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.

Click here to return to the E-zine and/or close this window