HOW TO BUY, SELL, MERGE OR PERPETUATE AN AGENCY: INTRODUCTION – PART IV
by Larry Morrison and Gary Jacobson
A Comprehensive Look at the Best Ways to Handle One of the Most Significant Financial 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.
CHAPTER 2 - NEGOTIATIONS
In Chapter 1 we dealt extensively with issues to be addressed prior to initiating negotiations to buy or sell an agency. In Chapter 2 we discuss the negotiations from both the buyer’s and the seller’s side.
THE FIRST MEETING
You’ve done your homework. Now it’s time for the first meeting (or two).
Both buyer and seller should have thought through, in advance, what they are willing to disclose in order to help establish mutual interest. For instance, the seller might be willing to disclose overall revenue numbers, but not profitability or who the agency’s best accounts are.
Until mutual interest is established, a Confidentiality Agreement is generally not signed and confidential information is not exchanged. Hence the first meeting often doesn’t include an exchange of confidential information.
Although confidential information might not be exchanged at the first meeting, this meeting is very important. At that meeting, a seller should be able to clearly explain to a potential buyer:
• Why the seller’s agency is for sale?
• Why now?
• What’s most important to the seller in the overall sale?
• What the seller will do to help the buyer post-sale?
Likewise, the buyer should be able to clearly explain to the seller:
• Generally speaking, what’s most important to the buyer in this potential deal?
• What makes the buyer a strong potential candidate to buy this particular agency?
The first meeting is usually not the time to talk price. Instead, we recommend starting with a general discussion of the items above.
SET THE BASIC RULES FOR THE NEGOTIATION
If the initial discussion goes well and a possible sale seems likely to be worth further discussion, then it will help; to set some basic “rules” the parties intend to follow in the negotiations. Nothing can guarantee success, of course, but following these basic rules will greatly improve the odds:
Rule #1: Win/Win negotiating.
Both sides must believe the sale will be a “win” for them. Never let negotiations become a contest to see who “wins” individually.
It’s rare for a buyer to feel that they simply must buy the seller’s specific agency. Most of the time, a buyer can just walk away if the proposed sale becomes a “lose” for the buyer.
Likewise, few sellers feel they have only one potential buyer. Even if only one potential buyer is currently at the table, the seller often has the option of not selling. Even in these situations when it seems the seller must sell to one specific buyer, your authors have encountered many prospective sellers who would literally rather wind the agency down over time than feel like a “loser” in the negotiations.
In almost every case, both sides will lose as soon as either side believes they have “lost”. Even if circumstances are such that the “loser” decides not to withdraw from the negotiations altogether, there will almost certainly be multiple ways the “loser” can try to even the score. Once this kind of thing starts, everyone loses, including the side that thought they “won”.
Rule #2: The sale must “work” for both sides.
The buyer and seller should cooperate to improve the overall tax effects of the transaction for both sides. Tax savings can sometimes be dramatic, and this can help bring a buyer and seller who are unable to agree on “price” back together. After all, the only part that counts is what you get to keep after giving the IRS its share.
The seller should cooperate to structure the sale in ways that will “pencil-out” for the buyer. This often means part of the sale will be seller financed, and it might include an “earn-out” provision that adjusts the price based on future results. If the sale must be an “all-cash deal”, the seller should recognize that the buyer must still justify the money spent based on the cash flow the buyer thinks is likely to be available following closing.
Rule #3: Both sides must control their respective advisors.
The technicalities of the sale of any closely-held agency can be highly complex. Both sides will probably need their own attorney and CPA involved in the process. Preferably, use advisors who are explicitly familiar with insurance agency sales. Insurance agencies have many differences from the typical closely held business; which means you’ll be better off if you don’t have to educate your advisors on the unique aspects of agency transitions.
The principals on both sides need to insist that their advisors respect rules #1 and #2 above. Your advisors know more about the financial and legal technicalities than you do, or you wouldn’t need them. However, they do not know as much about agencies as you do, and they won’t be the ones living with the results. They’ll want you to get the “best” deal you can, and sometimes work a little too hard to “improve” on the results the buyer and seller have already negotiated informally. Although your advisors are virtually certain to find a few things to argue about, don’t let their discussions about the fine points of a deal turn a win/win into a win/lose.
The cliché about “deal killer” attorneys or CPAs can easily turn into reality. In our opinion, trying to get the last 2% out of a deal isn’t worth the damage that pushing for that last concession might cause. In particular, letting an advisor talk you into changing something that the principals have already agreed on can be highly damaging to the overall negotiations.
When to Talk Price:
Don’t get specific about “price” too soon (generalities are OK). Talking about a specific “Price” is premature until:
(i) You have a meeting of the minds about how negotiations will be handled;
(ii) You have exchanged a substantial amount of confidential information;
(iii) The buyer has had a chance to assess the overall situation.
Talking “price” too early in the negotiations can lead to expectations that are too high, or money left on the table if things end up looking better than expected. Either one can kill what would otherwise have been a successful sale.
Confidentiality Agreements
Once the buyer and seller have agreed that proceeding to the next step is justified, and have set basic “rules” for the negotiations, the next step is for the buyer to sign a Confidentiality Agreement.
The buyer will need to see a great deal of sensitive and confidential information before the buyer can decide if even making an offer is really justified, much less what this offer should look like. The seller should not provide this information unless the buyer is willing to keep it strictly confidential.
This is a normal and reasonable part of all agency sales. It’s so basic that a buyer who won’t sign a reasonable Confidentiality Agreement should not be considered serious. Although these agreements are generally simple and straightforward, this isn’t always the case.
A well-prepared buyer or seller might even bring a Confidentiality Agreement that they consider acceptable to the first meeting. Because these are such a standard part of any closely held business sale, it’s common for a prospective buyer to sign this type of agreement on the spot. However, this isn’t always wise; it’s perfectly reasonable for a buyer or seller to have their attorney review the agreement first.
A typical Confidentiality Agreement will bind the buyer and the advisors with whom the buyer chooses to share the information. If the buyer is an individual, this is often all that is needed. If the buyer is a separate entity such as a corporation or an LLC, then such a format is not always broad enough. The key employees of the buying entity who are involved in the negotiations should also execute the Confidentiality Agreement if they present potential competitive threats to the seller, and the buyer entity should take some responsibility if such an employee violates the agreement.
When a closely-held agency is sold, it’s common for the buyer to be another closely-held agency. If this is the case, it might make sense for the Confidentiality Agreement to bind the owners of the buying agency individually, as well as corporately.
Bear in mind that providing confidential information without insisting on an agreement to protect this confidentiality can jeopardize the legal status of the information. In a worst-case scenario, the seller can accidentally turn confidential information into publicly available information that can no longer be protected legally.
Reciprocal Confidentiality Agreement:
The seller will probably be asked to offer seller financing for part of the purchase price. If so, the seller is perfectly justified in asking for enough information to justify extending credit. Depending on the information requested, it might be appropriate for the buyer to insist on a Confidentiality Agreement before providing this information.
INFORMATION NEEDED, AND WHEN
Once a Confidentiality Agreement has been signed, the seller can begin collecting the information needed to assess the opportunity before making an offer. The information needed at this stage is not as extensive as will be needed to complete the buyer’s due diligence.
Because no two sales are the same, it’s not possible to create a practical checklist of what information to collect. The typical minimum requirement at this stage includes five years of financial data, including both internal agency statements and agency tax returns, plus whatever extra information might be needed based on specific agency details.
The representations and warranties (“rep’s & warranties”) in almost all Purchase and Sale Agreements require the seller to disclose all material items proactively. This must be done at some point during the process – we recommend sellers proactively disclose every item the seller thinks might be material early in the process. The buyer can then decide what additional information will be needed before making an offer, and can incorporate the results into the offer.
Buyers will often walk away if they conclude that a seller has been trying to hide something material, and failure to disclose a material item not discovered until after a sale is closed can be cited as grounds to rescind the entire transaction.
This is also the time to bring up all items the seller considers essential to an offer. Leaving sensitive items until late in the process hoping that momentum will carry the day is a high-risk strategy and often a waste of everyone’s time.
Much more information will be needed to complete the buyer’s due diligence if an acceptable offer is ultimately made. We’ll discuss this in a later article.
THE PRICE IS NOT THE PRICE
Although isn’t yet on the table, but both buyer and seller might wish to consult their professional advisors. The structure of a sale can have an enormous impact on the final result, and it is easier to avoid pitfalls if you consult your advisors are early in the process.
Taxes. In the wrong circumstances with a poorly-designed sale, the combined taxes on the buyer and seller can easily exceed 50% of the overall available cash flow. It’s common for experienced advisors to be able to restructure the sale in ways that greatly reduce this confiscatory tax burden.
The buyer is almost certain to insist that the seller not compete with the buyer after the sale. Some of the consideration for the sale might be allocated to an agreement by the selling shareholders not to do compete. Selling “personal goodwill” and post-sale employment can also be major tools to help improve the overall sale. These tools have tax, as well as legal effects, and can often be designed to lower overall taxation on the sale.
In some cases it’s even possible to lower the price and simultaneously improve the after-tax cash flow for both sides. A lower price and better after-tax cash flow can be a win/win/lose (the loser is the IRS).
Risk. Risk can be even more important than price. Most sellers could reduce taxes by not being cashed out, but are afraid they might not get paid if they don’t get all their cash at the front end. Likewise, most buyers would be willing to pay more if they were confident they would succeed.
Terms. The terms are the key to reducing taxes and risk. Creative terms can easily end up being more important than the “price”. It’s common to see a retention based element in the sale, and there are a variety of formulas that pay the seller more if future results are good (sometimes referred to as “earn-outs”).
LETTER OF INTENT
If your discussions succeed, the culmination of this phase of the negotiations is normally memorialized in a Letter of Intent. We will discuss these in our next article.
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.