Future Shock: The Need For Agency Perpetuation

FUTURE SHOCK: THE NEED FOR AGENCY PERPETUATION

Very few independent agencies in this country have a written perpetuation plan. In fact, most owners have not even provided verbal instructions to their families, co-owners, accountants, or attorneys regarding their wishes for the future of the agency. Agency principals are focussing their attention on handling day to day management crises created by general economic conditions and industry problems. It seems as though keeping the agency in business today is taking precedence over concerns regarding the disposition of ownership five or ten years from now.

Many agency owners also have a tendency to believe that since ownership transfer has already occurred relatively easily in the past, things will work out fine in the future. If internal perpetuation does not materialize, the agency can always be sold at top dollar to an outside party. Given a ready market for insurance agencies, spending a lot of time agonizing over perpetuation issues is simply not necessary. Right???? The problem with this argument is that the number of buyers willing to purchase the agency at a good price is dwindling, particularly if the agency has been successful and has grown to such a size that it cannot easily be folded into an existing agency operation.

Ten or fifteen years ago, an agency with $1,000,000 in revenues was a prime acquisition target for most of the major public and regional brokers. Even five years ago, there were a number of large buyers actively pursuing business combinations in major cities. Now these same buyers have become sellers in a number of communities, divesting themselves of offices that they purchased in the seventies and eighties. Whereas they may have bolstered unprofitable branches by buying another book of business in the past, they are now closing down the offices in re-organizations such as the one recently announced by Alexander & Alexander.

So, after six long years of commercial soft market conditions and an economic slump that is wreaking havoc with fee income, the larger brokers are no longer as interested in acquiring general retail property-casualty agencies. To be a target, you must have something very special that one of these buyers is anxious to have. Or you must be willing to sell at a low price. Larger agencies that are still anxious to make acquisitions have their pick of distressed opportunities right now. Just because you decide that you want to sell your agency, you will not be guaranteed an interested buyer ready to pay the kind of money that you were expecting.

The recent trade press contained several examples of what is currently happening in the merger and acquisition arena. First there was the story of the agent in Tulsa who sold his agency to North American, a regional firm. The article said that he had been looking for a business combination with a larger agency for four hours. It took almost four years for him to sell after he decided that was what he wanted.

A second example is the recent acquisition of the I. Berman Co. in Montgomery, Alabama by Willis Corroon. The agency had revenues of $900,000 and was purchased for a total consideration of $566,340. This amount is only .63 times the prior year's revenues! Additional payments of a 'comparable amount' will be distributed to the principals-subject to performance criteria. In other words, these people will receive a maximum of 1.25 times for their agency with just half of that guaranteed and the rest payable only if the agency meets certain retention and profitability objectives. And the sellers are getting paid in Willis Corroon stock, not cash.

It is instructive to note that these were both positive announcements, made about situations in which both parties were presumably pleased about the outcome. For every one of these tales that are published, there are hundreds of 'fire sale' stories that remain untold. Some are about agents who fell into financial difficulties (usually because they paid too much for the agencies that they bought in the past) and who were forced to sell their expirations simply for what they owe the insurance companies or banks. Many are about financially stable operations that successfully grew themselves into a hole where there were one, two or three principals in their late fifties and no younger people willing or able to take on the responsibility of buying them out. Their only recourse is to sell to one of their competitors on a retention basis. It is not uncommon to see these based upon such formulas such as 30% of retained commissions for four years, with little or nothing guaranteed.

In short, agents who fail to plan for perpetuation no longer have a fallback position in an attractive external sale. The chances that there will be ready buyers with big bucks are a lot less than there used to be. And the agencies that do go for top dollar are those that planned to sell out and made management decisions accordingly. For most agency principals, the agency is their major asset. If left to chance, this asset could be significantly diminished. Whatever the size of your agency, don't let another month go by without establishing or updating your perpetuation plan.

The development and maintenance of a perpetuation plan encourages owners to share their personal goals and plans as well as to provide objectives for the entire agency. When does each owner want to retire and/or sell his or her portion of the agency? How much money do each of the owners expect to receive for selling ownership and on what terms? Are there children who will be coming into the business? Will they be given ownership or will they have to pay for it? Are there key people in the organization that want (and deserve) to be owners? Should they receive a discounted value? Will it meet everyone's objectives better if the agency is groomed for an outside sale?

The discussion of personal and agency goals should be conducted every year since circumstances will change. It is important to keep up-to-date on what each of the current and potential owners want. Remember, in an internal perpetuation transfer the goals of those who are selling will understandably be different than those who are buying. A successful plan will usually be a compromise, which is definitely easier to accomplish with on-going communication between all of the parties involved.

There are four critical requirements of a good perpetuation plan. First, the existing owners must come to an agreement on what they want to happen and when. The more owners there are, the more difficult this can be. Second, if the decision is made to transfer ownership internally, there must be a sufficient number of willing buyers to handle all of the obligations, either within the existing employee group or elsewhere. In addition to having the qualities that one looks for in an employee, potential owners should also have: a strong desire to be an owner of a small business, willingness to take a risk, current or potential management ability, leadership ability, personal stability and maturity.

Finding such individuals may be the biggest challenge of all. Not everyone who is a good producer or manager has the entrepreneurial spirit necessary to be a business owner, and yet the traditional place to look for new owners has been within the employee group, among the company ranks, or in other agencies. These are still good places to start, but it might pay to broaden your horizons. One possibility is to seek out people in other industries such as real estate or banking who want to enter the insurance business and who may also have some money to invest as a result of their prior activities.

Third, a good perpetuation plan needs sufficient funding, whether it comes from within the agency or partially from outside sources. Insurance companies can be a good source of funds. It is not as easy to get money from them as it was five years ago but many still seem to be receptive to planning with agents and to provide financial assistance if the proposed buyers are acceptable. The negative aspect of receiving help from companies is that there are volume commitments, collateral strings, and a 'big brother' attitude that may have to be endured. On the positive side, it can strengthen the relationship between the agency and the company and help provide management discipline within the agency.

Wherever the outside funding comes from, it will eventually have to be supported by the cash flow of the agency. To accomplish an internal transfer the sellers will probably have to agree to receive less than if they were to sell to another agency. And the buyers will have to accept making less money during the period of the buy-out. The structure of the deal and the tax consequences will dictate how much of the burden is to be borne by the various parties.

The fourth requirement, then, is to establish a proper value for the agency. If it is set too high, the buyers will not be able to meet the payments and if it is set too low, the seller is not receiving what he or she deserves. Remember, the basis of the value will be projected cash flow of the agency over the period of time that the sale is being carried out. A formula value should be used only if it coincides with six or seven years' of cash flow.

The current owners must agree to the events that will trigger the plan, have this agreement committed to written form by competent attorneys, and have it signed by all parties (including spouses). Often there will be two documents that will make up the plan. One is the Buy/Sell Agreement governing the disposition of the stock or partnership interest in the event of death, disability, retirement, termination, and divorce. This contract defines each of the events (make sure that the definitions coincide with definitions in any funding vehicles) and specifies price and terms for selling the ownership interest. It gives either the existing owners or the corporation the right of first refusal to purchase the stock and restricts owners from selling to outsiders.

If the transfer of stock is to be disproportionate between owners or if all owners will not be participating in the perpetuation plan, a cross-purchase agreement may be used. If ownership interests are roughly equivalent, a simple stock redemption plan may suffice. Sometimes the stock price and payment provisions will be different, based upon the reason for the sale. Events that can be funded such as death or disability might bring full value, whereas the pre-retirement termination of an employment might result in a lower purchase price since it could not be planned for in advance.

In addition to providing a value for the stock, this agreement should also contain non-compete provisions for the selling owners. In return for selling their interest in the agency, they must agree not to compete with it for at least a three-year period of time. This is critically important in situations where producers/owners leave the agency prior to normal retirement.

Another document should also be drawn up that outlines the wishes of the current owners regarding the offering of ownership to other individuals. This document is often in the form of Minutes from a Board Meeting and states the intent either to build up the agency for an outside sale or to sell internally. It outlines requirements for becoming an owner, a procedure for offering stock options to key personnel, pricing considerations such as discounts that will be offered in lieu of production quotas or freezing of value at the date of offering, and voting rights of the stock prior to full payment.

One of the primary reasons why agency owners avoid setting up this second document is that they have not yet decided what they want to do. Perhaps they are waiting for their children to decide or they may feel that they are too young to share ownership with others. It is still very important to have an interim agreement in case something unexpected should happen to all of the owners. Who will take over the running of the agency if you all die at the same time? The last thing your spouses need to worry about is managing an agency that they have never worked in. Set up a contingency plan that spells out who is to have control and which employees should be offered the opportunity to buy stock from the respective estates.

While the chances that all owners of an agency will meet their demise at the same time are pretty slim (unless they persist in traveling on the same planes), a one-owner agency is in a much more precarious position. This is one of the reasons why insurance companies are uncomfortable planting with smaller agencies. What will happen to the book of business if that owner dies or becomes disabled before an internal perpetuation plan has become activated? Until there are suitable employees in the agency capable and desirous of becoming owners, or until the children have decided to come into the business, single owners of sole proprietorships or corporations should enter into a Stand-by Buy/Sell Agreement with another agency.

In searching for an agency with which to set up such an agreement, the primary requirement should be mutual trust and respect. Geographic proximity, carrier relationships, level of customer service, and compatibility of employees should also be considered. Also, it would probably be a good idea to avoid selecting an agency where the only principal is nearing retirement or one that is in financial difficulties.

This agreement will obligate the survivor to buy the deceased/disabled owner's agency subject to the price, terms, and conditions previously determined. If the agreement is merely an option to buy, there is no real security for the family, employees, companies, and clients. There should be an agreement that the heirs must sell to the designated agency under the terms that were agreed upon. It would be unfair to expect the surviving agency to operate the firm during the period of time that the estate is being settled and then to sell it out from under them.

In addition to spelling out the terms and conditions of sale, the agreement should specify which assets are included and how liabilities such as outstanding debt, potential E&O claims, company accounts payable, etc. will be handled. Both agencies should agree on (1) a time frame for the consummation of the sale (probably 120 days from the event) and (2) the payment terms-which would generally run from six to ten years. The surviving agency should be entitled to management compensation during the period of time before the sale is finalized (20% to 25% of commissions would be appropriate) and the accounts and records of the two agencies should not be combined until after the sale.

Every agency should have a customized perpetuation plan that changes and grows with the organization and its principals. In another article, we will begin to present various methods of combining compensation and perpetuation options to motivate employees while addressing ownership transfer within the agency.