PEO Case Studies: Here’s the story of several happy HRO families.
Picking the right HRO partner is a deciding factor in improving your company’s chance of success… or, seen the other way, lowering your risk of failure. What makes a successful pick? Where are the pitfalls? These case studies tell all.
Conventional wisdom says that small- and mid-sized businesses fail 90 percent of the time. In the introduction to the reality TV show The Restaurant, the 90 percent failure rate is thrown around as casually as a plate of deli meat. The actual number is quite different, quite dependent on your choice of partners, and especially sensitive to your pick of an appropriate HRO provider.
Statistics from Professor H.G. Parsa of Ohio State University, as quoted in USA Today May 6, 2004, found that the actual three-year failure rate for restaurants is 59 percent. For small- and mid-sized businesses overall, the number is 50 percent over five years according to David Birch, a small-business research expert. Yet for those small businesses who choose HRO services from professional employer organizations, or PEOs, the anecdotal evidence is that the failure rates are much lower, probably as low as 15 percent for companies with less than 500 employees and 5 percent for 500+ employee companies, according to HRO Today’s informal survey of PEO top management.
What are the factors that go into picking the right HRO provider for small- and mid-sized businesses? How are companies that go the HRO route different from their go-it-alone counterparts? What is the experience of those who have partnered with a PEO? What are the risks and rewards? For these answers and many more, HRO Today turned to some of the leading PEO providers and their clients for frank answers and very revealing lessons. Here are their stories.
Finding Precisely the Right Partner
For Precyse Solutions, a successful HR outsourcing was all about finding the right partner.
Finding the Right Partner at the Right Time
A time and a place for HRO: for this growing company, HRO was a question of when, not if.
Man Bites Dog: Small or Large Provider?
Regus knew that one day they were going to outsource HR. The question was, what type of company could best meet its needs?
A Shot of Employee Satisfaction
Jose Cuervo Internationals HRO satisfies its highly discerning customers & Cuervos employees.
Brining the shine back to the PEO industry.
For 20 years, PEOs have been more sizzle than steak. Over-charged customers, faulty IT, scams, and catastrophic failures have overshadowed the successes. Finally, one company has broken through to the Holy Grail. But which one?
I have seen the future of the PEO, and its name is enterprise-level HRO for small business. It is a future I have predicted before. But until now, the reality was one brick shy of a load. Providers have lacked sufficient scale and adequate risk-management. They have lacked a mature management team and transparency in their IT systems and finances. And most importantly, they have lacked a broad, satisfied, and sustainably-priced client base.
For the first time, I see one company with 8,000 happy customers and 140,000 satisfied serviced employees. It has customers in more than 40 industries and in 50 states, paying more than $1,600 per employee per year, a price that is reasonably in line with value received. I see strong scale economies, with capacity for two or three times more customers. I see open financials and technology. I see an experienced management team befitting of an industry leader. I see both coemployment and non-coemployment choices for clients. I see a sales leader focused on ramping up to 15 percent net annual growth from new sales and cutting the cost of customer acquisition from its current $1,250 per employee to much lower numbers. I see the future. It has finally come. Hallelujah.
Certainly, because one company has done it, others will surely follow. Now more small business customers can be on a level HR playing field with the Fortune 500.
This news is quite convenient for us. Imagine, this clear winner emerged just in time for HRO Todays special feature on the segment (see the center gatefold).
The PEO, an acronym for professional employer organization, has been around since the late 1980s. The niche has always held bucket-loads of promise. It serves a great unmet needfor HR services and affordable benefits for small business. It spawned a high-flyer stock or two and some spectacular train wrecks. The business attracted some scoundrels. Some of those bad guys ended up in jail. Our center gatefold timeline of the PEO industry tells the tale of some horrors, near-disasters, and even flashes of brilliancea story of evolution in action. It is not unlike the history of 19th century British banking. After all, it took British banks nearly a century to figure out how to make a profit.
I have been waiting for this moment for a long time.
After a decade of publishing technology magazines such as PC, CRN, and UPSIDE, in 1993, I started a company called Payroll Options, as a division of public staffing company Uniforce. It converted 1099ers of Sun Microsystems, Wells Fargo Nikko Securities, and Silicon Graphics, among others, to W-2 employees, and leased them back. We cut employment tax and other risks for big company clients. Although I did not know it at the time, Payroll Options was a PEO. Then I started another one, ABE, now a big winner for Californias Nelson Personnel.
In 1995, as VP of Sales for TriNet, a PEO, I perfected that companys focus on venture-capital backed technology clients. In 1997, as CEO of EmployeeService.com, I invented a new employee service model for small and mid-sized business, the ASO (Administrative Service Outsourcing) or non-coemployment HRO services. I raised $20 million in venture capital and landed 150 dot-com clients. At peak, EmployeeService profitably served 20,000 employees. When the dot-com bomb burst in late 2000, so did the company. But my vision of HRO for small- and mid-sized businesswith both coemployment and non-coemployment options still burns strong.
HRO Today magazines mission is an extension of that visionto bring the promise of outsourced HR services to all business and government, big, midsized, and small.
It makes sense that it has taken a few years longer to grow a clear winner in the small-business HRO space than it did for several heavyweights to emerge in the large-market HRO space. To be sure, acquiring one 30,000-employee client requires much less selling, management effort, and expense than selling 2,000 clients of 15-employees each.
Proof of the wonderful promise of small-business HRO is the fact that you have read this entire column just to discover the winning companys name. Now here comes the payoff. Just go to your browser and type in GevityHR.com.
Look for the biggest and most effective PEOs to get bigger and more effective.
I have to apologize for leaving you hanging. In the last edition, after a brief history of the PEO and a discussion about their recent success in the public markets, I abruptly ended on a quite cynical (okay, dire) note about the future of the industry. Let me clarify.
I believe the co-employment (i.e., PEO) model will continue to work, and for some, thrive. Administaff, GevityHR, and TotalSource all generate (or are on target to generate) operating profit of $100-200 per serviced employee annually-that is real money to which investors and analysts will attach real value. However, I do not expect the sector to swing back into favor in the eyes of investors, and therefore, I do not expect the area to re-emerge as a booming area within business services. What I do expect is the perception of the co-employment model and possibly the PEO business model to change over the next few years.
The staff leasing (predecessor to the PEO) sector was created as a vehicle for small businesses to obtain cost-effective insurance. The idea was that scale, effective claims management, and the ability (sometimes unwarranted) to assume risk enabled the provider to maintain a lower cost of insurance. When PEOs emerged in the public markets in the late-nineties, the value proposition changed to one of fee-based HRO-much like you would find with ADP in payroll or TALX in automated employment verification. The trend has clearly been to de-emphasize insurance as part of the value. Administaff has always maintained a “white collar” focus within its client base; GevityHR has dramatically lowered its workers’ comp exposure; and ADP-TotalSource spent two years cleansing its worksite employee base. I believe the co-employment models-even the ones just mentioned-remain heavily reliant on the value of delivering cost-effective health and workers’ compensation insurance to small businesses. In other words, a substantial portion of the $100-200 per serviced employee per year comes from insurance-related profits, in my view.
Big problem? It depends. Insurance-related profits can be okay, at least for a while. Clearly, there is value to aggregating employees for distribution efficiencies. Insurance underwriters often struggle with cost-effectively serving the small business market, due to high cost of sales and service, and sometimes adverse selection. As a result, it is not uncommon for the premiums for comparable coverage to be substantially higher for small businesses on a per-employee basis, or for underwriters to actually pull out of some small business markets altogether. If PEOs can deliver small business employees to underwriters at a reasonable cost, value is created. How much value depends on many factors, but a good starting point is the sales commission typically paid to insurance agents. A 10 percent commission rate on health and workers’ compensation combined could produce “value” of more than $500 per employee per year or more-interestingly, this turns out to be the difference in gross profit per employee between a co-employment contract and ASO contract.
Insurance-related profits are bad (unsustainable) when the difference between what the PEO pays for coverage and what clients pay for coverage is simply the result of the PEO absorbing a higher level of risk. This is called insurance arbitrage, and is predicated on the notion that PEOs either do a better job than the insurance company in assessing risk (doubtful!), or believe that they can actually reduce risk (a possibility). Over periods where claims experience is relatively light and abnormally few adverse events occur, profitability may appear extremely high. However, the tables can turn quickly, and PEOs often do not have a strong enough balance sheet to handle a worst-case scenario.
The co-employment model will likely survive, but the perception will undoubtedly change over time. If the value proposition of co-employment is largely rooted in efficient insurance distribution, then the sustainable business models must include size, consistent client selection, and effective management and operations. Due to the complexities of employment and insurance, the PEO business is one of the most difficult to manage. Do not expect to see a line-up of new publicly traded PEO prospects coming out of the woodwork. Rather, look for the biggest and most effective to get bigger and more effective.
The PEO rollercoaster.
Surviving PEOs are bouncing back, but does it mean the industry will do the same?
When I began my career as an analyst in the mid-90s, my first major project was to understand an emerging area that promised to transform small business HR-the PEO. My goal was to figure out whether this would be an investible area. My conclusion? I am still working on it.
For those not familiar with the PEO concept, it is most easily understood from the client perspective. A company outsources their entire HR function and their employees become employees of the PEO for administrative purposes-a co-employment relationship. This offers small companies “big company” benefits. The value proposition is straightforward. The challenge is in managing the risks and the costs- PEOs act as underwriters and distributors of workers’ comp, healthcare, and state unemployment insurance. If the price charged to clients does not cover the losses, the PEO will have problems.
For the first few years, PEOs were a hit in the market. Employee Solutions, Vincam, Administaff, OutSource International, and Staff Leasing took turns in the IPO spotlight. Investor favorites ADP and Paychex paid large sums to buy their way into the business, legitimizing the model. However, investors discovered (the hard way) the difficulty PEOs have in managing risks. Employee Solutions and Outsource International became insolvent-largely due to inadequate workers’ comp reserves and acquisition-related issues. Vincam hit a wall following several acquisitions, before selling to ADP. Staff Leasing imploded more than once after discovering inadequate health and workers’ comp insurance reserves. And Administaff’s stock fell more than 90 percent during the nine months following the announcement of a dispute with its health insurance carrier. By mid-2002, investors had seen enough of the PEO.
But 2003 has been a different story. The two pure PEOs in the public markets, Administaff and Gevity HR (formerly Staff Leasing), have increased 81 percent and almost 300 percent, respectively (see charts below). Administaff is now trading at more than 5 times its low and Gevity at more than 18 times. TotalSource (ADP’s PEO) has arguably become one of ADP’s best performing business units, growing 37 percent in the recent fiscal year. Why the sudden turn? First, each of the Big-3 companies has undergone significant change resulting in stronger business-Gevity has refocused sales and retention on the less risky white collar clients; Administaff has changed health carriers and overhauled its billing system. Second, the extraordinarily tight insurance market has forced many smaller competitors out of business. Finally, rising insurance costs have become a big problem for small businesses, increasing the value proposition of the PEOs.
Is the PEO coming back? I don’t think so, and I would be cautious when considering investing. While the Big-3 should continue to show improving results, the industry faces three key obstacles: (1) Legislation is working against PEOs (more on that next month); (2) Insurance markets change-a less penalizing market for small businesses could take away from the PEO value proposition; and (3) The ASO concept is gaining traction, particularly among the payroll processors. Next month, I will elaborate on these challenges.
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