HOW TO BUY, SELL, MERGE OR PERPETUATE AN AGENCY – PART V
A Comprehensive Look at the Best Ways to Handle the Biggest Events in the Life of Your Agency
by Larry Morrison and Gary Jacobson
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, PART 2 - REACHING & DOCUMENTING A TENTATIVE AGREEMENT
You’ve had your first meeting (or two…). Things went well. Both sides are interested. The conversation is getting serious.
BACKGROUND FUNDAMENTALS
Win/Win negotiating: Never let negotiations become a contest to see who “wins”.
In almost every case, both sides will lose as soon as either believes they have already “lost”. Most of the time, the side that feels they have “lost” will simply walk away. The deal is dead -- and now both sides are losers.
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. Everyone loses once this kind of behavior begins, including the side that thought they'd “won”.
Confidentiality Agreements:
If you haven’t done this already, both parties should sign a Confidentiality Agreement. This is a normal and reasonable part of all agency sales.
The buyer will need to see a lot of sensitive and confidential information before deciding if it’s worth making an offer, much less what this offer should look like. However, the seller should not let this information be seen unless the buyer is willing to commit to keeping it confidential.
Reciprocal Confidentiality Agreement:
The seller is quite likely to be asked to offer seller financing for part of the purchase price. If so, the seller is perfectly justified in asking for enough backup information to justify extending credit. Depending on what’s requested, it might be perfectly appropriate for the buyer to insist on a Confidentiality Agreement before providing this information.
Information Needed, and When:
Once the parties have signed a Confidentiality Agreement, the buyer can provide 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 once an offer has been agreed to.
The typical minimum requirement at this stage includes five years of financial data including both internal agency statements and tax returns, plus whatever extra information the buyer might need based on specific agency details. Additional information often provided at this stage includes the size of the agency’s books of business with its primary carriers, its loss ratios, representative producer and employee agreements, and shareholder/buy-sell agreements. The buyer generally does not provide detailed information about specific accounts at this stage.
This is the time to bring up all items the seller considers essential to an offer. Leaving sensitive items until late in the process in hopes that momentum will carry the day is a high-risk strategy. This is also the time to bring up potential problems. Buyers will often walk away if they conclude that a seller has been trying to hide something material. Even worse, failure to disclose a material item that’s not discovered until after closing the sale might provide grounds to rescind the entire transaction.
Although the buyer discloses a lot of information at this stage, there’s no need to disclose enough for a full due diligence investigation until a potentially acceptable offer is on the table.
When to Talk Price:
Until (i) you have a meeting of the minds regarding the way negotiations will be handled, (ii) a the parties have exchanged a substantial amount of confidential information, and (iii) the buyer has had a chance to assess the overall situation – determining a specific “price” will be premature.
A buyer who commits to a specific price before they have received the information necessary to evaluate what they’re buying is either foolish or simply posturing. Some buyers will throw out a high price early in the negotiations as an attention getter or to freeze out other potential buyers, and then attempt to whittle the number down as specific information they “didn’t expect” comes to light. This approach can easily lead to substantial conflict later in the negotiations.
Consult Your Advisors:
Ideally, both buyers and the seller should consult their professional advisors before putting an offer on the table. It’s far easier to avoid later pitfalls if you consult your advisors before a tentative agreement has been reached.
A SERIOUS CONVERSATION
What’s Important to You?
If you followed our advice in earlier articles, you knew what was important to you before your first meeting. Don’t keep it a secret. Unless you tell the other side, don’t expect them to get it.
What about Price?
It seems almost everyone “knows” the secret to negotiations is to let the other side put the first number on the table. It’s almost a cliché. If only things were that simple! To say “make an offer and then I’ll think about it,” is likely to fail.
Someone has to put out the first number – and that they’re foolish to do so without at least having a ballpark figure.
Sellers:
Have reasonable expectations. The sale has to make economic sense and have an acceptable level of risk to the buyer, Ask for too much and you will get nothing.
Be able to articulate clearly the financial and other benefits to the buyer. Make them easy to see.
Although circumstances vary, but one way for sellers to broach the subject of price is to follow this two-step approach:
Step 1: Lay the Foundation. State the basic facts, and then define the “ballpark” within which you think these facts fit. Explain the range of value you think this justifies and why. The low end of the range should be firm and well supported, something no reasonable person would go below. The upper end of the range can less firmly defined but still within the realm of reason. For instance, you might note that agencies like yours sometimes sell for a multiple of commissions of 2.0 or more, and this particular situation looks pretty good compared to some of the agencies that got prices at that level.
Step 2: Describe the Upside Potential. Now that you’re established the range of value, you need to make the case for a premium price. The agency will be worth more if you can show its upside potential and how well it will fit the buyer’s needs. If your agency can become a castle, make sure the buyer knows it. If it only has got shack potential, make sure the buyer knows that it would be a beautiful shack. Either way, make sure the buyer knows just much buying the agency will help the buyer.
The seller can use fairly explicit numbers in step 1, but not in step 2. Using this approach you can use actual numbers to get the price discussion started, but do not actually have to put a price on the table. Remember, this is a sale. You’re probably pretty good at selling – and this is the biggest sale of your life.
Buyers:
Don’t insult the seller. Remember, price is often more than just money to the seller. For some sellers, it’s a subconscious measure of the value of the seller’s life’s work. This is particularly true for founding entrepreneurs – who might be so emotionally tied to an agency that selling it is akin to giving up a child. Emotionally, it just doesn’t get bigger than that.
We suggest that the buyer ask the seller to follow the two steps above. This forces the seller to think through the actual financial benefits of ownership and the price that justifies, without asking the seller to actually put the first number on the table. It also gives the seller a chance to tell the buyer all the wonderful things that make the agency worth a premium price.
If the buyer disagrees with the seller’s numbers, then the discussion can usually be kept low key and neutral. Sales forecasts and budgets are far less emotional than arguing about the seller’s self worth, or selling a beloved “child”. This type of discussion is also far less likely to degenerate into a “win/lose” power play.
This process allows the buyer to respond with an informed and reasonable offer. The seller might attempt to push the original offer upwards, but as long as the conversation remains focused on the underlying rationale for the change, the parties can keep the discussion at a win/win level.
Swing for the fences?
Some people always want to swing for the fences. In agency sale terms, that means insisting on a nearly impossible price and/or terms. Sometimes this works; however, people who want to swing for the fences should realize that they’ll strike out often.
TENTATIVE AGREEMENT
Most likely, the buyer will eventually say something along the lines of, “If we pay such and such, with basic terms of this and that, would we have a deal?”, and the seller will reply, “Yes”.
You’ve done it! Both sides have tentatively agreed on a price and terms! Now it’s time to – Put it down on paper! The next step is to get a signed Letter of Intent.
LETTER OF INTENT
Once you reach a tentative agreement, the next step is to write and sign a Letter of Intent (an “LOI” or “terms sheet”). Some ultra-cautious attorneys prefer to call it an “Indication of Interest”.
The purpose of the Letter of Intent is to record quickly and inexpensively the key provisions the parties have agreed to, before memories fade. If communications were less than perfect, it can clarify everyone's expectations.
A basic three or four-page document that covers all the most important points can make drafting the actual purchase and sale documents far easier, faster and less expensive. It does no one any good to spend a lot of time and money negotiating, only to have it all fall apart over a key issue brought up at the last moment.
This is an invaluable tool in virtually any agency sale. It should set forth the parties' respective positions on all the important issues clearly and concisely can usually be in plain language, especially if it’s “non-binding”.
A “non-binding” Letter of Intent will not include everything that the final documents will need to cover. It simply covers the fundamentals, often in basic outline form. Although non-binding, it will usually have some elements that are binding such as confidentiality provisions. A binding “no-shop” provision is particularly common, meaning the seller can’t negotiate with other potential buyers while the actual purchase and sale documents are being drafted.
A supposedly “binding” Letter of Intent, on the other hand, is far more formal and elaborate. In many ways it actually cements the deal, so it will be much longer and quite detailed. However, even binding letters of intent have a gigantic escape clause in that they are usually subject to satisfactory due diligence by the buyer. Because the buyer can always find something unsatisfactory in the agreement, the practical effect of this clause is to make even a “binding” Letter of Intent non-binding for one of the parties in actual practice
In spite of the “subject to satisfactory due diligence” escape clause, a seller might seek to dispute a buyer’s attempt to get out of a binding Letter of Intent. Although the lawsuit would probably be very expensive and difficult, the mere possibility means that you should treat these documents with great care. The deal is effectively struck when you sign that seemingly “preliminary” document. A court might require the parties to struggle ahead until final consummation of the deal, despite the fact that many troublesome details were missing altogether from the Letter of Intent.
Considering the extra complexity of a binding Letter of Intent, and the ease with which the buyer can often get out of it, we always recommend a non-binding version – which offers the same upside usefulness, without the downside risks.
Tax Trap Warning!
Do not lump together compensation for the sale of stock or assets, a non-piracy, or ongoing seller consulting/employment anywhere (including in preliminary correspondence or in your Letter of Intent) while referring to this aggregate number as the “price”! The IRS has successfully claimed that such a statement implied that all the various parts are really just a single disguised sale price. Naturally, this will undo all the subsequent tax planning that might have been an essential part of the sale. The IRS can make a lot of money this way.
So instead of lumping these various components together as “the price”, instead call it “total consideration” or a similar term. Use language such as “the total consideration in this transaction shall be…,” and then separate the components into distinct amounts. You might even wish to have each such element covered in a separate contract or exhibit, integrated together into the overall transaction documents.
DETAILED DUE DILIGENCE
The due diligence process began when the buyer reviewed the financial and other information necessary to make an offer. However, the due diligence at this stage need not be as detailed as the due diligence before to the actual closing of the sale.
Once the parties have signed the Letter of Intent, it’s time for in-depth due diligence. Essentially, the buyer is confirming that what the seller has represented is actually true, plus looking for hidden problems that have not been disclosed. This can be done at the same time the contracts are being drafted.
There are often other objectives to accomplish at this stage as well. The parties will need to review various third-party contracts, some of which will probably require renegotiation in the process of consummating the sale. Carrier contracts and premises leases often fall into this category. Give special attention to employment and producer agreements. The parties might need to redo many of these agreements, particularly if the sale is structured as an “asset” sale.
The buyer’s CPA should review the seller’s tax returns. Although this does not need to be a full-fledged audit, the buyer should be satisfied that the risk of owing money to the IRS is acceptable. This is especially relevant if the sale will be structured as a “stock” sale.
Future articles will discuss key issues such as these in structuring the technical details of a sale
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 Well, 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.