AGENCY VALUATION: WHAT YOU NEED TO KNOW
by Larry Morrison
Before putting a value on your agency, read this article.
INTRODUCTION
Every agency owner must learn certain basics about agency valuation, some of which appear to have no relevance to valuation. This is a practical guide to what you absolutely need to know to flourish.
Reading a set of instructional steps is a practical way to understand valuation, but other concepts that aren’t as directly related to valuation require your attention to put this knowledge into practice. For instance, you should know the difference between price and value, appraisal and valuation, and what makes valuation substantially different for agencies than for most businesses.
This article also includes a seven-step Agency Valuation process.
APPRAISAL VS. VALUATION
In many cases, an appraisal and a valuation yield approximately the same answer, but an appraisal costs more. An appraisal is often used to substantiate value for tax purposes, or in court. Consequently, it must meet certain standards, and the presentation will be more formal.
A valuation is usually just as accurate as an appraisal — but not always. This is because a valuation has no minimum standards to meet. You can get a cheap, quick, and dirty valuation if that’s enough.
Agency valuation is an art, not a science. No two appraisers are likely to provide the same answer to a question because a number of judgment calls are needed when evaluating an agency. Another section of this article will cover the criteria for judging an agency.
Moreover, a valuation by the best business appraiser in the world might be junk if that person doesn’t know the P/C industry.
AGENCIES ARE NOT LIKE MOST BUSINESSES
P/C agencies, especially small ones, are not valued in the same way as most businesses are. Most businesses are valued based on the cash flow they can generate for their owner, plus the value of any surplus assets connected with the enterprise. This cash flow is usually estimated by looking at the business’ financial statements and making adjustments for the various ways an owner can receive cash from the business. Although the same basic principles apply to agencies, estimating this amount is vastly different, especially for smaller agencies.
An agency that’s struggling financially has much more value than a similar-size business experiencing similar financial difficulties in another industry, because an agency’s book of business can often be sold to another existing agency with larger economies of scale. The purchasing agency can often integrate the purchased book into the purchaser’s existing operations with little apparent increase in costs.
In other words, an agency that was generating a trickle of cash flow for the seller might generate a tidal wave for the buyer. In many cases, the combination might increase volume enough to generate increased contingency bonuses, thus further adding to the value.
A WORD OF CAUTION
Many buyers tend to underestimate the cost of servicing a purchased book of business. This cost is well hidden, but quite real. Remember, failure to service a book is a sure way to lose it. And any surplus CSR and producer time you have available to service the book is no longer available to service your existing accounts, or help grow the agency.
CASH, THE FUNDAMENTAL SOURCE OF VALUE
The cash that a business can generate for its owner after taxes is the fundamental source of value for any business. In a small business (such as all but the largest agencies), the cash generated will be taken out of the business by the owner in the form of compensation, various fringe benefits, and a small amount of profit.
Since the cash generated by most small businesses is fragmented into several different forms, an appraiser will simply add up all the pieces and then subtract an amount for reasonable compensation (the salary you would have to pay an outsider to do the owner’s job). With insurance agencies, this approach leads to problems.
Past cash flow is history, which isn’t fungible; a buyer is purchasing future revenue. But because the future is uncertain, business valuation experts often use past cash flow as the first step in estimating future cash flow. With insurance agencies, this approach can lead to a completely wrong answer. The future cash flow is what matters, and that depends on the cost structure after the sale, not before. The cost structure will probably change far more with an agency sale (especially a small one) than with other types of businesses.
Because the economies of scale can be so high, the value of a small agency might be higher if it’s sold to someone who will shut it down and merge the book than to a buyer who will continue to operate the agency as it has in the past. This is a major reason for the declining number of small agencies.
Larger agencies fit standard valuation procedures much better than smaller ones. The economies of scale from merging two large agencies are not likely to be nearly as large. This is a major reason why large agencies usually sell for lower multiples than smaller agencies.
RISK SHARING
The terms of sale determine how risk will be shared, and this determination can make a tremendous difference in the value of the agency. If the seller is willing to bear some of the risk, it’s entirely appropriate for them to expect a higher price in return. This is easier to do with insurance agencies than with most businesses. The most common way to share risk is to sell on a retention basis (there are others).
A seller selling on a retention basis has assumed a large part of the risk. In exchange, a higher price is justified. However, the resulting comparison tends to confuse many buyers and sellers.
For instance, many buyers and sellers consider a sale at 40% of renewals for five years to be two times book: 0.4 x 5 = 2.0, right? In actuality, it’s far less. First, you must consider the time value of money (the interest rate). If the interest rate is 10%, the actual multiple is only 1.5, assuming that the size of the book remains constant for the full five years. Since normal attrition means that some accounts are certain to be lost, and rate increases in most cases will not make up for this loss, the actual multiple from this sale will be even less.
CAPITALIZATION RATE
The capitalization rate is the rate of return that fully informed, rational investors would expect to earn on their money if they bought the agency for cash. This sounds simple, but can be confusing. For instance, a lower capitalization rate leads to a higher valuation. Note: The capitalization rate is not the interest rate on debt taken on to make the purchase (the capitalization rate will be higher).
The capitalization rate plays a major role in the valuation. The value of the agency will be the current value of the future cash flows discounted back to the present at the appropriate capitalization rate. Even a small change in this figure can profoundly alter the valuation, and selecting the right number is always at least partially a judgment call.
In Property/Casualty agencies, this number tends to hover between 15% and 20%. A retention-based sale falls toward the lower end of the range, while a fixed price sale rises toward the upper. This number deviates toward the lower end of the range most businesses sell for, which means that agencies tend to sell for higher prices than most other types of businesses.
RETENTION
Expected retention is a major factor in the sale of an agency or book of business. The industry usually values Personal Lines at a higher multiple than Commercial Lines. This isn’t because Personal Lines are more profitable than Commercial Lines, but because retention on a Personal Lines book tends to be higher than on a Commercial Lines book when it’s sold.
CONTINGENCY BONUS
Most people don’t include the contingency bonus when valuing an agency because it’s unpredictable, and isolating what portion of a future contingency bonus received is generated by an acquired book of business is very difficult.
Assigning a zero value discounts the contingency bonus too much. A book of business that shows a solid history of good bonuses has a good chance to continue to do so in the future. It might be more difficult to value, but that book is certainly worth more.
LIFE/HEALTH COMMISSIONS
These commissions are often ignored when valuing an agency since renewals are typically a small fraction of the first year’s commission. Future cash flow relies more on future efforts than on renewal commissions.
As with the contingency bonus, a zero value discounts Life/Health commissions too much. Even small renewals have intrinsic value. If a significant portion of first-year commissions are due to leads generated from existing Property/Casualty accounts, then access to those leads is also worth money.
SPECIAL FACTORS
A book that has not been serviced in years can be a gold mine since a good agent can service these accounts and probably pick up a lot of additional sales in the form of new products sold. These accounts might be more likely to put the account up for bid when the agent changes, and large accounts are a major target for the competition anyway.
SURPLUS ASSETS
A certain level of fixed assets and working capital is needed to support ongoing operations, but possessions alone don’t add to the value of the business. Assets above this level increase the value of the business, and below this level decrease its value. An agency’s approximation of this number is “net book value,” an accounting term that simply means assets minus liabilities. Many owners value their agencies as some multiple of commissions, plus net book value. This is a close estimate of an agency’s value, since it usually doesn’t need assets much above its liabilities in order to operate.
The industry usually values agencies in terms of multiples of commissions. These rules of thumb are useful in general terms, but don’t work when applied in specific circumstances. Fortunately, you can use the basic concepts just explained to compute a multiple that fairly reflects the value of an agency.
PRICE VS. VALUE
“Price’ and “value” are different from each other. Due to the tax code, the value of the agency is likely to be divided into several different components when you buy or sell it. Among other business benefits, dividing the value into parts can reduce taxes for both buyer and seller substantially.
To take a common example, the value might be divided into a covenant not to compete, an employment contract, and a price for the stock or assets of the business. In this example, the value would be substantially higher than the price.
Why does this matter? Because failure to keep the difference clear at every stage in the negotiation can create a tax disaster. For instance, if buyer and seller reach a written agreement on the price and then turn it over to the lawyers and accountants to structure, they might well find the IRS claiming that the agreed price controls. The tax consequences could be disastrous.
Since structuring the sale involves tax trade-offs for both sides, you might often find that tax improvements for one side result in more taxes for the other side. If you can rise above the natural desire of attorneys and accountants to seek gain for their client at the expense of each other, balancing these tax effects can help both sides improve their after-tax cash flow. This type of tax planning can easily change the price.
A SEVEN-STEP VALUATION PROCESS
Step 1: Compute surplus assets, as defined above. For simplicity, you might want to take net book value straight off your balance sheet.
Step 2: Estimate future cash flows. This requires carefully checking the book and making your own estimates of likely future retention, rate increases, contingency bonuses, related product sales, etc.
Step 3: Estimate costs. If you’re doing your valuation in terms of a multiple of commission, you’ll want to estimate costs as a percentage of revenue. If you’re buying an agency to merge with an existing operation, be sure to estimate the full cost of servicing the acquired accounts plus reasonable pay for your own efforts.
Step 4: Compute cash flow. Subtract the estimated costs from the estimated revenues to get the cash flow. Don’t forget to estimate taxes.
Step 5: Select a capitalization rate (probably between 15% and 20%).
Step 6: Compute the current value of the future cash flows. Take each year’s cash flow and discount it back to the current using the capitalization rate.
Step 7: Add the result in step 6 to the result in step 1. This is your valuation.
CONCLUSION
Because the actual computations can be complex, you might not want to do them yourself. But you should be familiar with the key concepts presented here even if you never actually value an agency yourself. This is especially true if you are dealing with a valuation professional who is not already familiar with the Property/Casualty industry. Valuing an agency is not the same as valuing most businesses.
Larry Morrison, CPA, can be reached at the Business Transition Network, Bellevue, WA, Phone (425) 957-4754, Fax (425) 603-9149, or e-mail [email protected].