Valuation And Structuring Of Business Combinations

by Carol Hammes

There are three key elements that must be considered when valuing and structuring a business combination between insurance agencies. In the August issue of The Middleton Letter we addressed the first of these items, the growth potential of the agency. Before deciding how much to pay, you need to determine a probable estimated growth rate under the new ownership. In making this determination a buyer has to evaluate historical trends and ownership considerations as well as the type of business that has been written and the effects of the insurance cycles and economy on that business.

The second major factor to consider is the risk that the anticipated growth rate might not be achieved. A book of business that has been relatively stable under one situation may have a much greater attrition rate under new ownership. The average agency will lose around 6% of its personal lines clients and 8% of its Commercial lines accounts every year due to normal attrition. Under the best circumstances, the attrition rate will usually double during the first year after the sale of the agency. In situations when the seller is staying on as a producer or when the agencies have merged or clustered with the same personnel, there will probably be less disruption. But if the book of business is being moved to a new location for servicing and if that servicing will be done by different people, attrition could be much higher.

The following are some major items to consider in evaluating the effect that the change in ownership could have on the projected commission income. The information necessary to make this assessment should be available if you obtained the bulk of the items included in the Acquisition Checklist that was printed in the August issue. Remember that the purpose of this analysis is to help you establish the element of risk involved in the acquisition of this particular book.

Pay particular attention to specialty companies or to those that write more than 40% of the total volume. Will you be maintaining the same type of relationship with these companies? Are there special arrangements that might not be applicable after the sale? Are contracts and/or exclusive territories assignable? Does the insurance company contractually have the right of first refusal to buy the accounts that you think you are acquiring? Is the seller current with the company payables? Even if you are not taking on the outstanding liabilities you could get stuck having to make good on past obligations to retain the company contract?

Examine the relationships with any single account producing more than one percent of the total revenues or any types of accounts that together produce more than fifteen percent of the total income. Are there special connections between the seller and those business that relate to religion, politics, nationality, age, family or some other characteristic that does not apply to the buyer? Is it possible that the seller has retained the business because he or she has not been diligent with collections? So does your personnel have the level of technical expertise required to service this business? Is there a substantial amount of income derived from Health insurance, Workers' Compensation, Malpractice or other lines that are vulnerable to regulatory or legislative changes? Does the agency write a lot of nonstandard Auto or other business that tend to have a shorter than average life span? Is a substantial amount of business handled by a non-owner producer Internal Organization and Personnel Management.

Take a look at how the book of business has been serviced in the past. This review is critical if you are planning on acquiring the entire agency but is also important even if you are just buying the expirations. Any change that you might make in the type or level of service provided to the customers will have an impact on the retention rate and therefore on the growth potential. If the existing salespeople and service reps have poor morale or if they have not been adequately trained or managed, the accounts could be in pretty bad shape. You may not want to keep them or, if you do, it may take a lot of extra work to get them cleaned up. This housecleaning will then take time away from the production of new business.

After analyzing the agency's external relationships with insurance companies and accounts and the internal relationships with employees, you will e in a better position to assign a risk factor to this transaction. Weigh all of the information that you have reviewed and rank the situation according to the following scale:

[ ] Little risk involved and chances of achieving the projected growth rate are quite good - 8.

[ ] An 'average' situation that does not have any extraordinary features - 6 or 7.

[ ] High level of risk involved with substantial attrition possible 4 or 5.

Once you have determined the potential growth rate and the risk that this growth will not be achieved, you are ready to address the third key element in valuing and structuring a business combination, the anticipated cash flow. The price that you can afford to pay should be based upon he profit that you will be able to make from the purchased business. Depending upon what you plan on doing with the book of business or the agency, the anticipated profits may be higher or lower than the current owner has been realizing. It is important to also recognize that your expenses and projected profit margin might be significantly different than other potential buyers could achieve. It is therefore critical in the valuation process to determine what your expenses will be. If you get involved in a bidding war and end up agreeing to a price that requires payments greater than the available cash from the acquired agency, the difference will have to be made up either by the profits from you own agency or by each of the owners personally. This situation might be acceptable for a short period of time but it will quickly become uncomfortable and eventually be impossible to sustain.

To determine the anticipated cash flow, start with the revenues that will be generated. Include the direct commissions after figuring in attrition and growth potential and then decide whether it would be appropriate in this situation to also include contingent income, fees, and investment income. Subtract operating and sales expenses as they will be under your ownership (usually between 75% and 85% of the revenues) and the result will be the estimated pretax profit. The anticipated cash flow will be the profit, minus state, or federal income taxes, plus noncash expenses such as depreciation. In successive years the revenues and expenses may increase or decrease so you should do the projection for at least ten years in preparation for valuing the business.

The values of this insurance agency to you as a buyer under these circumstances will be the sum of the anticipated cash flow over a reasonable period of time. To determine what is reasonable, go back to the risk factor and convert that factor into years. If the situation is not very risky, use seven or eight years. If it is an average agency, it should pay for itself out of its own cash flow in a six or seven year period of time. If this time period seems short, consider the fact that the average account will stay on the books for seven years. Do you really want to still be paying for business after the revenues that you would receive from it are gone?

Once the initial cash-flow projections have been made, adjust the forecast to reflect the way the transaction will be structured. In an installment purchase, tax deductible interest will have to added to the expense projections. If amounts are to be allocated to expirations and covenants, tax deductions will be available that may allow the buyer to pay more for the agency. If the seller is to be paid as an employee, those payments and the associated employee benefits must be included in the cash flow. For planning and pricing purposes, the chart on the following page presents some of the more common structuring options and the tax treatment allowed by the recently enacted Omnibus Budget Reconciliation Act of 1993.

The new legislation finally resolved the issue of deductibility of expirations that had been a serious source of disagreement between the IRS and those insurance agents who had taken the depreciation deduction over the past several years. An agent can now write off 100% of purchased expirations and goodwill, making it unnecessary to document the value of each of these allocations. Since the purchased good will wasn't a deductible expense previously and since the IRS had been disallowing most of the deductions for expirations, this guaranteed deductibility is good new. But the bad news is that the deductions must be taken over fifteen years, twice the life of the average book of business. A buyer will probably have to pay for the expirations and goodwill over a much shorter period of time than the tax deduction can be taken. This time lapse must be built into your cash-flow projection and will affect the amount that you can afford to pay for the agency.

Another consideration that must be taken into account ins the change in the length of time, that noncompete covenants can be amortized. Previously the covenants could be deducted over their useful or contractual life, usually three to five years. Now they must be written off over 15 years. The buyer will probably have to pay for the covenant during the period of time that it is in force but must spread the deduction out over a significantly longer time span. Because the seller has to pay ordinary income tax on this time and will receive capital gains treatment on the sale of expirations and goodwill, it will probably be in everyone's best interest to minimize the amount allocated to the covenant and place more on the assets, just the opposite of what was advisable several months ago.

One way to get around the 15-year amortization period is to allocate a larger portion of the purchase price to a consulting contract or employment agreement. These can be written off as the payments are made but they can involve extra expenses for payroll taxes and employee benefits that must be taken into account. They can also affect the seller's receipt of social security benefits. As part of the negotiation process the buyer and seller will have to weigh the pluses and minuses of each allocation and a compromise will have to be reached. There are many ways to structure a transaction and, with some careful consideration, both sides can be comfortable with the amount of money that is changing hands and the level of risk that they each are taking. Once the negotiations have been completed, the buyer should revise the cash flow estimates one more time to make sure that the deal is still affordable in light of the compromises that have been made.

If the seller is willing to take some of the risk by having all or part of the price based upon retention of the accounts, the cash flow can be used to determine what percentage of commissions can be paid over what period of time. In some situations the payments can be as much as 40% of retained commissions over four or five years. But if your cash flow indicates that fixed expenses are going to be high, paying more than 30% a year could be too much of a stretch. In that case you would be better to offer the lower percentage but over a longer time period.

Because sellers tend to be more comfortable with the traditional commission multiple, you may find that converting the numbers to such a multiple will make the negotiation process easier. This should only be done, however, after you have determined what you can afford to pay based upon your own plans for managing the acquired agency. Relying strictly on a multiple can be extremely dangerous because it only looks at the top line revenues and ignores expenses that may differ substantially for different potential buyers. You must focus on the bottom-line results as you expect them to be under your ownership. When dealing with multiples, the cash flow projections should still be adjusted at every turn of the negotiations, particularly if there are other prospective buyers. If a competing agent offers 1.5 times the last year's commissions, do not attempt to meet or increase the multiple until you are absolutely sure that you can afford to do so. Remember, the quickest way to bankruptcy is to acquire yourself into it!

The following are general guidelines that may not be applicable to all situations. Professional advice must be obtained from legal counsel in your state prior to and during the transaction.

Tax Free Exchange of Stock.

Seller defers taxes until new stock is sold. Buyer does not have significant cash outlay./ Sale of stock can be restricted for 2-3 years and seller takes risk of decrease in value. Buyer assumes liabilities of seller. Buyer assumes same basis in the assets as the seller had.

Stock Purchase

Seller pays tax only on gain. Seller may defer some taxes by electing installment sale provision. Corporate seller does not have double taxation problem inherent in asset purchase. / Buyer must use after tax dollars. Buyer assumes liabilities of seller.

Covenant Not to Compete

Buyer can amortize for tax purposes. / Tax deduction must be taken over 15 years. Ordinary income treatment for seller.

Employment Contract

Payments are tax deductible for buyer. Seller can carry medical insurance coverage and other employee benefits through the agency. / Buyer must pay employee benefits, payroll taxes, and worker's comp premiums. Seller cannot receive social security benefits if payments are over the limit. Must withstand IRS scrutiny of reasonable compensation.

Consultant

Payments are tax deductible for buyer. / Seller cannot receive social security benefits if payments are over the limit. Must withstand IRS scrutiny.

Deferred Compensation

Payments are tax deductible for buyer. Seller's social security is not affected since this is ordinary income. // Must legitimately be for past services rendered for which adequate compensation was not received at the time. Seller does not receive capital gains treatment.

Expirations/Asset Purchase

Seller pays tax only on gain. Buyer can depreciate for tax deduction and may purchase on a retention basis. / Tax deduction must be taken over 15 years. Seller pays 'double' tax if C corporation.

Goodwill/Use of Name

Seller pays tax only on gain. Buyer can depreciate for tax deduction. / Tax deduction must be taken over 15 years.

Fixed Assets.

Seller pays tax only on gain. Buyer can depreciate for tax deduction. / Must be reasonable allocation for tangible assets acquired.

Commission Expense.

Payments may be tax deductible for buyer. Buyer does not have to pay for business that does not renew it is set up on a percentage of retained commissions. / Seller cannot receive social security benefits if payments are over the limit. Should not be used if seller is incorporated or if book of business is substantial. Deduction may not acceptable to IRS since it may be viewed as capital expense.