As Background Checks Get Big, the Little Guys Get Bigger
By JEFF BAILY

November 16, 2005

As long as employers have wanted to check up on job applicants, an industry of tiny background-checking companies has existed, prowling courthouses to check criminal records and working the phones to verify employment and education.

Driven by post-Sept. 11 wariness and the spread of public databases that enables more efficient checking from distant locations, the industry is now rapidly consolidating. A handful of national companies is bulking up by buying smaller competitors, seeking dominance in a business expected to double in sales over the next five years to $4 billion.

So the question is, does the little guy stand a chance? The answer appears to be yes, with enough capital and some smart investments in technology.

Sterling Testing Systems in the Chelsea section of Manhattan is betting that though bigger may be better, biggest is not necessarily best.

Sterling got by on sales of less than $1 million a year for two decades, but it has bulked up, too, in recent years, expecting 2005 sales of about $50 million, said William M. Greenblatt, the founder and chief executive. Sterling has also raised $9.5 million in capital to help pay for investments in technology to become more efficient, and now employs 700, including about 100 lower-cost workers in India.

At first glance, the industry appears to favor size over the hustle and grit of entrepreneurs. Expensive technology, as Sterling knows, is crucial.

The industry is going global, both in checking up on people who have moved around internationally and in sending repetitive tasks (phone calls, checking databases and the like) offshore to reduce costs, as Sterling has done as well. And there is the brand-name factor. A foul-up for the customer - imagine the headline announcing that your company hired a convicted sex offender because of a botched background check - is so horrible to contemplate that many employers instinctively choose a big, well-recognized provider to soothe the hiring manager's nerves.

ChoicePoint and First Advantage lead the pack, each buying in recent years smaller background-checking companies in a consolidation play known as a rollup.

Yet Mr. Greenblatt, 48, thinks that Sterling has enough scale to compete profitably against the larger companies, but it is not adding bulk for bulk's sake. "The very large companies are driving a cruise ship through icebergs," he said. "We're on a Jet Ski."

It will probably be years before the sinkers and the swimmers are clearly identified in background checking. But the record of more than 40 years of rollups in other major industries suggests that Mr. Greenblatt's skepticism of his biggest competitors is warranted. Rollups in trash hauling and funeral homes failed to effectively integrate acquired companies and ultimately their once high-flying stocks, which had been the currency to finance acquisitions, came crashing down.

Knowing that history emboldens smaller players in any industry now to say no to buyout offers, or to insist on cash for their company instead of stock. An abundance of investment capital means even smaller players can attract money to finance their growth and therefore remain independent.

Much of the background-checking industry's growth is owed to a paradox of the corporate human-resources function. Companies want to know all about their new hires, but they typically refuse to disclose much of anything about their former workers. So, stymied on their own, they hire background checkers.

Meanwhile, the cost of some elements of background checking have been falling, thanks to searchable databases. With the price lower, and with Sept. 11 and well-publicized instances of convicted felons being hired for sensitive jobs, there are fewer excuses for not ordering a check.

"There's wind at the back of the industry," said Mark Jennings, a partner at Generation Partners, a private equity firm that has invested in Sterling.

Still, criminal and other public records remain a patchwork. Some states have consolidated records, some haven't. People move around. There are more than 3,000 counties in the United States and some 5,000 separate court systems, said Bob Schlossnagle, an executive vice president at Kroll Background America. Depending on the breadth of the search, his company charges $25 to several hundred dollars for a standard check.

What does it find? About 20 percent of the entry-level work force has at least been arrested at some point. And about 30 percent puff up work experience or credentials.

Like its competitors, Sterling taps into databases and also hires some shoe leather.

Maria Calle, 36, who works in the San Diego County district attorney's victims assistance program, moonlights for Sterling by checking criminal records. One recent day, 9 of the 25 names Sterling sent her had an arrest record, Ms. Calle said. She bumps into other runners for competing background checker at the records department.

"It's a nice little side gig," she added. "My check comes every 15th and 30th."

In a study published earlier this year, KPMG, the accounting and consulting firm, found that employers rank the price of the service as the most important consideration when choosing a background-checking company. That pushes prices down. Profit margins, however, have strengthened as investments in computer systems have meant more efficiency.

Amid the consolidation, the KPMG study found that 27 percent of background-checking companies had mulled selling their business in the last year, and more than half had been approached by a potential acquirer.

Still, Cherie Smith Homa, a KPMG managing director, said the biggest firms were not necessarily going to win out. Integrating computer systems on acquisitions has been a problem, she said, which can be frustrating for clients trying to buy a range of background services from a single company.

"The reality is - First Advantage, ChoicePoint - they are running a number of different disparate systems," Ms. Homa said. "They have yet to come out with a solution that is commensurate with their position in the marketplace. That's not to say they won't."

She cites Automatic Data Processing, the payroll company that also conducts background checks, and Sterling as two with high-quality technology that is easy to use.

Still, she said, "No one ever got fired for saying I'm going to give this to ChoicePoint." The Top 5 background-checking companies, she added, are in that enviable position. Employers are increasingly worried about hiring mistakes.

Carmike Cinemas, a movie-theater chain, agreed in September to pay $765,000 to settle a lawsuit filed by the Equal Employment Opportunity Commission, which accused a male supervisor at a theater in Raleigh, N.C., of sexually harassing young male employees there. According to a related lawsuit filed by parents of some of the young men, Carmike hired the supervisor, a convicted sex offender, without checking his background.

Judy Russell, a Carmike spokeswoman said that since October 2003 the company has regularly done background checks on new employees 18 and older, and has also gone back and checked on current workers. Before that, she said, "We did not do background checks on theater-level employees." She would not comment on the E.E.O.C. lawsuit itself.

About 40 percent of ChoicePoint's 2004 revenue of $918.7 million came from business services, which include pre-employment background checks. And about two-thirds of First Advantage's 2004 revenue of $266.5 million came from business services that include background checks.

Mr. Greenblatt of Sterling said he wants to hit $400 million in sales and see what happens then. "I'm not in this thing to make a quick buck and retire," he said. "I've been doing this since I was 19. I hope to die here."