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
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 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.
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 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.
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.
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.
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.