As the M&A frenzy continues, buyers keep pushing the envelope when it comes to agency value. The private equity firms were initially paying top dollar to their first acquisition of a large, well-run firm platform acquisition. But now, many of the follow up acquisitions are offered similar deals.
What is Value?
When an agency owner sells their business, what are they really selling? The purchase price may include some value for receivables, retained cash, desks, office equipment, cars and computers. However, the main value of an insurance agency comes from its intangible assets.
Agency value is based on the cash flow that the business can generate. A buyer is looking for an existing business, its current clients, employees and other factors. These are assets that any business has.
There is a clear pattern of the components contained in a high value agency versus a low value agency. Both agencies may appear to run relatively smooth. They may even both provide the owners with a comfortable living. However, an astute buyer will look beneath the veneer to analyze how each agency is running.
Buyers are interested in the sustainable earnings that the firm can generate year after year. Both firms may have similar earnings under the current structure and with the current owners. In a high value agency, the potential earnings will remain long after the current owners sell. Low value agencies have a high risk that the earnings will not continue, so the buyer will heavily discount value.
There are several factors that distinguish a high value agency from a low value agency. Owners of low value agencies are often caught by surprise because they did not understand how the manner in which they run their business would adversely impact the agency value.
The profitability of any agency is directly related to compensation costs. These expenses are typically two-thirds of revenue. Therefore, low productivity and overstaffing will lower profits and thus lower the agency value.
Small agencies are impacted more by overstaffing than larger firms. If an agency needs only the equivalent of two and a half full-time CSRs, but they have three fulltime CSRs, they are 20% overstaffed. A large firm could have 33 CSRs but only need 30. The extra three CSRs accounts for only a 10% overstaffing condition.
It is not unusual for an agency to have a long-term employee that did not grow with the firm. That employee often works inefficiently or performs work that is redundant to other employees. The owner keeps that employee around out of a sense of loyalty.
Loyalty in this case does not necessarily mean it is in the best interest of both parties. If the seller insists the buyer keep all the employees, then the buyer can only afford to pay a lower price. A buyer who inherits extra employees, without any stipulation to retain them, most likely will fire them after the sale in order to generate a profit so they can pay the seller. Either way, someone loses — a lower value for the business or the firing of unnecessary employees after the sale — due to the seller’s management style.
Agency staff should always be well trained to allow them to grow with the ever-changing business environment. Productivity standards need to be set and adhered to. Performance reviews should be given annually at their anniversary date. Employees that fail to keep up should be put on notice and fired if their performance does not improve.
No Producer Contracts
There are many excuses not to have a producer contract: they are expensive to draft, they cause ill-will between parties, they are easily broken, etc. All of these excuses have some element of truth. The important point is that the lack of producer contracts will lower the agency’s value because no contracts increase the risk associated with the agency’s continued earnings potential.
Two topics all producer contracts need to cover are compensation and ownership of the business. Some agencies may also have a deferred compensation plan for the producer. Excessive producer compensation will certainly lower the agency value since it will lower profits.
A buyer is also interested in a clear understanding of who owns the business. Agencies without contracts for their producers might feel that the agency owns the business. But it often happens that the producers do not agree, and they may eventually walk away with their books of business. The agency then has little or no recourse since there is no formal agreement. The bottom line is that you cannot sell what you do not own. Buyers often make their purchase offer contingent upon having all producers sign a contract, which also must stipulate that the agency owns the business.
Account Ownership and Deferred Comp
Agencies that allow producers to have ownership in their book of business must understand how that impacts value. If the book is owned entirely by the producer, many buyers will not include it in the revenue stream or might pay the producer directly as part of the deal. This is because the agency owner does not own that business; the producer does. If the producer threatens to walk, the buyer may end up paying for that business twice.
It is better for agency value when the agency retains full ownership in the business and then sets up a deferred compensation or vesting plan to allow the producer some equity for their efforts. This eliminates any dispute on ownership while still satisfying the producer’s need for building equity and a retirement plan.
Producers Tied to All Accounts
Many owners and producers see virtue in the fact that they know all their clients and have an excellent relationship with each one. There is a difference between knowing your clients and having your clients dependent upon the owner or producer for most things.
Agencies whose clients are tied to the owner/producer are less desirable to a buyer than an agency whose clients don’t have a strong bond to the owner/producer. Or at least there is also a strong bond between the client and the service staff in high value firms.
A buyer needs to know that there will be a smooth transition of ownership without the fear of losing key accounts. If the seller is really tied to their accounts, a buyer may require the seller to stick around for a few more years than the typical two or three years to assist in the transfer of the relationships.
Many deals are also done on a retention basis. If the departure of the owner or producer also means the departure of the clients, the earn-out to the seller will dramatically decrease.
It is better to have the client look to the service staff for their day-to-day service needs rather than the owners or producers. Owners and producers should mainly be involved with the initial sale, remarketing of medium-to-large accounts and problem solving for major issues.
Only the service staff should handle the small accounts. Accordingly, a producer should be paid renewal commission only for medium and large accounts. Keep in mind that small and large are relative. A large regional broker might consider accounts under $5,000 in commission as small. Whereas, a small firm might set the small account limit at $500 in commission.
The key to value is profit. If a firm is paying 30% commission to a producer for small accounts that the producer does not even work on, then that 30% is pulled from the bottom line.
The Last Word
There are many factors that a buyer considers when looking at buying an agency. The main consideration is the ability to create and sustain a profit. Most of the active national buyers today only do deals with agencies that generate at least 25% to 30% or more in profits.
Most buyers are interested in well-run firms that would enhance their current business situation. Agencies that are poorly managed have fewer interested buyers and often get low offers for the business.
A good credo to follow is to always run a business as if it is going to be sold today. Streamlined operations have fewer problems and generate better bottom line profits. The owners of these agencies will make more money now and in the future.
Oak is the founder of the consulting firm, Oak & Associates, based in Northern California and Central Oregon. Schoeffler is an associate of the firm. Oak & Associates specializes in financial and management consulting for independent insurance agencies, including valuations, mergers acquisitions, sales and marketing planning as well as perpetuation planning. Phone: 707-935-6565. Email: firstname.lastname@example.org.