Maximize Your Staffing Firm’s Valuation: Strategies in Staffing
by Timothy B. Faber
Whether you’re retiring, shifting gears to a new industry, or planning a succession, managing your business to obtain its maximum value provides operating success and the greatest wealth creation. Want to get the best price for your staffing firm when you sell? … Here’s the “playbook”.
Tactics and techniques for gaining the greatest operating success (and profits) and getting the highest price for your staffing firm are not dissimilar. In many cases, what makes a fun, successful, and financially rewarding company are the same characteristics that provide the greatest return when it’s time to exit and sell.
In this paper we touch on key topics that help bring the best and highest price for your firm; we also discuss peripheral topics – those relating to lifestyle businesses, methodologies for determining price, and several items that will certainly cause your valuation to go down.
While not intended to be all encompassing, we spotlight many of the value creation items noted by capital intermediaries, investment bankers, business brokers, private equity groups, and the gamut of lenders.
The Basic Valuation Premise
There are always exceptions to the rule, and as they say, “price is what someone is willing to pay”, but most valuations are based on a Multiple X EBITDA formula … pretty simple.
So, to obtain the greatest valuation, we want to increase the Multiple and/or EBITDA. Since valuations begin by applying a multiple to EBITDA or the operating profits of the firm, let’s begin with a discussion about what is EBITDA and why it is important.
What are EBITDA, Adjusted EBITDA, and Normal Adjustments?
Most simply, EBITDA is your operating profit before charges of interest, taxes, depreciation or amortization. EBITDA is Revenue minus Cost of Sales (primarily temp payroll and associated taxes and benefits), minus Operating Expenses. Therefore …
Effectively, and with some minor variations, EBITDA closely represents the free cash flow (FCF) generated by your company before adjusting for how you have financed the business (interest), what capital expenditures or purchases you have made (depreciation and amortization), and how you pay taxes (which is closely aligned with corporate legal structure and disbursements).
A multiple of this EBITDA or FCF is often the guideline and basis for determining a company’s value.
To determine a more accurate picture of EBITDA that the buyer will receive, there are “adjustments “or “add-backs” made to the base EBITDA. Here are several examples of what may be included in Adjusted EBITDA.
- Excess Owner’s Compensation – In addition to salaries, owners typically pay themselves bonuses or excessively high compensation – well beyond what would be paid for staff or executives performing the same daily functions. The excess portion of their compensation is often added back to base EBITDA
- One-Time or Non-Recurring Expenses – This can range from one-time legal or professional fees, to office upgrades or build-outs, or new office start-up expenses
- Personal Owner’s Expenses – While all expenses must be “business related”, owners may have automobile expenses, travel, lodging, or entertainment included that may not continue after the sale of the company
- Normalized Rent – If the owner/seller owns the property rented or leased to the business, there may be an adjustment to normalize the rent consistent with local sq./ft. rates. In other words, the owner may be charging the business a higher than market rate for the lease
- Family Members on Payroll – While uncommon, some owners have family members on their payroll who provide minimal contribution to the operation of the company and would not continue after the sale or be employed by the buyer
- Expensed vs Capitalized Purchases – Some expenditures may be capitalized or expensed. If the decision is made to expense versus capitalize, this reduces EBITDA more so than capitalizing with depreciation. Smaller expenses such as furniture or computers are often in this category. The seller or buyer may want to recast EBITDA as if expenses were capitalized to increase adjusted EBITDA
Conversely, some expenses may be required or included that reduce EBITDA. Examples may include …
- Key Employee Replacement – Key employees that leave with the sale of the company may need to be replaced . For instance, if the owner is heavily involved in some operational role, a new staff hire may be required to replace her and continue to perform such functions. This addition would reduce adjusted EBITDA
- Shared or Outsourced Services – It is not uncommon that an owner “shares” services or personnel with other entities she may have under common ownership. Typical examples may include a CFO/accountant, general counsel, or an IT professional that provide services to several organizations including the “to be acquired firm”. If so, it may be necessary to hire dedicated staff to perform their functions after the company is purchased. Other shared services may include shared office space, servers, telephone systems, or shared costs for necessary travel, memberships, fees, or dues
Now that we have reviewed EBITDA and common adjustments, let’s apply EBITDA to frequently used multiples to arrive at a starting point for valuation. And, oh, why do people start at 3-5Xs EBITDA, anyway? Let’s discuss …
In meetings with staffing agency owners, we invariably have the discussion of valuation – casually or formally. The discussion typically begins with the reality that most valuations, all things being equal, begin in the three to five times EBITDA range. The question then arises as to why this range? Is this arbitrary? Who made or makes that determination?
The answer is fairly simple and grounded in fundamental financial and investment concepts.
To begin, let’s assume you’re an investor or buyer and you acquire a firm whose growth is flat – essentially no growth – and you buy the company for 4Xs EBITDA.
In this scenario, it’s accurate to say you are paying the seller all the profits/EBITDA for each of the next four years for the right to buy and own the company. With that said, as the buyer, you do not make your first penny of return on that investment until the beginning of the 5th year. Likewise, at the end of the 5th year, as the buyer, you have only made a return of ~20% on your investment … or roughly a 4-5% ROI over the five-year period … a very unattractive investment option, especially if you factor-in risk.¹
You can see where this is going. Even with slight growth, anything beyond 5Xs is very difficult to justify simply from an investment perspective. If you were to blend in some moderate client concentration, lack of a predictable sales model, no scale-able management, or outdated technology infrastructure, etc. it becomes difficult to justify pricing outside the 3-5Xs range.
Of course there are exceptions and we will discuss several in the next section. But it’s important to keep in mind that even in a frothy seller’s market, buyers have options and will be diligent in getting a fair price.
With a realistic expectation of the starting point for pricing, let’s get to the real meat of this whitepaper – how or what can make my staffing company more valuable. The basic formula is simple. If Price = Multiple X EBITDA; then, over the life of my ownership, I want to increase EBITDA and implement or improve those elements which enhance the multiple.
Let’s discuss several key items that effect either EBITDA, the multiple, or both.
What Makes My Staffing Firm More Valuable?
Staffing companies come in all shapes, sizes, geographies, and specialties. What adds value to one firm, may not impact another; however, there are items which are generally universal that make your firm more valuable.
- Growth– Consistent growth is one of the primary indicators of the health of the organization and one of the primary factors used to determine a firm’s value. Growth, all other things being equal, requires a predictable sales model that adds new customers at a rate faster than normal customer attrition. This usually requires a methodology or infrastructure for sales people to source and generate leads, interact directly with prospects through sales calls, and close deals. Likewise, an operational process is necessary to support sustained growth such as hiring and training new internal staff, managing document and contract methodologies, risk management and safety assessment, as well as on-going recruiting, customer service and account management. From a financial perspective, consistent growth enables an investment in the new organization to grow and provide an adequate return on investment (ROI).
- Diversification of Service Lines – While providing specialized, niche’ services has its own benefits, diversifying your service lines provides lower risk from reliance on one, specific sector. A staffing firm that has a mix of light industrial, office/clerical, and possibly healthcare is viewed as more valuable and a safer, more secure investment than one that is 100% light industrial. From a financial perspective, diversifying service lines has a propensity for lowering overall corporate costs as the company scales. The same senior and regional management teams, ATS systems, recruiting machine, and sales and marketing efforts can often be leveraged across service lines allowing for a greater diversity and scale of revenue while adding minimal SG&A costs.
- Corporate Infrastructure– The ability to scale requires an adequate, capable senior management team and ATS infrastructure. Most staffing firms are best served by having senior management teams in accounting & finance and company operations, i.e. a CFO, VP of Operations, VP of Sales, a Risk Manager, and a Director of Recruiting. These are all key positions that enable growth, sales, and a superior level of customer service and recruiting capability … all mission critical functions needed for successful operations. With this said, the reality exists that smaller firms generally do not have a corporate infrastructure built-out and that is understood; however, it is expected that the management team has some reasonable bandwidth to accommodate growth, thus adding value to the organization.
- Professional Services – While light industrial and office & clerical (often referred to as “commercial”) remain the stalwart and largest sectors of the staffing industry, professional services such as IT, engineering, accounting & finance, and healthcare, are growing and are considered superior sectors. Professional services often enjoy higher bill rates, GM%, and typically have longer employment cycles – longer assignments. For larger firms focused on these sectors, corporate overhead is often lower due to the ability to scale, lower transaction volume, and the absence of ancillary corporate functions necessary for risk management and “brick and mortar” expansion. Professional services may also be greatly facilitated by centralized recruiting efforts – further reducing corporate SG&A for a given revenue stream.
- Predictable Sales Machine– Closely aligned with growth, a predictable sales machine is valuable; in fact, invaluable. Whether your focus is “retail” sales, large account marketing, VMS, or onsites, having a process that provides a steady stream of new customers helps increase the price or multiple of your firm. A predictable sales machine requires a methodology for acquiring, training, deploying and monitoring salespeople. This includes implementation of key performance measures, commission plans, recognition, tracking sales activity, training and oversight, and territory management. An often-found symptom of a predictable sales model is a lack of client concentration (a good thing). Even for the acquisition of large accounts, if your sales machine is providing a healthy pipeline of leads and new customers, over a given period of time, concentration is usually mitigated, revenues and profits grow, and your firm becomes more valuable.³
- Audited or Reviewed Financials– Having 3-5 years of audited or reviewed (preferably audited) financials goes a long way towards endorsing the professionalism of your company. Not only does an audit provide authority to the numbers, but it helps streamline the due diligence process in the event of a sale. Audits can be costly, but that cost is generally handsomely repaid, especially if done by a reputable, well-known accounting firm.
- Geographic Footprint & Multi-Office Operations– It is not uncommon an acquirer is looking to expand into a geographic area in which you have a foothold. While there are few “preferred” geographies that can be discussed, having several branches in an area where your firm plays a dominant role, is attractive. Likewise, the more branches you have the greater the likelihood the valuation will be enhanced. Ideally, those branches are in cities or towns that will allow organic expansion by enhanced sales or recruiting efforts or by the introduction of new service lines to the existing client base.
- Multiple Service Delivery Models– Most staffing firms operate from branches with “boots on the ground” marketing efforts. This is great provided the results from those sales efforts offer financial results. Companies that have diversified into alternative delivery models may find their valuation enhanced – multiple delivery models simply offer a diversified revenue stream providing alternate means for growth and added lower-risk consolidated profits. The most immediate and well-known examples are VMS/MSP and onsites. VMS, though typically low margin business, allows expansion into large volumes of business with minimal overhead. The trick is efficiency and a solid, well run recruiting capability. Also, once the VMS capability is developed, it is relatively easy to expand into other service lines – engineering, accounting and finance, IT, and healthcare. With onsites (also referred to as Vendor on Premise – VOP), you have a similar opportunity. Once you have a few onsites “under your belt”, it is a relatively easy process to develop a sales and implementation program to expand that delivery model. Similar to VMS, the margins are typically low; however, onsites offer an opportunity to acquire large accounts operated with relatively low investment in infrastructure and support. And, both VMS and onsites benefit from a centralized recruiting program that can further enhance profitability and diversification of your revenue stream.
- Contracts with Customers– Regardless of the tenure of your customers and apparent solid relationships you may have at the operating and branch level, contracts are good. They provide the new owner some comfort that those relationships (and revenue) will extend past the sale of the company. For companies that have a high volume of smaller customers that use periodically, contracts are often unreasonable due to the velocity and sporadic volume of transactions. However, large accounts will be viewed as risky without some contractual arrangement in place.
- Higher Than Industry Margins– Margins are a function of the service lines you provide and the model in which they are delivered. However, low margins (especially gross margin – GM) may reflect low pricing and may be viewed as lacking “value-added” service. Being the low-price provider is risky. Customers who use price as a vendor selection metric, will often continue to look for the lowest price and shift to other vendors frequently. With that said, GM% is generally a reflection of the service line mix and will be compared to the industry. EBITDA margin is a bit trickier in that it reflects the operation that has been built to deliver those services. It can be affected by high investments in growth and development of management bandwidth to facilitate scaling the operation. In this respect, lower EBITDA margins may be looked at as favorable.
- Training Programs – Either internal or external training programs help develop your staff and make your company more successful and valuable. Associations like the American Staffing Association (ASA) and Staffing Industry Analysts (SIA) offer training and certification programs that provide enhanced capabilities and industry knowledge to your staff. Consultants in the industry offer management and sales training that help improve the effectiveness of your organization as well as often-needed techniques or guidelines to improve and accelerate sales and revenue. Further, many of the university business schools offer executive-level education that can help advance your management team’s ability to manage and motivate your employees. A robust program, either internally or with outsourced consultants, aids in the development of the organization, its success and value.
- Effective Recruiting Infrastructure – All things being equal in our economy, sales is often the competitive advantage for most staffing firms. But, at the heart of our industry, recruiting effectiveness is often a differentiating factor. Recruiting is the core of the organization and customers will judge us by the quality of the employees we provide. During a tight labor market, recruiting becomes a primary tool for developing a competitive advantage … the ability to fill open orders or “reqs” swiftly, efficiently, and with great candidates. Now more than ever, there are tools that allow us to interact and engage candidates and recruit them into our company. The ability to attract, engage, and retain candidates is a critical component to our success. And, while these tools (and their integration into advanced ATS systems) are critical, the recruiting process must be thoughtful and well-managed. Being able to utilize all the tools and available process to recruit can add tremendously to the value of your firm.
- Risk Management Program– For those staffing firms with a heavy blend of light industrial business, an effective risk management and safety program is essential. A historically low “mod rate” and claims history may prove to be a deciding factor as to the valuation of your firm, its price, and indeed if the company is “sell-able”. Investors often shy-away from staffing agencies with high trending mods or lacking a robust risk management program. Why? It may indicate poor client selection, a poor risk management program, and the mod and workers’ compensation rates can have a company-wide effect on profitability.
What Makes Your Staffing Agency Less Valuable?
Buyer’s, whether strategic or financial, go through a fairly rigorous process to arrive at a fair price – both for them and you. A “win-win” scenario is the most common objective.
For buyers looking to add your firm to their existing organization (strategic), pricing may be more flexible because they typically have a platform to absorb lingering or lost functionality, thus allowing reduced costs or improved efficiencies. For financial buyers (typically acquiring through private equity) acquiring larger staffing firms involves debt, equity, and various “players” to get the purchase consummated. For both, however, valuations ebb and flow, up and down based on various investment factors or key components.
Aspects of your firm that will likely reduce its value are …
- Client Concentration – Of the push-backs we have seen from buyers (and most certainly from banks, lenders, private equity, venture capital, and family offices), this is the most common. There is no magic number, but 15-25% concentration seems to be the range that gates investments and pushes the investors and buyers away. While client concentration can be mitigated financially with earn-outs or contingency payments, it is simply an issue most buyers don’t care to deal with. The list of problems related to client concentration is long and wide – and is a candidate for another whitepaper.
- Lack of Growth – Slow or no growth indicates a lack of a sales machine and infrastructure. Going back to our discussion of valuations in the 3-5Xs range, higher growth is often rewarded with a higher multiple; no growth often exults a penalty. Ideally, an investment provides an ROI after 5-7 years as the company grows organically with little needed infusion of cash. If the company is not growing or the buyer needs to install a predictable sales model(s), then the investment ROI drops and therefore the price and valuation. As a side-note, trying to convince a sophisticated buyer that growth is coming (in the future) though it has not occurred in the past, is a futile effort.
- Low Margins – Low gross margin or low NOI/EBITDA margin is a bit of a tricky conversation. If your firm is heavy light industrial, have large contracts or onsites, or operate primarily through VMS/MSP portals, then gross and NOI margins are expected to be low. If gross margins are low and you have a relatively diverse service line mix with little concentration or VMS, then you have a problem; in this case, low margins are indicative of a low-price marketing effort, poor training, and poor management or staff oversight. If GM% is relatively good yet NOI/EBITDA% is low, it may indicate poor management and cost control or, conversely, significant investments in growth initiatives.
- Out-dated or “Back of the Field” ATS Systems – In the past 3-5 years, we have seen an explosion of recruiting and sales tools that provide sophisticated operators the opportunity for a measurable competitive advantage. Though many tools may be operated “stand-alone”, most require integration into an ATS system to either operate or provide the greatest efficiencies. If you are running an old “gen” or antiquated version ATS system that does not lead the field in integration (and possibly “open source”), your valuation will be reduced. Converting to a new, advanced ATS system is costly, timely, and threaded with risk. If you are not there, expect a sizable ding to the price of your company.
- High Mod or Poor Risk Management Program – For companies that operate in the light industrial, skilled trades, or construction service lines, it is assumed you have a robust risk management program in place with frequent audits, safety training, and an on-staff risk and safety manager. A questionable, undocumented program, or firms with poor safety/claims history or a high workers’ compensation modifier (mod), can expect a reduction in valuation.
- Lack of Staff Training – Training is required to deploy new staff into the organization. Having someone “sit” with a new staff member for a few days is not good enough. Generally a thoughtful orientation and some internal and external formal training is expected for recruiters, sales, and managers. Lack of training is indicative of poor process, lack of growth, severely distributed management or simply lack of appreciation for training.
Buy vs Build Valuation Conundrum
With the 3-5Xs valuation out of the way and a discussion of those items that add or subtract value on the table, we now consider the buyer’s decision as to buy or build. As valuations approach or exceed the 5Xs mark, building the revenue stream (vs. buying) becomes more attractive.
Let’s consider another example.
As a buyer I am looking at a staffing firm with revenue of $25 million and EBITDA of $2M. The owner/seller wants 6Xs for her business for a valuation of $12 million. The company has little client concentration, moderate growth (5%), a small, but competent management team, and four branch offices. The company looks relatively good and the owner is well-paid – taking home much of the $2M as distributions and owner’s compensation.
For the buyer, the conundrum exists that it may be less expensive to use the $12M to open new offices rather than pay a premium for acquiring the company – regardless of how good it looks. Here’s how a buyer might evaluate this buy vs. build option.
To open a new commercial staffing office, a typical budget might be $200,000. This includes start-up expenses, cash to cover operating losses until break-even is reached, and possibly cash-flow requirements to cover accounts receivable as revenue ramps.
Most² independent, non-franchise offices attain break-even six to nine months after opening at roughly 1,200-1,500 billable hours per week. Normal or adequate contribution margin kicks-in around 2,400 to 2,500 hours after twelve months; and, satisfactory contribution margin (10-12%) is achieved at 3,000 billable hours – typically in eighteen months.
If we assume an average hourly bill rate of $20, then 3,000 billable hours per week generates approximately $3 million per year of revenue (per branch office). In this example, if we were to allocate the entire proposed purchase price of $12 million to opening new offices, we could hypothetically open 60 offices ($12 million/$200k per office = 60 offices). In three years, we could have a revenue run-rate of $180 million (60 offices X $3 million per office).
This is an extreme example and there are many factors to consider – risk, time value of money, intrinsic value of the acquired company, technology, geography, management, accretion, etc. But what this example does is highlight that valuation premiums require justification to a sophisticated and rational buyer. As such, for the acquisition of smaller staffing companies (especially 1-5 offices), the “build” option becomes much more appealing as the valuation (multiple of EBITDA) approaches the 5Xs level.
As a seller, it is wise to keep the buyer’s buy/build option in mind.
Another challenge we see is owners who are reluctant to give-up the lifestyle income their company generates – insisting on an artificially high valuation to replace that income.
This is a common theme with smaller companies as owners reach retirement age, are ready to move on to another project, or simply want to divest of the business and “take some chips off the table”.
By example, here are three real-world scenarios we have seen in the past several months.
Owner One has had her company for 30 years. She works one day per week and has a competent management team. The company has seven offices generating $34 million of revenue. She pays herself $1 million per year though her EBITDA is higher. She told me, “At 5Xs, after tax, I would net about $4+ million. That’s not enough for me to give-up my $1 million per year.” Candidly, we find it hard to argue against that comment unless you are truly ready to “walk away”.
Owner Two has had her company since 2001. She has one office that generates $6 million of revenue and she “takes home” between $500,000 and $900,000 per year. The issue for her becomes under what, if any, circumstance is she willing to forgo that income and the lifestyle it brings. Her comment to me was “I’m not ready to give-up that income – even for $4 million … maybe in a few years when I have no choice but to retire”.
Owner Three has a $25 million company generating $2 million of EBITDA. In addition to a salary of $175,000, the owner pays himself an annual distribution of $1.5 million. Combined he is taking out roughly $1,700,000 (and has been for almost 20 years). Again, the issue becomes at what point or under what circumstance is the owner willing to sell at a reasonable multiple. In this case, the owner is ready to retire and has other income that will supplement earnings generated by the sale of the company. Therefore, his expectation of the valuation is reasonable and in-line with the market.
To complicate the “lifestyle” valuation challenge is that owners rarely have invested in a sales or recruiting infrastructure beyond what will maintain the status quo (“we operate very lean and efficient”). This lack of investment results in stagnant sales and minimal growth – driving down the valuation/multiple further.
The typical “lifestyle” scenario is the owner reaches a point where the income and the lifestyle it provides is satisfactory … at which point the owner draws-down or distributes most of the operating profits and cash flow – further enriching the lifestyle. This leaves minimal investment capital available for growth initiatives and the company stalls. Revenue and profits waver on the demand of existing customers and fluctuations in the economy.
To be clear, this is not a criticism. Owners are free to do whatever they want with their privately-held companies. Enjoying the riches of their efforts and risk-taking is well-deserved, and candidly, is the hallmark of successful capitalism and entrepreneurship in our country.
The issue is arriving at a valuation palatable to both the seller and buyer.
Selling your company is difficult emotionally and professionally. For many, it’s the culmination of years of work and sacrifice (time, money and sometimes relationships); for some, it represents a life-hurdle as you move into retirement. Either way, you are giving-up your “baby” and possibly severing long-tenured relations with dedicated, loyal employees.
Being realistic about your company’s valuation is a good place to start; but being realistic, however, doesn’t mean you shouldn’t make every effort to enhance its value.
Hopefully this paper has outlined important items you should consider. Many of these items are well within the reach of most owners and should be carefully reviewed or implemented – preferably, three to four years before you decide to sell.
Copyright 2018, Talant Staffing Group, LLC
¹Those of you who are financial analysts or mathematicians at heart will argue the precision and details here, but from a broad perspective this is how the ROI is considered. Many owners will also argue that there is unrealized upside to their company and they simply have failed to invest in growth. That makes the argument against a higher valuation even stronger since the buyer now has to invest some of that EBITDA in growth initiatives.
²By “most” we mean 80%. My personal experience from opening 20+ branch offices and feedback from staffing industry executives support this percentage. Conversely, we assume 20% of our new offices will not succeed (not necessarily fail). The definition of “not succeed” varies, however – eventually closed, didn’t reach revenue or profitability levels, didn’t reach performance levels in a timely manner, did not attain satisfactory profitability, etc. My perspective is that any “mature” office below 3,000 hours is under-performing; however, an office above ~2,400 billable hours may be considered successful.
³At the risk of offending some owners I have met, I must address the “sales by referral or word-of-mouth” technique. There is no question growing sales and acquiring new clients by getting favorable client referrals through excellent customer service is important, appreciated, and welcomed. Happy, satisfied (thrilled) customers and employees should be our goal – regardless of marketing or sales techniques. However, client acquisition purely through referrals and word-of-mouth is NOT a sales process and is far from predictable. If you look at best practices from middle-market and large staffing firms that experience sustained, profitable and growing revenue, you’ll see they have a well-planned and executed sales process. If you rely exclusively on word-of-mouth and referral marketing, you will eventually be overrun by competitors. Sadly, it’s simply a question of when.