Finding A Compatible Business Combination

FINDING A COMPATIBLE BUSINESS COMBINATION

Over the past few years, many firms have entered into a merger, acquisition, or some type of cluster arrangement with another firm or a producer with a book of business. And often the venture has turned out to be unsuccessful.

Many mistakes are made because the participants don't take enough time to effectively evaluate the business combination they're considering. This can cause real problems for all parties involved.

Firms make the wrong decisions for many reasons. Among the more common reasons are: (1) not having enough information about the other party to make an astute decision; (2) searching for a quick fix for a loss of markets, or (3) finding a deal with a price that 'seems' good.

A recent IIAA study reported that only 46,000 independent insurance agencies exist now, compared to 53,500 five years ago. The study also indicated that 26% of these remaining businesses have been acquired or merged with another firm in the past few years.

The most difficult part of creating a successful business combination is determining whether the parties are compatible and if a combined entity will be an improvement.

Many firms think the key to a good deal is the price. This is far from true. Determining the appropriate price is much easier than finding a suitable party to conduct an ongoing business relationship with. It's like trying to find a good mate-it isn't easy!

To find a suitable, compatible business combination, several key areas need to be discussed in the 'schmoozing,' 'romancing,' or 'courting' stage. The parties can explore these key areas themselves, but it's advisable also to have a third party involved, who is respected by the parties (a consultant, board member, CPA, or attorney, etc.).

This article addresses the key areas that all parties need to explore, and the steps that should be taken to accomplish a successful business combination.

Each party should list its major strengths and weaknesses and then exchange the lists with each other. The goal: to see if each party will complement the other by minimizing weaknesses and maximizing strengths. Such an analysis may make it apparent that the combination will not help improve the problems each firm faces-may even make each party's weaknesses worse.

Each owner in each firm should make a list of personal goals and wish lists for the future. If the owners are nearing retirement, they should also be very specific about when they expect to retire, what future duties they want to have, what price they expect for their stock, and what 'perks' they expect to continue receiving until full retirement (for instance, office, car, travel and entertainment expenses, and so on).

If the owners want to perpetuate internally, their expectations for their buyout need to be realistic in relation to the cash flow available from the firm's activities.

Internal perpetuation might not be an alternative if the appropriate perpetuation candidates aren't available to manage the firm and sell and service new accounts. Moreover, the firm might not be able to support the financial burden of the buyout of the retiring shareholder. In either case, a sale of the firm to a third party or a merger or cluster arrangement may be necessary.

If two firms' operations are set up too differently, a business combination might not work. A firm's organizational structure often reflects the philosophies of management and the talents of the individuals employed. A successful business combination combined into one location can merge the best of each party's organizational structures and employees.

Melding the best structures and employees is the most difficult aspect of any business combination. Each party is usually too close to its own operations and employees to be able to pick and choose which ones are better for the new entity. A third party can greatly assist.

Examples of varying operational structures include the following:

• Having a small commercial accounts unit that services and sells all accounts under a certain size, instead of having all CSRs handle small accounts
• Functioning on an alphabetical basis instead of by producer unit
• Centralizing the marketing/placement function instead of having producers doing their own marketing
• Having separate individuals handle claims, versus producers handling most servicing of accounts-or hiring qualified technical CSRs to support producers, freeing them up for new sales

The philosophies on these operational issues need to be explored, and an agreement reached on how the combined entity would handle each of six functions for Life, Group, Personal and Commercial lines: sales, marketing, placement, client service claims, accounting, and administration.

In conjunction with the operational issues, the extent to which automation will be integrated with the systems and procedures of the firm need to be determined. Which computer system will survive the business combination?

A number of ratios should be calculated separately for each party to assess how well run each firm is before joining together. Combined ratios can also be calculated-but if ratios are determined separately first, each party will know whose firm is adding to the efficiency of the new operation and what weaknesses need attention.

The ratios should be compared to those of other agencies of similar size and agencies writing comparable accounts. The results should also influence the values placed on each entity, since they reflect the management of the current operations (profitability, staffing, expense controls, working capital, and so forth).

The ratios should include the following as a minimum:

• Expenses by line item as a percentage of revenues
• Revenue, expense, and profit per employee
• P&C or Life/Group commissions per producer and per CSR

For each line of business:

• Commissions per account
• Commissions and accounts per CSR
• Servicing cost per dollar of commission
• Return on investment
• Collections (aged accounts receivable history)
• Working capital
• Trust ratio
• Debt to inquiry
• And so forth

Each party should create a list of the top 10 insurance companies it represents, along with certain information on each carrier: premium or commission volumes, three years of loss ratios and contingency commissions paid, volume commitments made, preferred status or special profit-sharing agreements, solvency of carrier, and years appointed. This helps the parties understand the current situation and their weaknesses before getting together with the carriers to renegotiate contracts for the new entity.

The book of business written by each firm should be analyzed. What split does each firm have by line of business? A complimentary combination may be the best, rather than more of the same. For example, one firm might not have any Life and Group business, and may need in-house experts to sell the leads.

What target markets, areas of expertise, and specialties do the producers in each entity have? How well developed are the existing accounts written by each firm?

What's the attrition rates of the accounts by line of business? What classes of business are the top 10 commercial accounts, and how much volume do they represent? Is there much non-owned or brokered business that may affect markets represented?

Each party needs to know the compensation and perks the other party provides to its producers and employees. How the owners compensate themselves is also extremely important. It's essential to determine a new compensation plan for owners before putting the new entity together.

It's often difficult to change compensation plans, especially for key employees (owners, producers, managers), without adversely affecting their desire to stay in the new entity. On the other hand, it's also difficult to have one entity support two very different compensation plans for owners, producers, and key managers-or salary differences for employees having similar jobs.

Each firm should also share the contracts signed by the firm's partners, producers, and other employees. Today it's also becoming more common for all employees to sign non-piracy agreements to protect the firm's book of business and trade secrets. Some contracts may allow producers to vest in their books of business, some may have covenants not to compete or non-piracies, and some may actually allow producers to obtain equity (stock options) in the firm at a later date. The new entity should come to an agreement about the standard contracts that need to be signed by producers and all employees.

What kind of real growth (in number of accounts versus commissions) has each firm experienced for the last three years? Where is the growth coming from, and can it be expected to continue?

Is there anything on the horizon that will lead to a real decline in revenues (such as loss of a market, change in a commission structure from a carrier, loss of a program)?

What kind of perpetuation plan is currently in place in each firm? Are there any employees who are good perpetuation candidates and who could continue the current owners' management and production capabilities? When will the existing owners be retiring, and what are their expectations for a buyout? Is there a buy/sell agreement currently in place for a buyout that the parties will have to live with?

Last but definitely not least are the reputations that the firms (and especially of the principals) enjoy in the community, with carriers, and with insured clients. It's important for all parties to have similar morals, philosophies, goals, and desires. These things are difficult-if not impossible-to change later on.

Also, the parties need to feel a certain synergy when they're all together in the same room 'romancing' or 'courting' each other in the compatibility discussions' various stages. As with a romantic relationship, the chemistry has to be there.

If the 10 key areas in this article are explored from the beginning, it should be clear whether compatibility exists and the business combination will work. These issues should be identified and discussed honestly and openly. A good business combination will result only if this process is followed and these 10 areas are determined to be workable. A third party may be needed to facilitate this process.

Catherine Oak, along with Bill Schoeffler, runs Oak & Associates in Glen Ellen, CA. Their consulting firm specializes in agency management, automation, clustering, errors and omissions, evaluations, mergers, and producer compensation. You may E-mail Oak at [email protected] or call her at (707) 935-6565.