until the series is complete. This five part series will include: 

  • Gross Profit: Sales and Scale
  • Efficiency: Operations and Technology
  • Liability: Legality and Loss Ratios
  • Execution: Talent and Value Proposition
  • Results: Leadership and Financials
Leadership and Financials: Part 5 of a 5 part series on factors that determine a PEO’s valuation.

Results: Leadership and Financials

Leadership and financials may seem like a natural coupling. After all, it is leadership that is ultimately responsible for the PEO’s financial performance. Depending on how we look at each, it may also appear to be an odd pairing. For example, leadership is responsible for the future of the company and financials are the scorecard for past company performance. With leadership focused on tomorrow and financials conveying past performance, each may appear as bookends to the business. Ultimately, leadership and financials belong together for one simple reason. What leaders sew today, the company will reap in financial performance tomorrow. It also seems fitting that we end this series with proverbial bookends. Everything we’ve covered previously in this five part series is executed between the vision of the future and the results of the past.

Leadership

The tone of an organization is set by the company’s leadership. Leadership is responsible for creating an appropriate vision and ensuring the company has the right talent and model to execute the vision. It is leadership’s responsibility to promote a healthy company culture commensurate with achieving company initiatives. Superior leadership can set the tone to galvanize the workforce towards a common aim. Leadership creates the strategy for the organization and ensures appropriate execution. Ultimately, it is leadership that is responsible for all facets of the organization.

 

Leadership does not run the company. The workforce runs the day to day operations of the company. Leadership is a shepherd that guides the organization in a common direction. It is leadership that ensures the flock (company) is heading toward green pastures (abundant client segmentation). Leadership designs a strategy to keep the wolves (competition) from hurting the flock (company). Leadership must ensure that the flock (company) is healthy so that it can reap the benefits of the seasonal sheering of the wool (profit). Without a shepherd, the flock would run aimlessly, be susceptible to attack and would not have long term viability.

 

A PEO’s leadership must look to the future while being mindful of the past. It must consider internal capabilities and external drivers when formulating the company’s strategic intent. It is responsible for creating the right model, value proposition and internal mechanics to achieve the strategic intent and sound operational controls. Finally, it is leadership that must ensure it has the right team, workforce and alignment to execute its vision. Leadership sets the tone and standard for ethics and integrity within an organization. Leadership is also responsible for managing through chaos. Meaning, any unforeseen issues that may arise or turmoil within the organization or marketplace must be navigated successfully by the PEO’s leadership team. When a PEO’s executive team and varying layers of management are successful, the result is desirable financial performance.

 

Strong leadership drives a higher valuation. It creates a level of confidence in the buyer that the company has the appropriate team in place to achieve future performance goals. Superior leadership comes with a track-record of success which is evident in the company’s financial performance and finely tuned operations.

Financials

Financials are performance results. A PEO should be mindful of financial performance but it is ill-advised to solely make financial performance the company’s aim. Too often, when a company only focuses on financial performance, decisions are made that could negatively impact the future viability of the company. Publicly traded PEO’s have increased pressure to perform due to external stakeholders and quarterly results which impact the stock value held by investors. However, when a PEO focuses on the areas previously covered in this five part series, superior financials should be the result.

 

There are plenty of areas to review as it pertains to a PEO’s financials and the subsequent impact on valuation. A handful will be covered in this section as it relates to the valuation of a PEO, though more exist. The areas covered in this section will include:

 

  • Audited Financials
  • EBITDA Add Backs
  • Pro Forma
  • Working Capital

 

Starting with audited financials, a company that has its financials audited by a third party is in a better position than those that don’t when it comes time to sell. The formal due diligence of any acquisition is the process of thoroughly reviewing the validity of what has been presented to the buyer. When a PEO has audited financials, it creates an additional layer of confidence in the buyer’s mind that the financials presented are an accurate depiction of the company’s performance. Companies that do not have audited financials can expect increased scrutiny when a potential buyer is reviewing historic financial performance.

 

EBITDA add backs are common in M&A though surprisingly not well known by many potential sellers. An EBITDA add back would constitute an expense that could be eliminated once the company was purchased. Please see the below example for more insight.

 

EBITDA  $  3,000,000.00
EBITDA Add Backs
Season sporting tickets  $        75,000.00
Country Club Membership  $        50,000.00
COO Reduction  $      250,000.00
Company Cars  $        50,000.00
 $      425,000.00
Revised EBITDA  $  3,425,000.00

 

The above simple example illustrates the elimination of sporting tickets, a country club membership and company cars once the deal is made. Also, it shows the reduction of a COO, assuming redundancy in this position by the purchasing entity. The point of this exercise is to determine what is necessary to run the company on a go forward basis and what has been excess expenses the company doesn’t need to carry. In the above example, the company identified $425,000 in excess. Be mindful that the revised EBITDA, if validated by the buyer, is where the purchase multiples will be applied. Assuming this company was purchased at seven times EBITDA, the $425,000 would equate to roughly an additional $3MM in purchase price. This would take the purchase price from $21MM to $24MM representing an increase of roughly fourteen percent on the purchase price (valuation).

 

A pro forma is common when a company is looking to illustrate its expected growth. A pro forma will generally illustrate past performance along with current and future year projections. PEOs should avoid a hockey stick scenario where projected future performance drastically out performs past financials. If a PEO creates a hockey stick pro forma, it must validate the future projections for a buyer to accept the projections. A pro forma is a good tool to create projections based on recent developments within a PEO. For instance, if a PEO has recently gained a competitive advantage but doesn’t have enough historic time to illustrate its value, a pro forma can help convey the importance of the development and projected financial impact.

 

After a strategic or investor purchases a PEO, the last thing they want to do is reinfuse funds to cover the PEO’s working capital needs. Whether a PEO keeps working capital in the company at the time of purchase or whether the investor infuses working capital at the time of purchase is dependent on the deal points. However, no investor wants to have to reinfuse working capital into the organization at a later date. Working capital is the money required to run the company. An investor often doesn’t mind reinvesting for tuck in acquisitions or for growth initiatives. What an investor absolutely does not want to do is keep pouring money into an investment solely to keep it afloat. Therefore, a PEO that shows a historic trend of positive working capital that isn’t consistently relying on LOC’s to fund working capital is in a better position to drive a higher valuation.

 

Financials are the baseline for a PEO’s valuation. The other variables covered in this series influence the valuation’s upward mobility in a buyer’s mind. Ultimately, if a PEO is successful in all of the areas covered in this five part series, it will result in higher financials. A buyer that reviews a potential acquisition that has achieved the following…

 

  • Successful sales and revenue growth
  • Scaled efficiency
  • Tight, well-run operations
  • Superior and scalable Technology
  • Low loss ratios
  • Tight controls and reduced liability
  • Superior talent
  • Value proposition that creates a competitive advantage
  • Excellent leadership
  • Superior financials

 

…will be more inclined to offer a higher purchase price (valuation). There are other factors that may influence a PEO’s valuation such as comps, market trends, supply and demand, etc. These other aspects are uncontrollable variables. This five part series covers what a PEO can control to drive a higher valuation and ultimately, a better run organization. Achieving success in these areas requires focus and insight but is well worth the effort.

 

 

This concludes our five part series on factors which determine a PEO’s valuation. To review any of the previous entries, please select from the following choices.

Questions or comments? Feel free to use the comment section below and we’ll make an effort to respond promptly.

 

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. You may find more information on Business Resource Center, Inc. by visiting their website at www.biz-rc.com.

 

PEO Valuation: Talent and Value Proposition

Netprofitgrowth.com is releasing a five part series which will cover helpful topics regarding contributing factors to the valuation of a PEO. A new section will be released weekly until the series is complete. This five part series will include: 

  1. Gross Profit: Sales and Scale
  2. Efficiency: Operations and Technology
  3. Liability: Legality and Loss Ratios
  4. Execution: Talent and Value Proposition
  5. Results: Leadership and Financials
Talent and Value Proposition: Part 4 of a 5 part series on factors that determine a PEO’s valuation.

Execution: Talent and Value Proposition

 

A PEO’s talent and value proposition are key components to determining the company’s valuation. The value proposition may be defined as the results it delivers to its clientele. While the value prop is made up of varying mechanics, it is the results derived from the value prop in which a client will use to measure the validity of the relationship. Talent is equally important. Talent, to a large degree, executes the value proposition.  Some may view the value prop and talent as separate aspects within the model. We would argue that the two are interwoven. Each one cannot function without the other and optimal results are only achievable together. The combination of a well-designed value prop and superior execution via the PEO’s talent bodes well for a higher valuation.

Talent

Within the PEO model, superior talent is an advantage. In a world where the trend of automation continues, talent should not be minimized. Although automation and technology can help scale efficiency for the PEO, talent is a big component in driving the value proposition. The PEO model is abundant with consultative deliverables. Effective consultation to SMBs requires knowledgeable talent. Talent doesn’t come cheap, but it pays dividends in client retention, brand equity, profitability and business development. All of which drive towards achieving a higher valuation for the PEO.

 

The PEO model is an outsourcing and service model. Service, absent of talent, will fall short of client expectations. When reviewing the importance of talent within a PEO, the question could be asked: “what aspect of the business isn’t touched directly or indirectly by talent?” The truth is that every aspect of the model is influenced by talent. Whether that is the internal talent within the PEO itself or external talent contained within a partner company such as a technology or insurance provider. Talent will play a vital role in the success of a PEO and therefore should be at the forefront of importance for PEO business owners.

 

There are three primary avenues for securing viable talent.  

  • The first is to hire and groom from within. This requires training and will come with a learning curve but will likely cost the PEO less in salary for the beginning years. The risk is that the person doesn’t have a verifiable track-record and could possibly never achieve their potential.

 

  • The second avenue is to hire industry veterans. This requires a selective process as there are employees that float from PEO to PEO. Rather, the hiring manager should look to entice a top tier performer within the industry to join the PEO. This approach has a dual benefit in strengthening the hiring manager’s PEO while simultaneously weakening competition. However, this approach generally comes with a higher price tag in the salary category.

 

  • The third approach is to identify talent outside of the industry. This has been an increasing trend in the last ten years. More and more PEOs are verticalizing their approach and therefore look for industry experts within their target verticals. The benefit to this approach is industry expertise within a client segment focus of the PEO. The downside is the learning curve for a professional outside of the PEO industry.

 

Beyond selection of appropriate talent, a PEO must continue to develop this talent to create future leaders of the organization. In addition to training, the PEO will benefit from creating learning, well communicative teams, to effectively drive results.  Training for the workforce should not be limited to the subject matter a PEO trains its employees. If that were the case, the workforce could only regurgitate what the PEO already knows. While it is important for the PEO to conduct internal training, it should also encourage its workforce to learn from outside of the company. This enables the employees to gain a wider perspective and additional knowledge which can be applied in its consultative efforts. When a PEO fosters a team environment with superior communication, that external knowledge can be shared among peers to create a stronger team. A team that communicates and consistently learns will drive better results than a silo structure of individuals. To learn more about creating a learning organization, click here.

 

Wise, communicative and knowledgeable teams provide the following benefits:

  • Innovation
  • Value proposition execution
  • Sound operations
  • High organic growth
  • Superior financials
  • Business sustainability
  • Risk mitigation
  • Compliance assurance
  • Future leaders
  • Higher business acumen
  • Industry vertical diversity
  • Higher profitability

 

Ultimately, a PEO that has a bench of talent will be able to scale beyond the owner’s personal reach. In other words, the PEO isn’t limited or dependent on the founder to sustain. A PEO that can self-sustain will yield a higher valuation.

Value Proposition

Most familiar with the industry understand the generic PEO value proposition mechanics. This would include human resources, safety, compliance, payroll, workers’ compensation insurance, health benefits insurance, EPLI, tax filing, technology, retirement plans, etc. While many view these elements as the value proposition itself, it is the results that the combination of these elements deliver that is the true value prop. An SMB will judge the relationship based on the results the PEO delivered, not based on the PEO’s internal mechanics. A PEO could possess a plethora of deliverables at its disposal but if the SMB didn’t experience the benefits of these services, the PEO will fall short on retention. However, the mechanics of the value proposition, when designed appropriately, can create a competitive advantage for the PEO.

 

A PEO may identify what type of results it wants to drive to its clientele and then reverse engineer into the value prop mechanics to achieve these results. Better yet, if a PEO conducts case studies with its clientele, it can tap into its existing client base for market intel to determine what would be best received by its clientele. A PEO that can effectively deliver exactly what a client wants is a PEO that can charge premium rates and maintain high client retention.

 

The PEO value proposition has room for growth beyond the generic model. There are many other facets of business that a PEO could effectively provide for its clientele. Over recent years, a number of PEOs have diversified their offerings to include additional services beyond the aforementioned generic deliverables. This is a trend that is likely to continue. However, prior to diversifying its offering, a PEO should ensure that it has mastered the deliverables it currently offers.

 

When a PEO creates a workflow for its deliverables, it is better positioned to measure the suitability of each deliverable. In other words, a PEO that maps out its work flow will understand the time and capital required to deliver appropriate results. This process will shine the light on any areas that are costly to the PEO internally and not overly important with client retention or sales. Mapping out workflows will also allow the PEO to identify where it may become more efficient internally while driving the same high standard of results.

 

A PEO has many moving parts that make up the framework mechanics of its value proposition. It is important that these various parts work harmoniously and not in silos. A disjointed value proposition will cause confusion and can lead to poor client retention and increased liability. A PEO that fosters open internal communication and operates with a team mentality will often achieve higher client retention and increased customer satisfaction.

 

Ultimately, a PEO’s value prop should be viewed as the results and affect it’s had on its clientele. That’s how the PEO’s client is judging the relationship. An investor will likely ask how and why does a PEO “win” against competition. The drivers behind the answer to that question come from the value proposition and talent the PEO selects.

 

The 5th part of this 5 part series will be: Results: Leadership and Financialsdue out next week. Stay tuned for more on the factors that determine the valuation of a PEO. Questions or comments? Feel free to use the comment section below and we’ll make an effort to respond promptly.

 

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. You may find more information on Business Resource Center, Inc. by visiting their website at www.biz-rc.com.

 

PEO Valuation: Liability, Legality and Loss Ratios

Netprofitgrowth.com is releasing a five part series which will cover helpful topics regarding contributing factors to the valuation of a PEO. A new section will be released weekly until the series is complete. This five part series will include: 

  1. Gross Profit: Sales and Scale
  2. Efficiency: Operations and Technology
  3. Liability: Legality and Loss Ratios
  4. Execution: Talent and Value Proposition
  5. Results: Leadership and Financials
Legality and Loss Ratios: Part 3 of a 5 part series on factors that determine a PEO’s valuation.

Liability: Legality and Loss Ratios

Legality and loss ratios play a vital part in determining a PEO’s ultimate valuation. Ensuring legal compliance and removing doubt with outstanding legal issues allows an investor to get comfortable with the investment. Loss ratios are generally indicative of the PEO’s practices. Sustained favorable loss ratios with workers’ compensation and health benefits illustrate proper underwriting, client selection and risk mitigation practices. Unfavorable loss ratios call into question how the PEO is conducting its business to mitigate risk. Removing legal uncertainty and achieving a favorable loss ratio track record promote a higher valuation for the PEO.

Legality

Legality issues within the PEO model can be deal killers. This is handled on a case by case basis but an investor is not looking to incur unnecessary liability once an acquisition is made. At the very best, an investor may be willing to acquire a PEO if the PEO indemnifies the acquirer over legal uncertainties. Ultimately, if too many unanswered legality questions arise, the deal will likely not move forward. In the PEO industry, there are a few key areas where legal issues may hurt the valuation of the PEO. Some the major areas include ERISA compliance, DOL compliance, retirement plan compliance, employment law, and tax compliance.

ERISA, DOL and Retirement Plan Compliance

First off, we are not attorneys. None of this information should be construed as legal advice and a PEO should engage an ERISA, Employment Law or Tax Attorney if it has legal questions. With that being said, ERISA and DOL compliance is important with PEO health plans. With continuously increasing health benefits premiums and expenses, PEOs may look to creative ways to provide coverage for their clientele. Many would argue that the healthcare system in the United States is broken. Regardless of what side of the fence you personally land on, costs are increasing for health coverage. When a PEO structures its health benefits plan, it should work with an ERISA attorney knowledgeable in the PEO industry to minimize its liability risk. The PEO must make sure that it covers the State DOI requirements in addition to remaining within DOL and ERISA compliance. These factors will be checked during the due diligence of an acquisition and red flags that arise can hurt the valuation of the PEO and ultimately kill the deal if not remedied.

Employment Law Compliance

The area of practice known as employment law covers the rights, obligations, and responsibilities within the employer-employee relationship from wages and workplace safety to discrimination and wrongful termination. Employment lawyers typically specialize in representing either employers or employees, but rarely both.

Since a PEO enters into a co-employment relationship with its clientele, ensuring legal compliance within the employment law sector is important. The PEO should ensure that it remains within legal compliance and should engage an Attorney that specializes in employment law for the PEO industry when developing its client service agreements and other materials that could impact the legality of the relationship with its clientele.

A PEO with minimal liability will receive a higher valuation than those with a higher degree of liability due to loose controls.

Tax Compliance

Industry veterans know about the poorly run PEOs of the past. Those that didn’t remit taxes to the appropriate agencies or that used SUTA dumping practices in an effort to obtain new clientele. With much of this turmoil behind us, tax compliance is still essential to ensure that a deal would move forward. Most PEOs operate well in this area but we would be remiss if it wasn’t mentioned due to past sins from poor players that are no longer in business. A PEO should take the steps necessary and have the proper controls in place to ensure tax compliance on a State and Federal level.

Loss Ratios

Loss ratios affect the profitability of a PEO, impact the future insurance options it may offer to its clientele, and the viability of the PEO’s ability to price business. If we view a PEO as a boat, the ultimate claims expense is the leak within the boat. PEOs that try to outpace poor loss ratios with new sales will eventually sink. Therefore, superior loss ratios are an important factor in determining the valuation and longevity of a PEO. Beyond loss ratios, collateral requirements (when applicable) add an additional layer of capital outlay for a PEO. High loss ratios coupled with increasing collateral requirements can hurt a PEO’s ability to generate high profit margins, or in extreme cases, remain in business.

Workers’ Compensation

Loss ratios within the workers’ compensation platform will affect the PEO’s profitability. Lower than average loss ratios provide the PEO with flexibility to achieve greater profit margins due to lower premium remittance. Conversely, higher loss ratios can detract from the PEO’s ability to generate profit due to higher premium remittance. If a PEO is operating on an internal deductible, while premium remittance to the carrier is reduced, collateral requirements become a factor. A PEO that has an under-performing book of business is faced with the challenge of higher premium coupled with higher collateral requirements. A good rule of thumb is that a PEO cannot out price or out pace poor business selection as a sustainable business.

Health Benefits

Whether a PEO is operating on a guaranteed cost program or a fully insured minimum premium plan, loss ratios will affect the PEO’s ability to be within market range on plan expenses. Superior underwriting, pathway to care practices and lower utilization rates provide the PEO with a competitive advantage in plan selection and pricing. With all of the changes over the last five years for the ACA, the PEO model has seen a spike in revenue as an industry. This is due to the PEO assisting SMBs with compliance requirements. While this is good for the industry, a PEO must still manage its health care plans effectively. Otherwise, it may see increased attrition within its client base due to noncompetitive plan offerings. Many PEOs have overhauled their pathway to care programs to provide additional services to its clientele and increased benefits to the WSEs. Ultimately, a PEO must review its loss ratios continuously to identify any gaps in their processes. A PEO with a competitive health benefits platform and superior loss ratios will command a higher valuation than those that are run loosely.

Processes

A PEO that can illustrate multiple years of favorable loss ratios is in a better position to maximize its valuation in the eyes of an investor. Generally, lower sustained loss ratios are indicative of good business practices. These business practices would include the client selection process, underwriting, pathway to care, risk mitigation strategies, safety consulting and claims management. A PEO that justifies lower loss ratios with good business practices is a more desirable target for acquisition. Moreover, a PEO that can illustrate good business practices can instill more confidence in a buyer’s mind even if the PEO experienced a poor loss year. However, continuous poor performance is indicative of problems within the PEO’s business practices and will likely decrease the valuation of the company.

 

The 4th part of this 5 part series will be: Execution: Talent and Value Proposition, due out next week. Stay tuned for more on the factors that determine the valuation of a PEO. Questions or comments? Feel free to use the comment section below and we’ll make an effort to respond promptly.

 

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. You may find more information on Business Resource Center, Inc. by visiting their website at www.biz-rc.com.

 

PEO Valuation: Operations and Technology

Netprofitgrowth.com is releasing a five part series which will cover helpful topics regarding contributing factors to the valuation of a PEO. A new section will be released weekly until the series is complete. This five part series will include: 

  1. Gross Profit: Sales and Scale
  2. Efficiency: Operations and Technology
  3. Liability: Legality and Loss Ratios
  4. Execution: Talent and Value Proposition
  5. Results: Leadership and Financials
Operations and Technology: Part 2 of a 5 part series on factors that determine a PEO’s valuation.

Efficiency: Operations and Technology

A PEO’s operational design and chosen technology platform will largely determine its ability to achieve efficiency and scale. The benefit to efficient operations is an improved WSE to employee ratio, reduction of liability and greater flow from revenue to profit. These factors play a role in determining the valuation of a PEO.

An investor will look at the PEO’s present abilities and its future capabilities. An efficient PEO will capability to scale creates a level of confidence with an investor for superior ROI. Thus, the valuation of the PEO is driven higher than counterparts that have a loose operational structure and weak technology.

Operations

Operations are often viewed as the backbone of an organization. Items within a PEO’s operation that will be discussed in this article will include infrastructure, controls, finance, legal and design. While we will cover both finance and legal in subsequent sections of this five part series, this article will touch on the aspects of each that directly affect operations within this section.

Infrastructure

The infrastructure of a PEO can be defined as the underlying framework or features of the organization. This would include the operating structure such as a branch model, regional operating model or single location. It would also include the underlying service framework such as departmental segregation or business unit teams. Departmental segregation is when the placement of the service segments and teams are segregated by department whereas a business unit design would group the varying departmental service consultants together based on a common book of business serviced. There are hybrids of each design that have been utilized within the PEO industry as well.

Regardless of the infrastructure chosen, a PEO should be able to illustrate why the infrastructure chosen is appropriate for their business model and how effectively it can scale its operations. For example, if a PEO utilizes a hybrid structure where it groups its client facing positions in business units but segregates its back-end departments such as benefits administration and payroll, it needs to justify why it has chosen this infrastructure. In this example, a PEO could make the case that it is important for its client facing positions to operate within a business unit to ensure a collaborative and cohesive approach to its client service model. Moreover, by segregating its benefits and payroll departments into a regional operating center, the PEO can gain efficiency within these processing departments. This hybrid structure allows the PEO to achieve efficiency within its current model and is well positioned to scale in the future.

Controls

Controls are essential in any business but they are especially important within the PEO model. This is due to the number of moving parts and compliance requirements that a PEO faces. Controls should be in place for accounting, finance, State and Federal regulatory requirements, tax and insurance. Loose controls create opportunity for legal issues, compliance problems, insurance complications and profit erosion. Properly designed and executed controls provide a buyer with a higher level of confidence in the business operations. Removing doubt from an investors mind promotes a higher valuation.

Finance

While finance will be covered in greater depth in the fifth part of this series; Results: Leadership and Financials, we will cover a few items now at a high level. Appropriate management of financials and adequate accounting practices are essential to ensure proper working capital for the PEO. An investor does not want to have to fund working capital down the road after they have already spent millions on purchasing the PEO. If accounting practices and stewardship of finances is appropriate, a PEO needs to be cognizant of how a private equity or strategic buyer may value the PEO’s business. Exorbitant debt is problematic with a high valuation. A PEO should run efficiently enough so that it hasn’t incurred unnecessary debt.

Assuming the PEO isn’t in distress, how should it illustrate its financials to ensure an appropriate valuation? First, the PEO should look at where it is running “fat” with its expenditures. In other words, what within the organization is not necessary to run and scale the business? If the PEO has been a “lifestyle” business up to the point of sale, there is a high probability that there is trimming that could take place in the form of EBITDA add backs. If these add backs are validated by the investor, the valuation of the business will increase.

Legal

We will cover legal in greater depth in part three of this five part series entitled; Liability: Legality and Loss Ratios. However, a couple of items to mention as it relates to operations are client service agreements and insurance contracts. Having a qualified employment law attorney review and/or draft the PEO’s client service agreements is advised. A PEO takes a risk if it has pulled from another PEO’s agreement and assumes that it passes legal mustard. With insurance arrangements, a legal adviser with knowledge of the PEO industry should review any workers’ compensation and/or health insurance programs and plan designs to ensure legal compliance. These items will be checked during the formal due diligence process during and acquisition.

Design

For this article, we will view design as process flows. When a PEO is clearly able to illustrate its process flows, it gives confidence to the buyer that the design is appropriate. Understanding the process flows within a PEO’s operations also illuminates any areas that may be retooled for more efficient processes. Beyond efficiency within the model, the process flows provide a foundation blueprint on how the PEO may scale in the future. If the PEO acquisition is a tuck in, the design provides the acquirer with an understanding of how the PEOs will integrate most effectively in the future.

Technology

Technology is an important part of the PEO model.  The client facing aspect of technology can act as a differentiation for a PEO. Additionally, technology is a key component in a PEO achieving scale and improving upon the WSE to employee ratio. Over the last 10 years, technology has increased in its ability to “plug and play.” As a result, a PEO can have a suitable technology platform without creating and maintaining a proprietary system. While a proprietary system may carry certain advantages, it also comes with the expense of maintaining and updating the system. A PEO should consider the variables of each option carefully before deciding what technology platform they will use.

If the PEO utilizes a known technology platform within the PEO industry, it should ensure a handful of key items. First, it should make sure that it has negotiated the best possible terms for the platform it is buying. Second, the PEO should ensure that it knows how to utilize the platform to its fullest extent or at least to meet the PEO’s needs. Third, the PEO needs to determine whether or not the platform it chooses is the most efficient option in the market. Fourth, the platform should integrate well with the other systems the PEO is using. Fifth, the platform should provide an appropriate level of data integrity and security. Finally, the PEO must make sure that its employees are adequately trained on the systems and that the technology partner has the bandwidth to provide timely support to the PEO’s internal employees when required.

If the technology platform chosen is a known quantity to the PEO industry, it is easier to map out an integration if the purchaser is utilizing the same technology partner. If the platform is proprietary, the system should create a competitive advantage that can scale over the purchasing entity to create additional efficiency and profit. The ease of integration with a known platform or the competitive advantage of a proprietary platform will contribute to protecting or driving the PEO valuation.

 

The 3rd part of this 5 part series will be: Liability: Legality and Loss Ratios due out next week. Stay tuned for more on the factors that determine the valuation of a PEO. Questions or comments? Feel free to use the comment section below and we’ll make an effort to respond promptly.

 

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. You may find more information on Business Resource Center, Inc. by visiting their website at www.biz-rc.com.

PEO Valuation: Sales and Scale

Netprofitgrowth.com is releasing a five part series which will cover helpful topics regarding contributing factors to the valuation of a PEO. A new section will be released weekly until the series is complete. This five part series will include: 

  1. Gross Profit: Sales and Scale
  2. Efficiency: Operations and Technology
  3. Liability: Legality and Loss Ratios
  4. Execution: Talent and Value Proposition
  5. Results: Leadership and Financials
Sales and Scale: Part 1 of a 5 part series on factors that determine a PEO’s valuation.

Gross Profit: Sales and Scale

Sales and scale are important factors in determining a PEO’s valuation. Organic revenue growth can act as an indication of a well-conceived value proposition and effective go-to-market strategy. Scale, on the other hand, provides the PEO with an increased ability to achieve a higher profit to revenue ratio. The combination of sales and scale will equate to a higher EBITDA as a percentage of net revenue.

From a buyer’s perspective, a successful organic sales track-record creates a level of confidence that organic revenue growth will continue to increase. Scale provides the buyer with a platform which will allow them to realize synergies and efficiency. This will result in greater profitability with future acquisition “tuck ins.” Combined, sales and scale play an integral part in driving the multiples a buyer is willing to pay. Moreover, sales and scale will help increase the base EBITDA to which the multiples are to be applied.

Sales

When forming a strategy on the most effective way to increase sales, we generally start with reviewing the PEO’s value proposition. However, since the value proposition will be covered in section 4 of this 5 part series, we will focus this section solely on the sales engine itself.

Aside from the value proposition, there are four key components to increasing sales within a PEO model; sales talent, go-to-market strategy, compensation and ongoing service.

Sales Talent

The first step is to hire the right business development talent. The second step is their continued development. Business is in a constant state of flux. As such, the sales arm of a PEO should remain abreast to new developments that could impact the PEO and the industries in which they serve. Development of the sales team shouldn’t solely be the responsibility of the PEO. Hiring self-motivated inquisitive business development professionals will lead to increased individual learning that can be shared with the team. When selling a consultative model, knowledge is power. A business development professional can only properly advise a client based on what they know. Remember, a PEOs brand equity is heavily influenced by its sales force. If the prospect to client close ratio for a PEO is 20%, four out of five companies that encounter the PEO will likely only experience what the sales professional conveys.

Go-To-Market Strategy

Another important component to increasing sales is cultivating a successful go-to-market strategy. Within the PEO model, this could take the form of direct sales, channel partnerships, advertising and client referrals. Many PEOs rely on a hybrid of the aforementioned elements. Regardless of the options utilized, a PEO should consider multiple factors when designing and augmenting its go-to-market strategy. The first factor to consider is opportunities achieved and the associated close ratios. A PEO that has a 100% close ratio but only sees three prospects a year is doomed. Likewise, a PEO that receives 10,000 submissions but only has a 1% close ratio is inefficient. It is the combination of casting a wide enough net while closing what is caught that allows a PEO to run a successful go-to-market strategy. Another factor to consider is the financial commitment and resulting profitability of the chosen strategy. In other words, what upfront capital and time is spent on sourcing prospective clientele versus what profitability is the clientele yielding to the PEO’s bottom-line? For example, if a PEO spent $100,000 in time and money to source and close clientele they obtained by charging low admin fees, there is an imbalance in the equation. The goal is to design a plan with minimum or justified upfront expenses that will yield supremely profitable accounts.

Compensation

Compensation design is important. It is important to attract and retain the right sales talent and it is important in promoting best practices.  What do we mean by this? If compensation is poorly designed, it can promote poor business practices that will ultimately harm the PEO. For example, if a PEO only pays commissions on the first year the client is on board, a sales professional may not be concerned with client retention as they are only compensated that first year. If a PEO subscribes to paying the sales professional only on the first year, it should ensure that it has solid underwriting and prospect vetting controls in place to mitigate the potential for poor business selection.

On the other hand, a successful compensation design can be an ally to the PEO. In a residual commission model where the sales professional is paid ongoing for a duration or all of the client tenure, it may create benefits to the PEO. In this scenario, a successful sales professional that has been with the PEO for five years is less likely to leave the organization since they are experiencing the financial rewards from building up a successful book of business. Think of this as the “golden handcuffs” on a smaller scale. Moreover, the sales professional is more likely to focus on writing good business since they are paid a less percentage than a one year deal but will continue to reap the financial reward the longer the client stays with the PEO.

If a PEO is worried about a successful sales professional resting on their laurels once a large book is built, they likely hired the wrong sales person. That being said, to mitigate this concern, they can institute a hybrid compensation structure where the residual income is contingent upon annual production requirements.

Ongoing Service

The service arm of the PEO either validates or invalidates the expectations the sales professional set during the sales process. A service team that validates the expectations will achieve higher client retention and increased client referrals, both of which are good for business. It is important that the sales and service staff communicate appropriately so that they know the right expectations to set. Considering that a good sales person can only sell what can be delivered, the service team is essential to the longevity of a successful sales organization. This is precisely why we normally start with the value proposition when reviewing how a PEO can increase its sales.

Scale

Scale within a PEO can yield increased profitability. Achieving scale gives the PEO the ability to better negotiate with suppliers in order to achieve higher profit margins. Moreover, scale provides increased internal efficiency within the model itself. For example, a larger PEO that utilizes regional operating centers for certain aspects of the model, they can likely achieve better WSE to internal employee ratios. If a PEO utilizes a branch structure for its client facing operations but houses the benefits administration and payroll teams in a regional center, the WSE to employee ratio generally improves.

In addition to the regional center infrastructure, technology and insurance can increase profitability when a PEO achieves scale. When thinking of scale, consider the fixed costs and variable costs. Scale helps minimize the fixed costs allowing for increased profitability to the PEO.

From a buyer’s perspective, a PEO that has achieved scale provides a platform for future “tuck in” acquisitions. A tuck in acquisition or sometimes referred to as a “bolt-on” acquisition is when a company purchases a PEO with the sole intent of merging it into a division of the acquirer. When a PEO has scale, it can leverage that scale over a future tuck in acquisition and realize greater profitability on the acquisition post close.

A PEO that doesn’t have scale but aligns some of the facets of its operations with larger counterparts can likely increase its valuation. In other words, if a smaller PEO uses the same insurance carrier, technology platform, accounting practices, etc. the buyer may be more enticed to pay for the acquisition because theoretically it would take less work to assimilate the tuck in acquisition. This is generally more enticing to a buyer than if the acquisition’s systems and model were misaligned.

 

The 2nd part of this 5 part series will be: Efficiency: Operations and Technology due out next week. Stay tuned for more on the factors that determine the valuation of a PEO. Questions or comments? Feel free to use the comment section below and we’ll make an effort to respond promptly.

 

Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. You may find more information on Business Resource Center, Inc. by visiting their website at www.biz-rc.com.