HOW TO BUY, SELL, MERGE OR PERPETUATE AN AGENCY: INTRODUCTION – PART III
by Larry Morrison and Gary Jacobson
A Comprehensive Look at the Best Ways to Handle the Biggest Events in the Life of Your Agency
Editor’s note: This article is one of a series that covers buy/sell arrangements for agency valuation and tax issues, shareholder internal buy/sell agreements, related estate planning, employment contracts, and non-competes. It’s part of a unique pre-publication book by the authors that gives you practical street-level understanding of one of the most significant financial events in the life of your agency.
The first two parts of this chapter covered big-picture issues that buyers and sellers should be familiar with before they start the process of buying or selling ay agency.
Part 3 covers the remaining “big picture” issues, focusing on what to do once the process has actually started. We’ll provide some tips on how to set the stage for successful negotiations, some crucial points you need to know about tax control early in the process, and finish with suggestions on how to evaluate the odds that a transaction will actually “pencil out.”
CHAPTER 1, PART 3 - Introduction / Getting Ready
Buying or selling an agency is a lot of work, very time consuming and expensive, and the outcome is never certain. You can raise the odds of success if both sides are ready before the process ever starts.
For Sellers:
Many successful agency owners, especially founding entrepreneurs, have an intense emotional tie to their agency. This is good, and might even be a key part of their success. However it can also interfere when the time comes to sell. It’s surprisingly common to find a seller who is so emotionally tied to the agency that no offer and/or buyer will ever be good enough.
Before you start the sale process, ask yourself, honestly:
- Are you a willing seller?
- Why are you for sale? Why now? If you can’t answer these questions you’re probably not ready to sell.
- What criteria are most important to you in the sale? Are there specific things that must happen, such as protection for certain long-time employees?
- Who are your best potential buyers? Your agency will be worth more to some than to others.
- Are you willing to help the buyer succeed, after the sale? How?
- Are you willing to sell for a realistic price and terms? Do you know what realistic price and terms for your specific agency actually are? Most sales include seller financing for part of the price, and might optimally include an “earn-out” for part of the price as well, if your professional consultants are familiar with these concepts.
Just how strong does a buyer need to be financially? Will you provide seller financing for part of the price, or will only an all-cash deal suffice?
If you don’t have realistic expectations, you’re probably wasting your time.
However, if you’re really ready to sell, then you owe it to yourself and to your family to do the job right. Never lie or misrepresent; be ready to clearly show a prospective buyer the true financial benefits of ownership plus all the other reasons why buying your agency makes sense.
For Buyers:
What are your (and your agency’s) unique strengths and weaknesses? In light of this, what agencies can you buy that result in 1+1 = 3 (or 4)? Given the cost (both time and money) and the risk (all agency acquisitions are risky), you might not want to buy at all if 1+1 is not more than 2.
If you’re interested in buying a particular agency, then someone else probably is too. It’s not all about money. Why should the seller sell to you? Are you ready to sell yourself and/or your agency?
Especially if you already have an agency to run, do you have the time and management depth to make sure the acquired agency is a success, post sale?
Are you strong enough financially? Do you have a good enough banking relationship to borrow the down payment, or enough cash to make one from your own funds? If borrowed funds or seller financing are involved, are you (and your spouse) willing to guarantee the purchase personally?
In other words, are you ready to buy?
For Both Sides:
It’s rare that either side is compelled to proceed, regardless of how the transaction is shaping up. Once either side concludes that the sale is a “lose” for them, the sale is probably off. This is so important that we strongly recommend both sides commit explicitly to negotiating for a “win/win” result early in the negotiation process.
If it becomes apparent that the sale isn’t likely to happen, it’s time to walk away politely. However, don’t burn your bridges; the time for a sale might very well be better at some point in the future. Nevertheless, it’s generally a waste of time and money to chase after a deal once one side or the other feels the sale has become a “lose”.
Start With the Big Picture
Once both sides are talking, start with the big picture. Any deal needs to work for both sides. The seller needs to understand that the sale must “pencil-out” for the buyer, that the risk must be acceptable, and that cooperation from the seller is likely to be needed after the sale.
Most agencies have key customer or vendor relationships that must be preserved and specialized expertise that must be taught to the buyer. Sellers should commit to help the buyer with these key items. This reduces the risk for the buyer and raises the chance that the sale will go through. It might also justify a higher price.
Sellers must also recognize that buyers aren’t interested in competing against the seller or key employees after the sale. A seller’s non-piracy agreement, as well as an enforceable one from producers and other key personnel, forms an essential part of any agency sale. If key employees aren’t already covered, getting their agreement is often a fundamental requirement before closing.
Buyers need to understand that this is far more than just a financial matter to the seller. The successors should make an extra effort to respect the person selling. We’re dealing with people here – not machines. They have expectations, dreams, and fears. Some of these are rational, others are not; but all are real. If you don’t recognize and address the seller’s “felt needs”, you’re probably wasting everyone’s time.
This is why we recommend that you address the people issues first. The parties need to clarify what matters the most to each of them. Don’t assume that these items are self-evident, and don’t leave the issues you believe are likely to be the most difficult to the 11th hour. It’s better to discover and address difficult issues early-on than to waste everyone’s time and money working on a transition that never happens.
Risk can be more important than price for both the buyer and the seller. The buyer’s risk is well known (most buyers assume Murphy was an optimist). However, risk can also have a major impact on sellers. When a seller demands a large down payment, the underlying reason is often their concern about not getting paid if the agency doesn’t do well after the sale.
Terms have a huge effect on cash flow, taxes, and risk. Terms can even be more important than price! Terms can be so powerful that it’s sometimes possible for experienced advisors to lower taxes, improve after-tax cash flow for both the buyer and the seller, reduce risk for both the buyer and the seller, and lower the price – all at the same. We’ll discuss how to do this later in the book.
Plan Early for Tax and Legal Issues
There are three parties to every sale: The buyer, the seller, and the IRS. The IRS thinks that it’s entitled to a big part of the seller’s cash, plus a big part of the buyer’s cash as well. Total combined taxes can easily be over half of the before-tax cash flow of the agency.
In a worst case situation, the seller’s taxes alone can come to more than half the value of the entire agency, with the bill due before the cash to pay those taxes has even been received.
Maximizing long-term after-tax cash flow for both the seller and the buyer, with acceptable risk, is a fundamental objective. A carefully structured sale can be a win/win/lose (the “loser” being the IRS).
Bring in the attorneys and CPAs early, before the parties’ respective positions become “set” and ego prevents them (or their respective advisors) from coming off of their position. Tax and legal expertise can easily make or break a deal! Experienced advice early in the process can prevent irreparable errors in structuring the sale, and might keep the process from falling apart at the last minute when advisors point out unexpected legal and tax problems for the first time.
Cash Flow
Cash is king. There must be enough cash for the buyer to earn a reasonable wage, make the required payments, earn a reasonable return on the money invested, and make the additional investments necessary to keep the agency viable.
You can use cash flow “scenario testing” to assess the potential cash flow. A “scenario” is a collection of assumptions. Scenario testing uses a set of assumptions as a way of estimating future after-tax cash flow for both the buyer and the seller. Simplifying assumptions will be necessary, so don’t expect exact results, even if by some miracle you’re fortunate enough to develop a set of assumptions that exactly match the future results. However, since no one knows the future, be sure to test more than one set of assumptions.
Cash flow scenario testing on an estimated after-tax basis is essential. Taxes can be so high that what looks like plenty of cash flow might not be enough. Without including estimated taxes in the analysis, you have no way of knowing if a transaction is likely to make financial sense for the buyer.
The agency can generate only so much cash flow. If both buyer and seller recognize that the sale must make financial sense for the buyer, and they agree on the basic rationality of the assumptions in the scenario; then the basic reasonableness (or lack thereof) of the price and terms will become conspicuously self-evident from the numbers. Besides providing a much needed reality check on the price and terms, this type of testing can even reduce haggling. It’s hard for a seller to insist on a particular price/terms combination when the deal clearly can’t work financially for the buyer, even when using assumptions that the seller agrees are reasonable.
IMPORTANT NOTE: Sellers should be careful not to make any promises or even predictions about future results. If the seller supplies the numbers and/or the analytical framework, be certain to include a very strong and clear disclaimer. Otherwise, you might have inadvertently “guaranteed” at least a minimum result and might even be vulnerable to rescission of the entire transaction later on!
Try to structure a transaction that still works under a reasonably foreseeable downside case as well. This can address the risk concerns of both buyer and seller. It can estimate cash flow needs if things don’t work out as well as hoped, and even lead to modified terms with the flexibility needed to protect both sides later.
For example, the buyer’s promissory Note might defer principal payments if operating results are poor in a particular year (continuing to accrue interest, and adding any deferred amount to a balloon payment at the back end). Initial payments might be interest-only, perhaps until an outside lender or prior acquisition has been paid off. Pricing based on an earn-out subject to customer retention might lower the risk to the successors enough that the seller can justify what will in fact become a higher price if customer retention is good. This also gives the seller a strong incentive to make things work after closing the sale.
No one wins if the seller doesn’t get paid, and taking back a wrecked agency is generally a lose/lose proposition. Scenario testing, combined with creative use of terms, can dramatically reduce the chances of this happening.
Larry Morrison, CLU, ChFC, is president of the Business Transition Network (Arlington, WA), a firm specializing in agency evaluation, purchase, mergers, and business succession planning. You can reach him at (866) 475-9992 (toll free); or e-mail: [email protected].
Gary E. Jacobson, JD, a partner at Vander Wel, Jacobson, Bishop & Kim, PLLC ( Bellevue, WA), offers expertise in the legal aspects of agency evaluation, purchase, mergers, and business succession planning. You can reach him at (866) 498-0008, toll-free; e-mail: [email protected]; or visit www.vjbm.com.