It is said there are more rumours about recruitment agency sales and the prices paid than there are companies in the industry! And there are a lot of companies in the sector.
As almost all recruitment agencies are privately owned in Australia and New Zealand, there is little published information on the pricing and deal structures for the great bulk of equity transactions. Most of what is published relates to larger deals. These can be misleading in terms of setting pricing benchmarks for small to medium sized agencies, especially if they involve publicly listed companies as the buyer. It is also important to interpret the detail of larger-scale transactions. Otherwise, comparisons can’t be validly made, and it is potentially an “apples with oranges” situation.
Likewise, drawing conclusions from articles about other market sectors or from overseas can be misleading, if applied to your market.
Most of what happens in the recruitment industry involves deals between private companies and are consequently kept confidential. The nature of ‘what’ and ‘how’ a deal is structured is important in this context too. When discussing business M & A transactions, was it a share sale or an asset sale? Is working capital included or not, and how was that defined? In some cases, we may be discussing whether it was a multiple of tax before profit or a multiple of profit after tax?
This article gives some definition and explanation to help understand what is really happening in those transactions.
(1) A definition
For consistency, unless otherwise qualified, HHMC Global talks about business value as a multiple of normalised profit before tax including agreed target working capital. This is usually and EBITDA value.
Normalised profit means adjusting expenses (sometimes revenue) to reflect the business as if someone else was running it. A good example is to compare to how a corporate entity would run it. The major adjustments are usually related to shareholders’ expenses (some private expenses may be able to be removed). Adjustments to shareholders’ total resalary packages (they may be paying themselves more or less than market rates), ensuring major items such as rent are at market value, and understanding debt sources and costs.
Net Working capital, for this purpose, is most easily described as cash plus debtors less creditors less staff entitlements (such as annual leave).
(2) Past performance is “interesting”
Looking at the past two- or three-years financial performance is an important part of understanding an agency’s capability and potential. But this past performance is not an appropriate guide to future performance.
For a services industry like recruitment, the business value may be thought of as the risk associated with a new owner generating profits in the future. The seller is asking the buyer to pay a multiple of future profits for the business. What generated profits in the past? Are those characteristics available for the new owner in the future? Aspects like sustainability, revenue sources, business development capability, leadership team and key staff, and market conditions all need to be evaluated by the potential buyer.
Calculating the “average of past 3 years profit” is not a relevant valuation method and is frequently misleading.
(3) Temp and Contract is very important
Let’s repeat that. Temp & Contract is very important to business valuation.
One of the very few ways an agency of less than, say, 5 consultants can show sustainability is to run a strong temp and contract book – something greater than 50% of gross profit contribution.
In today’s maturing recruitment industry there are additional sources of solution-based revenue – for example providing RPO services or undertaking SOW projects – that reduce the reliance on single occurrence perm placements requiring sustained sales activity.
In most cases, any agency that is dominated by permanent recruitment, no matter what its size or sector, will have greater challenges attracting buyers and struggle to achieve a strong value for their business when compared to agencies with a strong source of continuing revenue. Specialist firms operating in some highly in-demand employment categories may see some alleviation in this risk assessment.
(4) Sustainability is a key determinant of value
HHMC talks about sustainability a lot. We like the definitions provided by Michael E. Gerber in his book “The E-Myth”.
Smaller companies struggle with sustainability – they will have single points of failure such as being reliant on one person for most of the business development, or one person for the majority of billings, or one client for the majority of revenue.
Agencies that fail the sustainability test do not attract a standard valuation.
(5) The industry is constantly changing
There is little disagreement that the recruitment industry has changed dramatically over the past few years and the rate of change is continuing. If your agency has not evolved to meet current business requirements, then an astute buyer will be concerned about its future.
(6) Longevity is rewarded
Agencies that have shown the ability to prosper through changes in business conditions and industry evolution will be rewarded with a lower risk rating when their business is being assessed. Conversely, start-up businesses or those agencies that have not shown the ability to grow and adapt will be assessed accordingly.
(7) Desirability Factors
There are many passionate agency owners that are justifiably proud of their achievements in market positioning, technology implementation, business processes, candidate databases and social media presence. Some are also proud of their logo, web page and even office locations and fit-out.
These aspects of a business may add to the desirability of an agency – more potential buyers may be interested in evaluating the business. But what a buyer will pay for a business will primarily be determined by the rate of profitability of the business.
Investment decisions need to reflect this reality – invest to grow profit in a sustainable manner.
(8) Deal structure affects business value
Purchasers are looking to reduce the risk of generating future profits. Sellers are looking to exit their business with as few risks or time delays as possible. The balance of these two requirements impacts the value of a business (and is a unique negotiation for each buyer/seller discussion).
If a seller wants to sell a business for 100% cash up-front and leave the business immediately then they will receive less for the business.
Sellers can potentially increase the amount they may receive from a purchaser by participating in the business for a period following the sale and accepting part payment for future performance. This will reduce the buyer’s risk and allows a greater share of the future result to be paid as part of the price. Earn-out and deferred payment models are structured in this way at the time of the deal.
(9) So what’s a standard deal these days?
There is no such thing as a standard deal, but with reference to all the above comments the value of small to medium private recruitment agencies usually have these characteristics:
The multiple of normalised profit before tax most often fall in the range of 2.0 to 4.0. This has not changed for over 15 years, but profitability has certainly varied throughout this period.
Deal structure often involves about half being paid up-front and the remainder paid on the future performance of the business over an earn-out period of between 6 months and 2 years.
Many agencies fail the sustainability test and are valued at less than a multiple of 2.
Many agencies fall into the “personal services” category and are not able to have a business valuation applied. In these circumstances the value of work in progress or the value of the temp book may be the value of the business, or an arrangement can be made to transition employment arrangements to a new company.
(10) Advice for small to medium agency owners
There is no single correct strategy for a recruitment agency owner in terms of growth, size, sector, or business mix.
Building a business that generates good cash returns, but limited equity value can still be a valid strategy.
Owners need to understand the implications of a chosen strategy. Do not drift into a situation; make a conscious decision. For example, building a small perm-dominated business is a valid strategy BUT the equity value of the business will be low.
All agency owners should have a wealth creation strategy that is more consistent and sustainable than “one day sell my business for a lot of money”. Research shows that consistently rewarding shareholders, in balance with continued business investment, is the most successful wealth creation strategy for small to medium business owners.
HHMC Global provides an external review and market valuation service for recruitment agency owners that will be beneficial to your strategy. Contact Us to discuss further.