Beware The Outdated Shareholders Agreement

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Published statistics suggest that the damage and personal injury caused by home fires is significantly greater than it should be-not because smoke detectors are absent, but because their batteries are dead or they're just not functional.

There's a similar hazard shared by insurance agencies. Just as most homeowners have smoke detectors for protection, most jointly owned insurance agencies have (or should have) shareholders agreements. However, many of these agreements have 'dead batteries'-that is, they're outdated or contain provisions that, far from helping the shareholders in an emergency, may actually hurt them.

A shareholders agreement is a contract that defines the conditions under which stock in an agency may be bought and sold. As such, it serves as the protection that all shareholders need when it's time to buy one of them out. Whether shareholders' stock is being repurchased under adverse conditions (for example, death, disability, or shareholder conflict) or even under more favorable circumstances (normal retirement), it's in everybody's interest for the transaction to occur fairly. A well conceived shareholders agreement can certainly help.

On the other hand, a poorly conceived or outdated shareholders agreement can actually create problems. In our consulting work, we encounter a large number of shareholders agreements each year, many of which suffer from one or more of the following problems:

    1. The agency's value is based on an outdated or inappropriate valuation formula.
    2. The balance sheet is improperly addressed in the valuation formula, or simply ignored.
    3. Certain assets or liabilities are not properly figured into the valuation formula.
    4. The valuation formula used does not consider the absence or presence of restrictive covenants.
    5. The effects of agency acquisitions are not properly addressed in the valuation formula.
    6. The shareholders agreement does not exclude the proceeds of Life insurance, which are produced to redeem the value of the interest held by the insured shareholder.

The most common problem we see is probably a shareholders agreement that establishes an inappropriately high value for an agency. The reason: Most rely on formulas (for instance, 1.5 times annual revenues), which, even if correct when the contract is drafted, often become outdated shortly afterwards. If your shareholders agreement values your agency at 1.5 times annual revenues today, you may have a problem on your hands.

Consider the following: In 1988 you and your 50% partner decided that for buy-sell purposes, your $1.0 million revenue agency would be valued at 1.5 times revenues plus any tangible net worth. Now, nearly 10 years later, you hear that the average agency is worth between 1.0 and 1.2 times annual revenues, and you're getting nervous. After all, your partner is four years older than you and is clearly preparing for retirement. And for some reason, he doesn't seem all that concerned that your formula may be off slightly. If your agency is actually worth 1.2 times revenue, and assuming your revenues have grown to $2 million, you are facing the prospect of overpaying him by a hefty $300,000, or 25%!

But it's even worse than that. When you provided Johnny, the up-and-coming producer, with an equity interest in his book six years ago, you didn't fully consider the impact of doing so on your agency's value. Johnny's done quite well; his book of business now generates $300,000 in commissions, of which he owns 50%. Unfortunately, because your shareholders agreement does not exclude his business, his book causes a significant additional overstatement of the agency's value.

The fact is that no formula, no matter how well conceived, can take into account all the factors that will affect your agency's value in the future. To get an accurate value, someone who really understands the agency business must appraise the business.

When pressed, many agency owners aren't sure exactly what their shareholders agreement says about valuation. In many cases, the contract was drafted years ago and has simply been forgotten. We recommend that you pull it out, dust it off, and, if appropriate, amend it immediately.

Many smoke detectors are now equipped to beep when their batteries get low, to ensure that homeowners don't suffer from a false sense of security. Unfortunately, shareholders agreements don't come equipped with any type of alarm. They just sit silently in the file cabinet, waiting to punish those who forget about them.

Angela Bemiss is a senior vice president and principal of Reagan & Associates. Before joining Reagan & Associates, she served as chief financial officer for two of the most successful regional brokerage firms in the country. Kevin M. Stipe, CPCU, is senior vice president and principal of Reagan & Associates. Reagan & Associates is an independent Atlanta-based management consulting firm working with insurance agents, brokers, and companies. In conjunction with the Independent Insurance Agents of America, it developed and annually produces the 'Best Practices Study.' This article is reproduced with permission from The National Underwriter, P/C Edition.
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