| Valuing
a Background Screening Company
Assessing
the market value of a company in an active and consolidating industry,
such as the background screening industry, is more of an “art”
rather than a “science.” Value is ultimately determined
as the price a “willing” buyer will pay and a “willing”
seller will accept. In order to understand how to value a background
screening company, it is important to understand the factors that
impact value and the methodologies for calculating value.
Factors
Impacting Value
Factors that
impact value include broad macro-economic factors, specific industry
factors, and even more focused company-specific factors.
Macro-Economic
Factors
Macro-economic
factors such as: economic growth, availability of bank financing,
public stock market value, availability of private equity investment
capital, and overall M&A activity is analogous to the old
adage “high tides raise all ships”. In essence, strong
macro-economic factors provide buyers with the required capital
and liquidity to make investments and acquisitions across all
industries.
Today’s
favorable macro-economic factors positively impact overall company
valuations. The U.S. gross domestic product (“GDP”)
has grown at a rate of between 3% and 4.5% over the last eight
quarters, and the Dow Jones Industrial Average and NASDAQ market
indices are stable and at a four-year high level. In addition,
banks that provide debt capital to the economy are less conservative
today and there is currently a high-level of private equity investment
capital that has not been invested in recent years. As a result,
macro-economic factors have created the required capital and liquidity
for buyers to make investments and acquisitions. Consequently,
M&A activity is strong and the number of completed transactions
in the U.S. has reached levels we have not seen in five years.
Industry-Specific
Factors
Although macro-economic
factors are a good barometer of broad M&A activity, industry-specific
factors are more important in assessing the valuation of a specific
company. Over the last three years, there have been over 50 publicized
transactions (and even more undisclosed transactions) in the background
screening industry. There are a number of active, “willing”
buyers and the industry is poised for continued consolidation.
A few characteristics that are driving the consolidation include:
high growth, fragmentation, and the inherent competitive advantages
of a larger company.
Most background
screening companies are bullish on the future growth of the industry.
In a recent KPMG Corporate Finance LLC survey (the “KPMG
Survey”) of companies in the background screening industry,
nearly all respondents expected revenue to increase over the next
12 months, and 40% expect revenue to increase more than 25%. Over
the past few years, the awareness of the value of screening has
increased substantially and more companies are requiring screening
as part of the new hiring process.
The industry
is highly fragmented and can be characterized by a barbell shape.
There are a small number of larger providers (only four companies
have screening revenue in excess of $100 million), a limited number
of mid size companies (less than 30 companies have revenue over
$10 million in screening revenue) and a large number of small
companies. In fact, the majority of companies have screening revenues
less than $2 million.
Larger and
mid-sized screening companies have a competitive advantage over
the smaller companies. Larger and mid-sized firms have the ability
to leverage investments in technology, infrastructure, personnel,
compliance, and marketing and can compete more effectively for
the larger corporate clients. These firms have a proven track
record and are considered the “safer” vendor choice.
As a result, to be successful, smaller companies will increasingly
focus on a core group of customer relationships or become a niche
service provider.
In the recent
KPMG Survey, 54% of all respondents have considered acquiring
another company, with over 70% of large and medium-sized companies
considering acquisitions. Current acquisition activity is being
driven by firms trying to: 1) expand and bundle complementary
software and services with screening services, and 2) expand the
range of existing business footprint via geography, services,
or customer base. The positive outlook for the industry, the fragmented
nature of the industry and the competitive benefits of being a
larger company, will result in continued consolidation.
Company-Specific
Factors
Although industry
characteristics are a good barometer of industry M&A activity,
company-specific factors are the most important valuation drivers
for a specific company. Characteristics that impact value include
revenue size, technology, historical and forecast financial performance,
customer base, compliance procedures, reputation, and management
team. These characteristics determine whether a company can be
considered a “platform” acquisition. To be considered
a platform, companies need to provide an acquirer with more than
customer relationships. Generally, a platform will have a number
of the following characteristics: greater than $10 million in
annual revenue, high growth prospects, a scalable infrastructure,
and proprietary processes or technology that will be utilized
by the acquirer. Platforms are able to achieve higher valuations
since acquirers are willing to share a portion of the synergies
expected post-transaction.
On the other
hand, non-platform companies are typically smaller in size. Since
the acquirer is essentially buying a target’s customer relationships
and is unlikely to utilize the technology platform or internal
infrastructure post-transaction, the acquirer will not pay for
synergies expected to occur post-transaction. Most companies in
the background screening industry are not platforms and although
there are likely a number of willing buyers, these companies will
not realize a premium valuation in a sale.
Valuation
Methodologies
A company’s
economic value can be determined by widely-used valuation methodologies
such as the income approach and the market approach. In addition,
the substantial transaction activity in the background screening
industry has resulted in a number of “rules of thumb”
that can be helpful in assessing valuation.
Income
Approach
The income
approach generally relies on the valuation methodology called
the discounted cash flow analysis (“DCF”). DCF assesses
the value of a company based on its ability to generate cash flows
and returns in the future. Since a company’s future is not
100% certain and a dollar today is worth more than a dollar tomorrow,
the DCF considers both the time and the risk of a company’s
future cash flow. The cash flows adjust for private company expenses,
such as excess owner’s compensation and discretionary expenses,
which would not occur under a new ownership structure. Mathematically,
the DCF value is determined by summing the present value of a
company’s future cash flow (the projected cash flow reduced
by a risk-adjusted discount rate) and the company’s terminal
value (the value of a company at the end of the projection period).
Market
Approach
The market
approach is a historical perspective valuation and can be compared
to the process of assessing the market value of a house. In establishing
the value for a home, home owners and real estate agents evaluate
the price paid for similar homes (completed transactions) as well
as the price of similar homes that are currently offered for sale
(listed homes). Similarly, the value of a background screening
company under the market approach considers acquisitions of other
background screening companies as well as the value of the publicly-traded
companies, such as First Advantage and Choicepoint, which compete
in the screening industry.
Valuation
multiples are developed by comparing the acquisition price of
a comparable transaction or the market value of a public company
to their respective prior twelve month revenues and/or earnings
before interest, taxes, depreciation and amortization (“EBITDA”).
Those multiples are then applied to the annual revenue and/or
EBITDA of the company being valued to arrive at an approximate
valuation. Since small, private companies are inherently riskier
than large, public companies, public company multiples are often
discounted before being applied to the acquisition target’s
financial parameters. Furthermore, caution and judgment should
be used when analyzing information about comparable transactions
since most information regarding the sale of privately-held companies
is not public, potentially incomplete, derived from third-party
sources, and/or misleading.
Rules
of Thumb
In industries
with a substantial level of M&A activity, it is possible to
develop “rules of thumb” that can be used as guidelines
for valuing a business. It is important to understand that rules
of thumb are guidelines only and that a number of other factors
such as transaction structure, motivation of the buyer, transaction
strategy, and objectives of the seller ultimately will determine
the valuation of a business. Furthermore, guideline multiples
referenced below are of a general nature reflecting broad market
and industry characteristics today and are not intended to address
the circumstances of any particular individual or entity now or
in the future.
Valuations for non-platform companies are generally more consistent
than for platform companies and currently range from .75x to 1.25x
revenue and 4x to 5x EBITDA for small companies with a portion
of the purchase price deferred. Medium-sized non-platform companies
generally receive a slight premium over smaller companies (1.25x
to 2.0x revenue and 4x to 7x EBITDA) the transaction structure
is more favorable. As discussed previously, platform companies
attract a higher valuation. The valuations for platforms can vary
substantially, however, platform acquisitions typically attract
valuations in the range of 1.5x to 2.5x revenue and 6x to 10x
EBITDA (though the valuations can be significantly higher).
Conclusion
Since economic,
industry, and company factors are dynamic, the value of a company
today is not the value of that exact company in the future. A
business owner can only control the company-specific factors but
overall market conditions and industry dynamics could have as
much impact on valuation. There is not just one method for determining
value and different buyers will arrive at different valuation
conclusions. In the end, the ability to generate cash flow in
the future is a key to determining value under all approaches.
Cherie Smith Homa is a Managing Director with KPMG Corporate Finance
LLC. Ms. Homa can be reached at 410-949-8692 or csmith@kpmg.com.
KPMG Corporate
Finance LLC provides a full suite of investment banking and advisory
services to its domestic and international clients. Operating
in 52 countries, KPMG's Corporate Finance practice comprises over
1,600 professionals. In 2005 KPMG's Corporate Finance practice
was ranked the number one financial adviser for completing the
highest number of transactions globally (429 deals totaling $40.3
billion), according to Thomson Financial's global M&A league
tables.
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