Originally prepared for and published by PBSA in the Sept-Oct 2023 edition of the Journal. Read the full issue here: https://thepbsa.org/resources/publications/
Merger and Acquisition (M&A) transactions are some of the most transformative events any organization will experience.
Whether you are contemplating acquiring another business to accelerate your growth, or think the time may be right to sell all, or part, of your own company, long-term planning is critical and is often the key determinant of success in a transaction.
Growing levels of interest from institutional capital in the background screening industry, and broader human capital management sector, coupled with continued consolidation efforts by large players, are impacting the sector and will likely impact your business in the near term, if it hasn’t already.
Below are some key transaction considerations for business owners and leaders whether they see themselves as a buyer or seller.
Having a pulse on the current market environment is important to setting expectations, defining success, and having realistic outcome parameters in place. Like the public markets, the M&A market can be both cyclical and complex, with certain industries, or transaction types, in high demand while others may face headwinds.
Even within industries market preferences can shift over time; for instance, about 10 years ago the prevailing strategy for acquirers in the background screening industry was to grow screening volume as fast as possible through acquisition. The thinking was that by consolidating the volume of smaller players onto an established large platform, significant margin savings per screen and other synergies would arise. While this approach is still seen at times today, many buyers found screening volume was lost as quickly as it was added, with up to a third of acquired customers turning over in the first year post-acquisition.
To counter this, in the last few years, buyers have increasingly shifted to focusing on the strategic fit of the customer base they are acquiring, as well as considering their target’s technology platform, management talent, and industry relationships. Alignment in these areas often leads to smoother integration and greater customer retention post-transaction.
Value Enhancers / Eroders
One of the first questions any seller or buyer will ask when evaluating a transaction is, what is the company in question worth? The answer is often complex, and while simple proxies like revenue and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiples can provide a ballpark estimate range, a nuanced analysis of the key attributes of the company is needed to develop a more precise valuation.
There are generally 4 primary areas of focus when valuing background screening companies and determining which end of the premium – discount valuation spectrum a business should fall on.
Stability or predictability of the revenue base is one of the most important areas of consideration for companies in this sector. Attractive assets have well-diversified client bases, with no single customer or small group of customers making up an overwhelming portion of revenue. This provides downside protection in case a customer is lost and provides the opportunity for a new acquirer to increase volume with a large pool of existing customers to sell to.
The predictability and stability of the management team at the target company is often a key consideration. Companies with a skilled and experienced management team that is in place, and plans to remain with the company post-transaction, often have a significant advantage over those where much of the management team is leaving with the transaction, or where key leadership roles and institutional knowledge are concentrated to one individual. In these situations, post-transaction integration can be more challenging, and there is an increased risk of disruptions in operations.
In an industry that at times can struggle with the perception of being a commoditized service, differentiation shines as a key attribute. Companies that trade for premium purchase multiples generally have one or more factors that meaningfully differentiate them from the competition. Proprietary technology that offers full-service capabilities with well-designed interfaces on both the customer and operator side is a major differentiator on the positive side, where reliance on a 3rd party system with limited capabilities is seen as a negative.
Long-term client relationships and strength in focused end markets are also seen as positive differentiators, demonstrating both superior client service and a focused commercial strategy. The relative attractiveness of end markets can vary, with those focusing on highly regulated or high turnover fields like health care, education, and financial services being the most desirable.
Most acquirers will be looking at acquisition as a way to generate growth, with the hope being that the target company will see its growth accelerated once under the umbrella of new ownership. Having a demonstrated history of growth, particularly one with a track record of successful M&A deals is highly attractive to financial acquirers. The ability of leadership to articulate a vision and strategy for future growth is also key, as acquirers are less interested in opportunities where a company has reached its full potential and is at the end of its growth trajectory.
Opportunity also manifests itself in a company’s operations. Companies with top tier assets demonstrate the ability to adapt their service offerings to meet changing needs in the marketplace and offer dynamic services to customers. Companies with limited or fixed capabilities, or those carrying the baggage of significant ongoing or past litigation often receive discounted valuations.
There are two general points of emphasis when looking at the margin of a company in a transaction. The first is the current EBITDA margin. Generally speaking, 10% and above is the minimum threshold for a healthy margin, while much below that can raise red flags in the eyes of acquirers. Secondly, the margin profile trends are important. In a growing company, the hope is that as revenue increases, operating leverage improves, and margin grows. Further, large swings in margin year to year can indicate management challenges or operational disruptions.
Preparing for a Transaction
While some aspects of transaction preparation will be the same for buyers and sellers, here are some key seller-focused steps business owners should undertake before contemplating a transaction.
- Company Evaluation – Using the factors above, analyze potential drivers of value / competitive differentiation. Review customer base, end markets, growth opportunities, and management team capabilities.
- Financial & Commercial Diligence – Review financial performance, with a particular focus on the company’s ability to produce reliable, insightful financial reports and a customer-level sales database. Consider potential adjustments to EBITDA to normalize earnings for non-recurring or non-operational items.
- Market Opportunities – Monitor M&A market trends and recent sector activity to develop an estimate of value. Consult a tax advisor to determine your after-tax proceeds under various valuation scenarios.
- Transaction Planning – Determine your objectives, including if you plan to remain involved operationally in the business post-transaction, how much of the business you would like to retain, if any, and what your timeline is for pursuing a transaction.
Business owners and acquirers who invest the time upfront into preparing for a transaction are significantly more likely to reach a successful outcome. The background screening industry in particular is highly dynamic so stakeholders need to remain up to date on market trends, the latest M&A activity, and regulatory changes. Through diligent planning, you can ensure you are ready to act when the time is right for a transaction.