Selling a PEO will be a time consuming and stressful ordeal, but it is worth it if you are ready to exit and prepared for the process. All deals are not created equal, and while some processes are more daunting than others, each deal brings with it a level of stress and time consumption. Typically, this type of transaction is the largest monetary event that will occur in an owner’s life. As a result, the process can get emotional for selling stakeholders. Solid preparation will help mitigate emotional reactions and position the company for a higher valuation.
This article will cover some of the reasons why this process takes time, creates stress, and it will provide some tips to help prepare for the M&A process.
I’ve seen deals that take around three months to complete and others that take almost two years. Each deal is different but there are some things that a seller can do to make sure they avoid an unduly long M&A process. From my perspective, there are three items that typically slow down the M&A process. Access to information, legal concerns, and negotiations. Assuming the buyer has the appropriate access to capital, it is these three areas that can expedite a deal, slow a deal, or kill a deal.
Access to Information
Due diligence partners typically state, “as long as we have access to the information we need, we can complete our work within the specified time frame.” What slows down the process is inadequate data, inaccurate data, and/or incomplete access to data. A buyer, especially an investment buyer, needs to justify to its investment committee, investors, and lenders that proper due diligence has been completed. If data is not available, inaccurate, or inadequate, this creates a problem for the buyer and will slow or stop the process.
There is not one investor alive whom wants to pour more money into an investment after they have purchased the company (aside from strategic capital for growth and acquisitions). Therefore, potential legal liabilities are scrutinized during the buying process. The buyer will look at legal infrastructure to make sure that there are not compliance issues lingering and will also review open legal liabilities. Often, if the legal liability is tolerable from a compliance perspective, the purchase agreement may contain verbiage that the seller will assume the financial liability of an unfavorable outcome with any pending litigation. If the seller assumes the liability, they should also negotiate to receive the reward should any pending litigation come out favorable. Regardless, responsibility for open litigation will need to be addressed.
The seller will typically negotiate the Letter of Intent (LOI) prior to entering formal due diligence. Once formal due diligence is complete, there will be plenty of negotiating on the purchase agreement and ancillary documents. This can take the form of price, reps and warranties, employment contracts, working capital, rollover equity, vesting schedules, non-competes, and the list goes on much farther. The seller should procure an Attorney whom is experienced in transactions. This will save the seller and buyer time, money, and aggravation.
There is no doubt about it, selling a company is stressful. Since the sale will likely be the largest financial transaction of an owner’s life, the result of the deal carries a lot of weight personally for selling stakeholders. Couple this with the fact that buyers will review the organization thoroughly and negotiate on weak points of the company, it can feel like an attack on the company/ownership if this process is not looked at properly. Remember, the seller is trying to maximize value at the time of transaction. The buyer is looking to maximize value post transaction. These can be opposing forces during negotiations which is why we often see earn outs and equity rollovers contained within the deal structure to align interests.
Moreover, senior leadership is derailed from their day to day activities in order to compile information, provide insight, answers, analysis, justification, and schedule time for a plethora of calls, data requests, and meetings. To top it all off, all the above is typically done in a consolidated timeframe which means long hours working on the deal while still trying to run a PEO business simultaneously. Stress will be present in the process. But, like anything in business, if the team is well-prepared, a certain level of stress can be mitigated.
Prior to reviewing preparation tips for the selling process, let’s first review the types of buyers a PEO owner will encounter.
Types of Buyer
Typically, there are two types of buyers in this space; PE and PEO. The PE (private equity) is considered the investment buyer whereas the PEO (professional employer organization) is considered the strategic buyer. This doesn’t mean that each buyer isn’t strategic or investing, both do each. Rather, it is the terminology they are commonly labeled. The strategies of each category of buyer typically differ materially in time and capital outlay.
Private Equity Buyer
The PE (investment buyer) will generally be more aggressive with acquisition opportunities using a more consolidated time frame (typically 5 to 7 years) to achieve economies of scale prior to exiting the investment. The PE will focus on driving EBITDA increase, especially in its exit year, which will require growth and operational efficiency. Moreover, if the PE is newer to the PEO industry, the PEO may have to explain and educate the PE team on how the PEO functions.
The PEO (strategic buyer) will generally make less acquisitions than the PE buyer but rather focus on how the acquisition strategically improves the PEO in lieu of simply achieving economies of scale. The PEO will generally be more familiar with the inner-workings of the PEO model than the PE investor but may also carry some biases on how a PEO should be run based on their own operating model.
Not all buyers are the same, but this framework gives a high-level foundational outline for the focus of each buyer.
There are some moves that the seller can make prior to courting buyers that will help streamline the process and maximize valuation.
If the seller has hired an investment banker prior to selling, the banker will help guide them through the process and act as a buffer between the seller and the buyer. Hiring an investment banker will typically cost 4% of the enterprise value. However, from my experience, if the seller is not well-versed in the M&A space and/or is an emotional person, an investment banker may be worth their weight in gold.
EBITDA Add Backs
Typically, in the PEO space, deals are structured on a multiple of EBITDA (earning before interest, taxes, depreciation, and amortization). For example, assuming a PEO has an EBITDA of $10mm and it receives a 7X multiple, the deal valuation would equate to $70mm. However, ownership should review which expenses the PEO currently generates that will not be required going forward. These expenses can be added back into the equation to bolster current EBITDA. The add back expenses don’t need to be cut prior to starting the selling process but will require follow through post transaction.
If, for example, a PEO carried the following annual expenses:
- Sporting event tickets: $40,000
- Private jet expenses: $75,000
- Client entertainment: $150,000
- Ownership Bonuses: $500,000
- Company cars: $50,000
And it planned on eliminating these expenses going forward, the organization would achieve $815K in EBITDA add backs. Applying a 7X multiple to this number would increase the purchase price from $70mm to almost $76mm. EBITDA add backs will be scrutinized by the buyer but if the are justifiable, generally they will be accepted.
One of the most labor-intensive aspects of the process is gathering all requisite information for the buyer. This will include company financials, marketing material, insurance information, information technology, tax information, sales data, legal documents, operations information, organizational information, third-party vendor information, etc. The list is long, and the seller will likely be required to provide more data/information throughout the review process from the buyer. The better prepared the seller is in gathering and housing the information (data room), the more swiftly the M&A process will likely move. Moreover, a well-prepared team creates a higher degree of confidence with the buyer. If the PEO has retained an investment banker, they will be able to guide PEO ownership through this preparation process, assuming the investment banker is good.
Earlier we discussed that a buyer is trying to maximize the company’s value post transaction. As a result, they will review proforma trending to estimate future performance. A typical mistake the seller may make is a hockey-stick pro forma. A flat historic growth curve followed by a steep projected performance. Be legit in your future projections. If your pro forma contains a hockey stick, be prepared to justify it.
Senior leadership of the seller should have common vision. Fractions within a leadership team become apparent during the review process. A disjointed leadership team can be cause for concern if the issues run deep. Anyone whom is under the umbrella (in the know about the deal) should be aligned in messaging, vision, and execution. This creates confidence in the buyer that they have the right team to maximize valuation post-transaction.
With an article format, we’ll never be able to provide all that you need to know about selling a PEO, due to word-count restraints. However, hopefully this article provided you with some insight into the process. Ultimately, prior to entering the process, consider the following:
- Be sure that you actually want to sell your business and decide what your involvement will be post transaction.
- Understand that the process will be stressful and time consuming.
- Decide if you will utilize an investment banker and which banker is right for you.
- Take the requisite time to gather all applicable data and conduct thoughtful proforma and EBITDA add back processes.
- Make sure your attorney is well-versed in transactions.
- Make sure that your senior leadership and stakeholders are aligned.
- Know what you want for a purchase price and be prepared to justifiably defend that number with the buyer.
- There is prep-time prior to engaging buyers and there is work to be done post-transaction. Make sure your team understands this.
If ownership is successful with the above eight bullet-points, and the PEO is considered a desirable target in the eyes of the buyer, the results will likely be favorable from the seller’s perspective.
Rob Comeau is the CEO of Business Resource Center, Inc., a business consulting and M&A advisory firm with a niche focus in the PEO industry. For more information on BRCI, visit them on the web at www.biz-rc.com.