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.

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.

• Gross Profit: Sales and Scale
• Efficiency: Operations and Technology
• Liability: Legality and Loss Ratios
• Execution: Talent and Value Proposition
• Results: Leadership and Financials

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.