It’s well-known in the staffing M&A community that the more direct hire business a staffing firm has relative to its contract business, the lower its valuation. Even 10-20% of revenue from permanent placement lowers Enterprise Value to EBITDA multiples by as much as 50%. That means a staffing firm with $1M EBITDA (Earnings Before Interest Taxation Depreciation and Amortization) with a heavy direct hire mix might have a 3x EV/EBITDA multiple, meaning their Enterprise Value is equal to $3M (3 x $1M EBITDA). In comparison, another staffing firm with the same $1M EBITDA from 100% contingent staffing might have a 6x multiple, giving them a $6M valuation. There should be a few questions for staffing firm owners, especially those who are early enough to structure their business mix. First, is this true? Does permanent placement really create such low enterprise value? And, if yes, why is $1 of contingent EBITDA worth sometimes 2x more than direct hire EBITDA?

Are direct hire firms worth less?

The best way to determine whether direct hire lowers valuation is to look at what other staffing firms are selling for or what public staffing companies are trading at (what investment bankers call “trading comps”). Unfortunately, few private staffing M&A transactions disclose their valuations, and relatively few publicly traded staffing firms to examine. Determining the mix of direct hire versus contract staffing is difficult from the outside for private staffing firms.

Our best bet is to look at publicly traded staffing firms where we can see the EV/EBITDA multiple and determine their revenue mix between direct and contingent from their financial reports. Two extreme examples are the publicly traded executive search companies Heidrick and Struggles (HSII) and Korn Ferry (KFY), which have virtually no contingent staffing revenue. Compared to the rest of the publicly traded staffing companies, which have varying degrees of direct hire revenue, the executive search firms trade at dramatically lower multiples. Both have traded around a 5.5x EV/EBITDA multiple on average for the last five years. Other staffing firms with relatively more minor direct hire business lines have traded around a 7.5 EV/EBITDA multiple.

These are not perfect comparisons since executive search firms have retained search revenues and have other services that are not directly analogous to direct hire placement fees. Another analysis would be to look at the publicly traded staffing companies and then evaluate their percentage of direct hire revenue versus their EV/EBITDA multiples, controlling for factors such as size, location, and growth. We won’t do this analysis now but will leave that to a future post. We’ll take it as a given that direct hire lowers valuation.

Why is direct hire valued so low?

Most staffing executives and M&A professionals will say that direct hire is valued less because it’s not recurring. It’s helpful to put this into concrete terms to see why this matters for a buyer, so let’s look at two hypothetical staffing firms.

Our assets walk out of the door each evening. We have to make sure that they come back the next morning.

- N. R. Narayana Murthy, co-founder of Infosys

Hypothetical Staffing Firms

Staffing Firm A makes ten direct placements for the year with ten clients, with each candidate making a $200,000 annual salary. The recruitment fee is 30% of the yearly salary, so the staffing firm makes $60,000 x 10 placements, which is $600,000. The staffing firm’s expenses and costs are $300,000, so they make $300,000 EBITDA for the year. Staffing Firm B places ten temporary assignments for ten clients, each with a pay rate of $200,000 and a markup of 50%, billing the client $300,000. Since payroll burdens cost 20% for the firm, staffing firm B makes $60,000 gross profit for each contractor, $600,000 for the year. The underlying expenses and costs are also $300,000, so staffing firm B makes $300,000 EBITDA. While Staffing Firm A and B’s revenue are the same, Staffing Firm B earns monthly revenue as the contractors work for the end clients. So why is Staffing Firm B’s revenue so much more valuable? Unfortunately, our example takes a turn for the worse. Staffing Firm A and B’s recruiters have a tradition of celebrating New Year’s Eve together, and this year, they decide to fly to St Kitts for a party weekend. Disaster strikes and the plane goes down; all the recruiters perish. Tragedy aside, on January 1, whose business is more valuable?

Staffing Firm A, which no longer has recruiters, will have $0 revenue from January onwards. Staffing Firm B, on the other hand, will have revenue as long as the contractors continue to work for the client, which could be many months.

This example illustrates what people mean by the value of recurring revenue from contingent workers. For the contingent firm, the recruiters could disappear, yet the contingent contractors would still produce revenue, making the temporary assignments more valuable. Contingent firms sell eggs from their golden goose (the candidate), and permanent placement recruiters sell off their golden goose at every placement. Since direct hire firms are fundamentally selling off their assets, their revenue depends on a constant effort to acquire and transact assets; thus, investors treat perm fees as one-off cash influxes incompatible with revenue multiples. There are examples in other industries where one-off revenue is valued less than their recurring cousins: Custom manufacturing versus manufacturing, Project-based software development versus software as a service, and construction companies versus building maintenance. When the work stops, the revenue stops.

Other Reasons Contingent Revenue is Valued More

The recurring nature of the revenue is not the only reason contingent staffing is valued more than direct hire. Contract staffing firms have more power. If the perm placement recruiter gets fired from the client, the end client’s business goes on. If the client fires a contingent firm, workers might not show up, and the company might stop: that’s power, and it gets translated into consistent profit. Contingent staffing firms have more regular contact with a client’s business. Contract staffing firms insert themselves into the day-to-day operations of a client, understanding their business and their organization in a way that allows more sales and further integration, if only for being around for opportunistic moments. Contract staffing has lower month-to-month volatility of earnings. Contingent placements happen faster and more frequently, whereas clients reject permanent search submissions much more often, potentially leaving months of revenue drought on a per-client basis and more inherent revenue volatility. Contract staffing firms experience lower recruitment costs over time. Candidates can work for several clients over several years, with a close relationship with the staffing firm. In contrast, a direct hire candidate will be gone after the placement, with few touchpoints to re-engage at some unknown future point. Direct hire is more competitive. The direct hire barrier to entry is essentially zero, making the perm market very fragmented and filled with hyper-niche players. Anyone can set themselves up as a perm placement recruiter. Contract recruitment has barriers such as working capital financing, insurance, and operational requirements such as payroll and compliance.

Reasons to do direct hire

Is there ever a place for direct hire if the goal is to maximize long-term valuation? Yes, permanent placement is not going away since clients need permanent candidates, so there will be demand, whether in the form of conversion fees or placement fees, so it’s irresponsible to reject this client demand. Permanent placement goes straight to the bottom line (there is minimal cost other than commission), so it’s helpful for newer firms with funding constraints. However, this cash comes with a price since the contingent candidate would have produced more revenue. Like selling a house instead of renting it out, sometimes you simply need the cash. Last, and perhaps the best-kept secret in staffing, direct hire can help you place a leadership candidate in a client that will eventually purchase staffing services from you. The top staffing firms use direct hire strategically to drive contingent business.

What should direct hire firms do?

Look into contingent staffing, ask your clients about their needs, and try to use contract staffing as a foot in the door with clients. Don’t be intimidated by the barriers to entry for contract staffing. Many firms can help you do everything regarding staffing back office, compliance, payroll, billing, and funding (my company, Ascen, is one of those companies, but there are several excellent ones to choose from).

No matter what your current mix is of direct hire and contract staffing, just remember that by increasing your touch points with your clients, making yourself more important to your client’s businesses, and holding on to your dearest assets, your candidates will improve your current and future value as a recruitment firm.

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