A New Look At Insurance Agency Valuation

CMEditor

This content has not been rated yet.

A NEW LOOK AT INSURANCE AGENCY VALUATION

by Carol Hammes

It’s becoming increasingly important for agents to recognize that having a complete, professionally prepared appraisal won’t always provide the answers they need. If you’re planning on selling your agency, either internally or externally, there might be a better way to use a consultant’s expertise. Carol Hammes takes a look into contemporary agency valuation and provides an article on the subject by IMMS Consultant Chris Burand.

 

For example, it might be more advantageous to have outside assistance in running cash flows and helping you decide how to structure the transaction to minimize the tax consequences. Or you might need only a short opinion letter rather than a 40-page evaluation of the agency and its value. Knowing why you need assistance and being able to communicate this to the consultants or accountants will help both them and you decide the best approach.

In any transfer of ownership it’s important to recognize that expenses and cash flow will probably be different than they are in the existing organization. But how different they’ll be and in what way depends on the circumstances. A buyer who merges an agency into their organization and eliminates a stand-alone office will realize greater expense savings and thus higher cash flow than one who’s going to use the agency as a branch office. It’s important to recognize that internal buyers won’t generate the expense savings or extra cash flow that an external fold-in buyer would achieve.

This means that agency principals seeking to maximize the value of selling the agency might have to look for outside buyers. Selling internally can be psychologically more appealing, particularly if some of the buyers are family members. But it also means that the selling principal might have to take a discount so that the younger people could afford the payments. The days of having employees willing to guarantee a price of two times commissions are pretty much over.

Even if the hard market lasts for a few years (which will help drive up the prices that buyers can afford to pay), most agencies can’t and won’t generate enough cash to support values much more than 1.5 times commissions. And many will have a multiple value of less than one times, particularly if the balance sheet is weak. At least 50% of the agencies in this country have a negative tangible net worth that seriously decreases the value of the stock or partnership interest. The impact of this condition on overall value and ownership return in certain types of valuation situations can be significant. Selling owners need to recognize both the realistic value of the future cash flow and its potential impact on the balance sheet in negotiating with prospective buyers to make sure that the price is right. There’s nothing worse than having to come back in and take over an agency several years later.

The following article was written by Chris Burand (Burand & Associates, Pueblo, CO). Chris began his insurance career in 1987 as a company underwriter and marketing representative. He’s a frequent contributor to trade publications and has been a featured speaker at more than 100 seminars and educational programs across the U.S. and Canada. Burand & Associates was established as a consulting firm in 1992, under the name of Growth Planning, to help independent agencies determine their competitive advantage and how to pursue it. The firm provides appraisals for various purposes, contingency contract analyses, cost of sales analyses, advice on setting up compensation plans, and merger and acquisition assistance. Chris can be reached at Burand & Associates, LLC, PMB 345, 1829 S. Pueblo Blvd., Pueblo, CO 81005, (719) 485-3868, fax (719) 485-3895, e-mail [email protected], or Web site www.burand-associates.com.

 

AGENCY VALUATIONS: WHICH DEFINITION IS BEST FOR YOU?

When asked to complete an agency valuation, experience has taught us the first question we should ask is, 'What definition of value would you like to use?' This might sound esoteric, but it’s something all agency owners should consider before having their agency valued. Different definitions are appropriate for individual situations and lead to far differing values. Here’s a summary of the most common definitions of value, their strengths, and their weaknesses. Each definition requires its own set of assumptions and adjustments. This summary is not meant to be all encompassing or to be used without further guidance.

FAIR MARKET VALUE

Definition:

Fair Market Value (FMV) is based on '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 the relevant facts.' Additionally, a landmark ruling states, 'The willing buyer and the willing seller are hypothetical persons, rather than specific individuals or entities, and the characteristics of these hypothetical persons are not necessarily the same as the personal characteristics of the actual seller or a particular buyer.'

Furthermore, FMV assumes the buyer is an arms-length, financial and not a strategic buyer. A strategic buyer is a buyer who could bring value-added benefits that would enhance the agency and/or enhance the buyer’s other business activities through the acquisition. Examples of a strategic buyer who could bring value-added benefits are another insurance agency, an insurance company, or a bank. Also excluded are buyers who are already shareholders, or related or controlled entities that might be willing to acquire the interest at a higher or lower price due to considerations not typical of the motivation of the arms-length, financial buyer.

Other common FMV assumptions include:

1. The business will continue as a going concern and the current owners, if they’re managers, will be replaced upon the sale of the agency.

2. The Appraisal Foundation’s definition of Fair Market Value states that payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto ... This means the agency is being purchased on a guaranteed cash price rather than on a renewal basis or with debt.

3. The seller will stay with the agency after the sale for a reasonable amount of time to smooth the transition of accounts and improve retention.

4. The valuation is based on 100% controlling, closely held basis.

Uses

FMV is probably the best known definition of value and thus, the most commonly used. FMV valuations are popular for buy/sell agreements, estate planning, some mergers, internal perpetuation, and anything that might involve the government such as taxes. FMV might be appropriate in other situations, too.

Strengths

FMV probably offers the most precise definition of value because the IRS has specified standard rules for completing FMV valuations. Further strengthening its definition is a considerable case and tax law history. It’s also the least biased method because it generally doesn’t favor the buyer or the seller.

Weaknesses

FMV’s precise definition and assumptions have a huge effect on an agency’s value. Because the buyers and sellers are hypothetical, the agency’s actual future expenses aren’t a concern. As a result, the FMV might not be appropriate for some situations, such as an internal buyout or when an external buyer is known. For example, the hypothetical financial buyer defined by FMV would probably not continue to employ an experienced producer with a $100,000 commission book on which he was being paid 50% of renewals. The result: the pro forma (adjusted) profit margin will be much higher than the agency’s real profit margin, which in turn will result in a higher valuation. If the actual sale is internal between partners, then the valuation might be so high, the buying partner can’t afford to buy their partner’s share.

MODIFIED FAIR MARKET VALUE

Definition:

Modified FMV is based on how the agency really operates, not how a hypothetical buyer would operate it. Certain expenses are still adjusted, as are revenues when required, but other adjustments typical of an FMV aren’t. For example, the experienced producer with a $100,000 commission book making 50% on renewals might not have their compensation adjusted under the modified FMV definition.

Uses

Modified Fair Market Value is most appropriate for internal perpetuation and buy/sell agreements. Other practitioners call this a 'going concern valuation.' However, because most valuations (except a liquidation valuation) are 'going concern' valuations, I avoid using such a misleading title.

Strengths

Because modified FMV is based on how the agency currently operates, the resulting value might be more realistic, fair, and affordable for internal perpetuations and buy/sell agreements.

Weaknesses

Modified FMV can open the door to significant disagreements between the buyer and seller regarding expense and revenue adjustments. This is because it’s biased toward the current ownership, often resulting in the selling partner getting a lower price than if FMV is used.

Buyers and sellers can resolve this by agreeing to use the judgement of an appraiser or by negotiating income and expense adjustments, item by item. Either way, a modified FMV still often results in a lower value than FMV.

FAIR VALUE

Definition:

Generically, fair value means the value of the stock (or assets) without discount for the abuse a controlling shareholder(s) might cause non-controlling shares. In other words, small shareholders should get the same price for their shares as majority shareholders. Under FMV, the valuation industry and the IRS generally recognize that the per share value of small stockholders of private and closely-held companies is worth less than that of majority or controlling shareholders because the controlling shareholder controls the corporation.

Uses

Fair value is often used in lawsuits, particularly divorces and minority shareholder suits.

Strengths

Fair value protects minority shareholders, spouses, and non-controlling shareholders from getting poor values for their stock, even if the poor value is the fair market value.

Weaknesses

Fair value isn’t as well defined as FMV. So before using it, an attorney should help draft the specific definition for the situation. The definition of fair value can literally change from one jurisdiction to another. In a lawsuit, never confuse Fair Value with Fair Market Value.

INVESTMENT OR STRATEGIC VALUE

Definition:

Strategic value is the value of a business to a particular buyer. To determine value, adjustments are made to future income and expenses based on a known buyer’s operation. Strategic value considers any economies of scale the buyer might be expected to achieve.

Uses

Strategic value should be used for acquisitions, or if selling, to determine how much a particular buyer can pay. It might also be applicable to some mergers.

Strengths

It’s the specific value of an agency to a particular buyer at a specific time. Of the major methods, it’s usually the only one to consider economies of scale.

Weaknesses

Buyers in all industries, including the insurance agency business, have a strong tendency to overestimate their economies of scale. Although it might appear that some people can be eliminated and certain expenses reduced, in reality the expenses might actually be greater for the first several years. It’s best not to plan on a higher level of expense savings.

MINORITY OWNERSHIP DISCOUNTS AND MAJORITY OWNERSHIP PREMIUMS

Definition:

Minority discounts and majority premiums account for the disparity between the per share value of controlling and non-controlling shares in a closely, privately held corporation. For example, the per share value of 5% ownership in a closely, privately held corporation is worth less than 51% ownership. In other words, if each share is valued at $100 each for 100% of the stock with 100 shares outstanding, then five shares are probably not worth $500 and 51 shares are probably worth more than $5,100.

Uses

Discounts and premiums are used for estate taxes, lawsuits, buy/sell agreements, internal sales, and rarely in our industry, an actual sale.

Strengths

Most people recognize the logic of these premiums and discounts. Discounts are useful in internal perpetuation and buy/sell agreements because they might be applied to a FMV, which is the most unbiased, well-defined definition, to make the FMV more affordable. This is a simple, clean way to make internal sales more affordable.

Weaknesses

Minority discounts and majority premiums are probably the two most litigated valuation issues, especially with the IRS. The contestable point usually is not whether a discount/premium should be applied but rather, how much of a discount/premium should be applied.

OTHER COMMON DEFINITIONS

Other common definitions of value include, liquidation value, book value, and intrinsic value, but those detailed above are the most common.

OTHER CONSIDERATIONS

Many sellers want to know what their agency is worth to the highest bidder. They really don’t care about FMV, modified FMV, fair value, or any discounts. Although this is an understandable goal, it might be difficult to ascertain unless the agency is put out to bid because we don’t know who might want to buy the agency or whether the prospective buyer’s passions or brains will rule. If this is your goal though, make sure your appraiser knows what you want.

Depending on the situation, it’s conceivable an agency might need different valuations using multiple definitions. In most cases, many appraisers can calculate additional values using different valuations definitions at minimal additional cost.

SUMMARY

Many agencies have encountered problems because they didn’t know that multiple definitions of value exist and/or they unfortunately didn’t choose the best definition for their situation. Because the field is complex, I recommend hiring someone knowledgeable and experienced in valuations to advise you before taking any action that involves your agency’s value. I also strongly recommend hiring a consultant who specializes in insurance agencies. Choosing the right definition can make for fewer and less intense disagreements with partners, facilitate transactions, and save all parties money.

The late Carol Hammes, principal of The Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed.

Login or Register (for FREE) to gain access to thousands of other great articles.

There are no comments posted.
Search Articles/Libraries 
Select a Category
Choose a Content Package
Content Packages 
  • ~/Upload/Images/ContenPackages/editor@completemarkets.com/imms_logo.png
    This article is part of the IMMS Library, which contains more than 2451 documents published by industry-leading authors.