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
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.
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.
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.
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 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.
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 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.