What Are the Fundamentals of Valuation?

In the market today more and more agencies are trying to figure out how to grow their book of business.  Well one of the best ways to do this is to look into growth by acquisition; this can be a very valuable tool when part of an effective strategic marketing plan.  Before an owner can think of growing through acquisition they must make sure their agency can grow internally.  If the agency is not showing growth internally it is not going to look appealing to an outside buyer.

Since many agencies today are using acquisition as a major growth strategy, you need to understand valuation for that transaction.  When an agency is at either end of a merger or acquisition the issue of agency value is a poignant one.  If an owner already in the middle of the deal it is probably too late to worry about agency value.  The time to take action is well before any move toward a merger or acquisition or even implementation of an internal buy-out.

So how are insurance agencies valued?  Well there are actually a few ways.   The first way is through a multiple of revenues.  This approach for valuing a business is outmoded and is not recommended by most professional consultants.  This method survives by word of mouth and misunderstanding.  Multiples published in trade journals or consultants’ newsletters after a sale is a reference used to communicate the purchase price, but does not detail the actual approach to the establishment of that price.

When a valuation uses a multiple of revenue it ignores variation in profitability and risk.  Two firms with the same revenue may vary significantly in both the risk that profit will be sustained, as well as in the actual profit margin.  An astute buyer would not pay the same revenue multiple for both firms.

The next approach to valuing a company is fair market value.  This is how a professional consultant would appraise and agency.  Fair market value is defined in IRS Revenue Ruling 59-60 as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Fair Market Valuation is dependent on three major factors:

Sustainable Earnings Capacity — the value of the firm’s earning capacity, the profit the firm should be able to generate for a third-party.

Inherent Risk — the value of the firm’s earning stream must be tempered by the risk that the earning capacity will not be maintained over time.

Tangible Net Worth — the value of the firm’s balance sheet after assets have been turned into cash and all liabilities have been satisfied.

After the consultant has looked into these factors they will then adjusts the pretax earnings by making pro forma adjustments.  These adjustments are done to show the true earning potential of an agency that a third-party could expect to generate.

In each of the valuation methods, value is adjusted to take into account the amount of working capital necessary to produce the income stream.  An investor buying only a book of business typically contributes working capital of 30 to 60 days (45 is average) of cash to generate the income stream. The amount varies based on the collection practices of the agency.

In conclusion, the most important action you can take to improve your agency’s value is to commit to make all decisions based on their effect on the agency’s value.  Owners should operate as though they need to justify those decisions to a third-party.  By following the advice above owners can position themselves today to sell at an above average fair price tomorrow.  Remember that everyone must sell someday, either internally or externally and why not maximize the price!?

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