Diversification: Business Imperative with Traps for the Unwary

Mitigating Risk Through Client Diversification 

By Mark Roberts, CEO, TechServe Alliance

Diversification—specifically client diversification—is a top priority for most business leaders of IT & Engineering Staffing Firms. Of course, the motivation to diversify is captured by the well-worn maxim: Don’t put all your eggs in one basket.   

A business, no matter how well run, that has not sufficiently diversified its client base is at-risk—perhaps existential risk—to forces beyond its visibility and control. Your largest client’s industry can take an unexpected downturn, your internal sponsor at the heart of the relationship can leave, or a client’s talent acquisition strategy can shift. No client relationship—no matter how longstanding or how deep—is guaranteed.

Diversification is Difficult and Elusive for Many Firms …

The remedy for mitigating the risk of client concentration is simple in concept, but exceedingly challenging in practice: get more clients to reduce your vulnerability.

For many firms in the industry, client diversification has proved elusive.  Over decades of benchmarking IT & Engineering Staffing Firms through our annual Operating Practices Report (OPR), the numbers have varied little year-to-year: the median industry firm’s largest client and top five clients represent approximately one-third and two-thirds of revenue, respectively.  As medians, one-half of IT & Engineering Staffing firms had even greater client concentration putting those firms at an elevated risk of significant disruption caused by the loss of one or more of their largest clients.

… But Diversification is Critical to Maximize Valuation on Exit 

Beyond the risk to the business, lack of client diversification can have a significant impact on enterprise value and deal terms when an owner decides to exit.  In the TechServe M&A Marketplace Program, we regularly see potential sellers with high levels of client concentration.  When these owners ‘go to market’ to sell their businesses, client concentration is a factor buyers consider when setting the multiple of EBITDA—the primary formula for determining enterprise value and the sales price.

Further, high levels of client concentration impact deal terms as well; specifically, the amount of cash paid at closing relative to the amount and length of any earnout—the portion of the purchase price typically paid over one to three years post-closing that is conditioned on achieving certain performance thresholds.  The reason for buyers taking this position is the same as the owner’s motivation to diversify—mitigate risk.

However, all diversification is not the same… 

So, is all diversification good?  Unfortunately, it is not so simple.  There are traps for the unwary.

If you are adding new client logos who are interested in buying IT staffing services under a similar approach and margins to your existing business—great!  However, you should think through both the consequences while weighing the upside in taking on new clients under different business models or in other verticals.

If you are an IT staffing firm that operates a high-touch business with regular hiring manager contact and above average margins, you should consider if your company is structured to profitably work with clients that have a VMS/MSP in place with a submittal-to-close rate of 3% at 16% gross margins.

If you are going to undertake payrolling alongside your core business, is the justification or upside sufficient to offset the dilution of your average gross margin?  When it comes time for an eventual exit, potential buyers will consider if your business and your average gross margins are accretive and would enhance, rather than depress their enterprise value.

Consider the Insurance (Yes, Insurance) Implications  

While insurance may not be the first thing that comes to mind when weighing strategic decisions, it can have a real impact on outcomes.   Based on our experience in TechServe’s Business Insurance program in which we insure almost 500 staffing firms, we have seen more than a few companies decide to go beyond their core business. This has taken the form of a one-off placement outside IT and engineering or an effort to fully expand into another staffing vertical.

Why does insurance matter in such cases?  It matters because it can change the economics of the opportunity.

IT staffing has historically had extremely low claims rates across all commercial insurance lines of business including worker’s compensation and professional liability. Consequently, it is considered a highly preferred class of business by insurance companies with low rates commensurate with the low risk. Other staffing verticals, not so much.  For example, the worker’s compensation rates for nurses are 20x the worker’s compensation rate for an IT consultant.

The cause for concern extends beyond worker’s compensation. Through our proprietary program with the Hanover Insurance Company, we have a professional liability (E&O) policy for IT staffing firms that comes with several special enhancements.  However, that policy, despite its breadth of coverage will not cover professional liability for nurses (also known as medical malpractice). No professional liability policy intended for IT staffing firms covers such a risk.

In other words, absent buying a separate medical malpractice policy, you would have no coverage for a nurse that you just staffed with a hospital.  In addition to likely not meeting client contract requirements, you are exposed to a potential medical malpractice claim for which you have no insurance coverage—a scenario that can take down your entire company (it is also the reason you should discuss with your attorney potentially forming a new entity to segregate the risk).

Can you buy a separate medical malpractice policy as a solution?  Possibly, but such policies differ from policies purchased by IT staffing firms. Unlike Tech E&O policies, medical malpractice policies can be much harder to secure and often come with minimum annual premiums as high as $30,000 a year. If your current worker’s comp carrier won’t write insurance for nurses, you may need to also secure a separate worker’s compensation policy with a minimum premium of $15,000 to $25,000.  You may want to consider if you have sufficient margin built into your bill rate to absorb these types of costs.

When Adding Payrolling as a Line of Business—Be Cautious 

Payrolling represents several challenges if it is part of a diversification strategy.  Many staffing firms will at some point ‘payroll’ one or more individuals at the request of a client.  While some staffing firms will do payrolling only as occasional client accommodation, others will actively pursue this type of business. Proceed cautiously.

As discussed above, any prospective buyer will consider your average gross margins when making an offer—assessing whether your business once combined with their business is accretive. Unless separated from your core staffing business, payrolling will lower your average gross margin—making the business less attractive to some would-be acquirers.

Additionally, because payrolling is done at extremely low margins, your margin for error is extremely narrow. Miscalculate the burden because you underestimated the worker’s comp insurance rate or a state tax like unemployment is increased unexpectedly, and your deal may wind up underwater. While payrolling has worked for some firms, for many others it represents increased risk without the commensurate potential for gain.

Diversify You Must, But Diversify Carefully 

Diversification is a business imperative. Without sufficient client diversification, you put your company at risk—potentially existential risk.  When you are ready to exit, lack of diversification can have profound implications for the sale price you can command, and the deal terms you will be offered. However, diversify carefully.  Weigh placing a one-off bus driver or forklift driver (yes, we have seen both) or whether or not venturing into nurse staffing makes strategic sense for your business.

For expert insight on diversification in the context of enterprise value or an eventual sale, reach out to John Larson or Steve Norris.  If you have questions about the insurance implications of diversifying into other verticals, contact Don Beemer. Have other questions? The entire TechServe team is here to help.