SUCCESSFUL STRUCTURAL OPTIONS: MERGER, CLUSTER, OR ACQUISITION?

by Catherine Oak and Bill Schoeffler

The pros and cons of merging versus clustering.

Agents and brokers all over the United States have been considering various ways of defending themselves against the threat of lower commission rates, withdrawing and limited markets, and various legislative reforms in such areas as health care, Workers Compensation, and Auto insurance. Conventional defensive options include:

• Seeking backup markets to minimize the risk of losing existing markets should markets decide to restrict underwriting or withdraw from the state
• Carefully regulating communications with insureds to minimize E&O exposure and sell additional coverage
• Merging or selling
• Clustering
• Acquisition

This article focuses on the pros and cons of merging versus clustering. If you've already decided on a merger without considering clustering, this article gives crucial steps to follow for any successful transaction, including acquisitions.

CLUSTERING DEFINED

A cluster is a group of agents or brokers forming a joint venture to market and place their individual books of business as a larger book. Traditionally, agents form clusters to obtain:

• More clout and improved profit-sharing agreements with markets
• Economies of scale: reduced selling and administration expenses and better use of existing facilities, automation, and personnel
• A potential market for buyouts
• Some specialization and stratification of the cluster's workforce

In a cluster (as opposed to a merger), all this can theoretically be achieved while the owners maintain independent ownership of their accounts. If an owner sells the business, he or she loses independence, ownership, some tax write-offs, and most of the control.

DRAWBACKS OF CLUSTERS

Clusters are to mergers what living together is to marriage: a partnership without commitment. Because of that lack of commitment, those who form clusters must worry about the void that can be left (with markets, shared expenses, and personnel) if a partner decides to his or business and leave the cluster.

A cluster is typically an organization managed by a committee of owners. Each owner has his or her own ideas-often very established ideas. Unless each participant is willing to place the ultimate executive authority with a few individuals, the ability to develop basic functional goals and implement decisions will be thwarted.

Bringing together of a number of different firms into a cluster increases the likelihood that operations will be hampered by the cultural differences among them-for instance, a predominantly sales-oriented firm would have trouble working with a firm that focused primarily on servicing existing accounts. Different management priorities could easily result in conflicts among the owners.

Each participating firm will also have its own kind of operational efficiency. If accurate expense allocations are difficult to determine, the more efficient firms will bear a disproportionate amount of the costs.

A cluster might not be able to obtain extra influence with carriers unless one or more of its participants have already formed a preferred relationship. An insurance company will have to approve of each firm participating in the cluster before agreeing to establish a relationship -- and a new contract-with the cluster. Today, it's not easy for new firms to gain a carrier's approval; many carriers prefer to reduce, not add, to their agency force.

Firms that want to cluster usually have small books of business or existing placement problems. Naturally, carriers are aware of this threat of adverse selection. They also know that a cluster group does not have the same degree if commitment to the group that a merger would have. Most insurance companies would rather deal with merged organizations than with cluster groups.

MERGER RECOMMENDATION

For these reasons, and the fact that clusters often fail to fulfill the owners' expectations, we recommend that firms consider merging instead of clustering.

If properly organized, a merger brings in more benefits than a cluster would without losing all the advantages of ownership. The advantage just described for clusters also apply to merging (more clout with carriers, economies of sale, better market for buyouts, more production and management talent, and so on). And markets are more likely to contract with a merged entity.

Also, a merged firm does not have the major disadvantage of a cluster: the void when a member decides to leave. It provides all the advantages of ownership, and the stockholders are committed to operate a much larger, stronger business.

MERGED OWNERSHIP

Ownership in the merged entity is usually based on each firm's individual contribution to the aggregate's value. Each firm should be appraised to determine:

• its contribution to aggregate value
• its strengths and weaknesses

For example, if Agency A's value is determined to be $1.3 million, Agency B's value is $1.6 million, and Agency C's value is $1.9 million, the distribution of ownership in the new entity would be 27.1% for Agent A, 33.3% for Agent B, and 39.6% for Agent C.

New alternatives to structuring the merger are based on contribution to the total value of the new firm. In one alternative, incentives for the future contributions to management or production can be designed through vesting in a new corporation, providing motivational rewards. Incentive compensation systems can be explored with a qualified consultant.

ESSENTIAL STEPS

The following steps should increase the likelihood of success in a merger, cluster, or acquisition:

• Carefully evaluate each potential partner to ensure that your corporate cultures and goals are compatible.
• Make sure that all information is exchanged. All closets should be opened and all skeletons removed!
• Use professional accountants to conduct thorough due diligence.
• Draw up a mutually agreeable letter of intent outlining general terms of the transactions, and follow it up with a legal purchase/merger/cluster agreement.
• Establish and agree on a compensation plan for stockholders based on ownership, production, and management responsibility.
• Discuss forming a satisfactory retirement plan.
• Establish the travel/entertainment and auto policy.
• Draw up buy-sell agreements between shareholders in the event of death, disability, or retirement.

Whether merging, joining a cluster, or acquiring, an owner should carefully evaluate all alternatives and issues. There must be a commitment in theory and practice for any association to succeed. A cluster is often used as a prelude to a merger. If given a choice between merging and clustering, a merger is the best way to ensure commitment.

Catherine C. Oak, CIC, AAI and Bill Schoeffler can be reached at Oak & Associates, P.O. Box 2047, Glen Ellen, CA 95442, (707) 935-6565, fax (707) 935-6515, E-mail [email protected].