HOW TO BUY, SELL, MERGE OR PERPETUATE PART VI
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 3: SPECIAL FACTORS WHEN VALUING AN AGENCY
Although we discussed agency value in general terms in earlier chapters, this is a huge topic with many special factors that affect agency value in ways that don’t impact most closely held businesses. This chapter focuses strictly on special factors that can affect agency value, many of which are unique to insurance agencies.
Agency owners should be aware that even the best CPA or business appraiser is unlikely to be aware of these factors unless you, the agency owner, make a point of explaining them.
It’s Not That Simple!
We all know that although the value of a house is ultimately based on what the buyer and seller agree upon, we also know that a reasonable starting place is often the price for which similar homes in the neighborhood have recently sold. We also know a realtor can greatly simplify the process. This might seem difficult to some, especially those who have never bought or sold a house before, but it’s child’s play compared to valuing an agency.
Many buyers and/or sellers are in the same position as a person who has is buying a house for the first time, but without the help of a realtor.
Valuing an agency is far more difficult than valuing a house. Finding out what a similar agency just sold for is very difficult. Even if you did, you still wouldn’t know enough to make a comparison unless you knew all the terms of the sale, the special factors that applied to the other agency, and the special factors that will apply to your agency.
“Value” is not the same as “price.” The only part that counts is what you get to keep, after tax. You need to know the overall tax effects based on the way the sale was structured before you really know what “value” is being placed on the agency. Taxes vary considerably for both the buyer and the seller, depending on how a sale is structured. Put another way, the “price” is not the real “Price”!
Understanding agency value requires considering many factors, some of which most agency owners generally overlook. These include:
- Basic Valuation: Value boils down to expected future cash flow and the risk the buyer must take in order to get it;
- Balance Sheet Analysis: Businesses with stronger balance sheets are worth more;
- Buyer’s and Seller’s Markets: We’ve been swinging back and forth between a buyer’s and a seller’s market for the past several years;
- The Buyer: An agency is worth more to some buyers than to others;
- The Seller: The sellers themselves affect the value of the agency;
- Tax Laws: When tax laws change, so do agency values;
- Terms: The terms and sale structure can be even more important than the “price”; and
- Earn-outs: Part of the price might depend on using a formula that shares future success.
Let’s examine each of these factors:
Basic Valuation: Many factors can push the value up or down (just as owning a vacation resort may have more intrinsic appeal than owning a trash collection service, for instance). However, the basic factors in valuing most agencies come down to:
- The future cash flow the buyer can reasonably expect from the agency; and
- The risk the buyer must take to get it.
The future cash flow the buyer can reasonably expect from the agency, after subtracting reasonable compensation the new owner would be paid for doing the same basic work if he or she was a non-owner employee instead, is the primary source of value for an agency. This is the financial reward the buyer gets in exchange for the money paid.
The cash flow that matters is in the future. The buyer can’t be certain it will really happen. Another word for this uncertainty is “risk.” Higher risk means lower “price.”
A basic valuation combines these two factors to estimate the value of an agency.
Mathematically, the expected future cash flows are discounted back to the present using a risk-adjusted discount rate. The resulting “net present value” is the agency's real value.
Doing these calculations can be complicated. It starts with an estimate of reasonably expectable future cash flows. The estimation process often uses past results as a starting point, followed by further analysis to adjust for unusual past events and updates that reflect current conditions. Regardless of how detailed the analysis of past results might be, the estimate of future results will always involve subjective judgment on the part of the person doing the analysis. Even a certified appraiser who specializes in agency valuations will have to make subjective judgment calls to do this analysis. Likewise, although estimating the appropriate risk-adjusted discount rate often starts with scientific looking methodology, the result always includes the subjective judgment of the appraiser.
NOTE: Because estimating cash flow and the appropriate risk-adjusted interest rate is always subjective to some degree, an agency appraiser will always state the resulting appraised value as an “opinion” of value.
NOTE: A sale can be structured to lower the risk for the buyer. The lower risk can often justify higher total value (some of the “consideration” might not be labeled as “price”). It’s fairly common for part of the total consideration to be dependent on future results (an “earn-out”), meaning you won’t know the actual value received/paid until several years in the future.
Given the wide range of possible tax effects, plus the widespread use of “earn-outs”, defining the “price” of a transaction is misleading at best.
Balance Sheet Analysis: The balance sheet can raise or lower the value of the agency. The calculations might seem complex, but they’re really just common sense. An agency with a lot of debt will have a lower value. An agency with surplus cash, or assets that could be sold without adversely affecting agency operations, will have its value increased by the amount of the surplus. Assets tare needed to operate the agency neither raise nor lower the value above what the cash flow generated by using those assets to operate the agency can justify.
The balance sheet also helps establish the “floor” value for the agency. The floor value is the net cash that could be received if the agency were simply shut down in an orderly process and everything it owns sold off piecemeal.
It’s common for the seller to withdraw surplus cash and assets at or prior to the sale’s closing date, and pay off the agency’s debt at the same time. Details will depend on the way the sale is structured.
Buyer’s and Seller’s Markets: As with the stock market, the same agency can be worth more (or less) this year than it was last year, even if everything has stayed exactly the same. For instance, the financial crisis of 2008 temporarily reduced agency values. Some, but not all, agencies eventually bounced back. Another financial crisis is certainly possible, and the effects cannot be fully predicted.
Taxes can have a significant effect on agency value. Higher taxes mean a buyer will have fewer dollars left over to pay the seller. When sellers get to keep less money from what they bought they can’t afford to pay as much for it in the first place.
Regulatory change can also affect agency value. An extreme example would health care reform. Under the law as currently written, the future role and compensation expected to be received by agencies in the health care arena in the future is quite uncertain. The value of a typical agency’s health care book of business has fallen as a result.
The Buyer: Any particular agency is worth more to some buyers than to others. With the right fit, some buyers will have a 1+1=3 opportunity; meaning the agency will be worth more to that particular buyer than the agency standing alone would be worth.
When an agency is worth more to some buyers than to others, the seller should identify and contact the potential buyers to whom it’s worth the most. It helps if you can identify at least two high-potential buyers; and three or more is even better.
The Seller: The sellers themselves also affect the value of the agency. Many of the things on the list below can be addressed by the sellers even before the agency is put up for sale. Ultimately, sellers who make it easy for the buyer will find it easier to sell; and the value is likely to be higher as well.
If there are multiple owners, are they in agreement about selling? Do they have a shareholders’ buy-sell agreement that can be used to compel sale if a single shareholder is resisting selling?
Will the sellers stick around long enough to help with the transition? Will they help retain key accounts? Will key carriers terminate their contracts if the agency's "founder" is no longer around?
Are any key non-owner employees likely to leave? Do they have, or can you create, enforceable non-piracies with them?
What about the building? Does it belong to the present agency owners? Is the Lease transferable if with a third-party landlord? Is rent likely to be raised post-sale?
Tax Laws: Taxes affect agency value, and tax laws change. Higher taxes mean lower agency values.
For instance, if income tax rates rise, the amount of cash buyers get to keep if they buy the agency goes down. If they get to keep less, the price they can afford to pay also goes down.
Higher taxes have less obvious effects as well. If an agency owner must pay more in tax, it will be harder to accumulate the cash needed to grow the agency. Lower growth means lower value. Likewise, because higher taxes generally lower overall economic activity, agency growth slows when the economy slows.
An emphasis on after-tax cash for both sides when planning the structure of a sale can be very helpful. Thanks to our agonizingly complex tax laws, it’s sometimes possible to lower the “price” and simultaneously raise the after-tax cash received by both the buyer and the seller!
For instance, simply changing the sale from an “asset” sale to a “stock” sale format and simultaneously lowering the price can sometimes save the seller up to 35% in taxes. The buyer will lose a tax deduction, but the lower price compensates for the loss. Sharing those savings with the buyer leads to a win/win/lose scenario (the “loser,” of course, is the IRS).
To illustrate how complicated even the simple example above can be, the savings apply when the seller is a “C” corporation (or has recently been a “C” corporation). In this situation, it’s even possible for a seller to face total taxes in excess of 50%, with most of that tax due in the year of sale! Even a 40% down payment would not be enough to cover the taxes the seller would owe! Needless to say, a seller who finds he or she will owe more in taxes than they receive in the down payment is not likely to be a very motivated seller.
Fortunately, tax disasters like this can often be avoided with proper planning. We’ll discuss the basics of structuring a sale in a later chapter.
Terms: By now it should be clear the terms and associated sale structure can be even more important than the “price”.
As described above, terms can strongly affect taxes for both sides. Since it only counts you get to keep it, this can be far more important than haggling over the final 5% difference in price.
Terms will also play a critical role in how the sale will “pencil-out” for the buyer. For instance, seller financing for ten years is far easier for the buyer to pay for from ongoing cash flow than five-year financing, and the reduced risk can often justify a higher price.
Terms affect the risk for both sides. Terms so stiff that the sale can’t possibly pencil-out, will obviously raise the risk for the buyer. Although it’s less obvious, the seller might also incur more risk from such draconian terms. An upside-down buyer is far more likely to look for an excuse for rescinding a sale, for some way to sue the seller for misrepresentation, for a breach of the representations and warranties in the purchase and sale agreement, or to simply default and walk away.
Earn-outs: Terms can also be used to share the risk and share the fruits of success. This is done with an “earn-out”. Many closely-held agency sales commanding a premium price will include an earn-out for part of this price if structured by knowledgeable professional advisors.
In an earn-out, part of the sale is based on future results of the business. A formula is used to determine how much extra will be paid. Earn-out formulas vary widely, but are generally based on either total future revenue (the simplest), or some measure of future cash flow (more complex).
Conclusion
Agency valuation starts with estimates of future cash flow and risk, which are difficult enough. However, many other factors also influence value. The same agency will be worth different amounts to different buyers; and it might be worth more or less at any given time even if nothing has changed. Nothing is as certain as death and taxes, and changes in the tax laws will change agency values. The terms of sale can be even more important than the price. Last, but not least, if the “price” includes an earn-out, then the actual price will not be known for years.
Simple, right?
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.