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
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 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.
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 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.
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.
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.
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 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.