WHAT IS AN AGENCY WORTH?
by Roy Phillips, CIC, CPIA
Check out these four ways of determining an agency’s value.
Agency management consultants are often asked, 'What is the value of an independent insurance agency?' During the 15-plus years that I've been involved in pursuing that elusive, intangible figure, I've discovered four methods that have been developed to determine agency values. But before I review them, a little history.
Early consultants attempted to define agency value as multiples of gross revenue. Consultants still use this concept, but only to communicate an agency's value, not to determine it. After that era, different multiples were assigned to different lines of an agency's business. A consultant might assign a multiple of two to the gross annualized commissions of the Homeowners book, while assigning a multiple of one to the more volatile Personal Auto business. Other even less valid attempts to define value included calculations of 'what an agency in this area recently brought.' It is not surprising that contract disputes and litigation have arisen from these subjective attempts to determine agency value.
Enter the IRS
Consultants attempting to determine an agency's value must rely on guidance from accepted accounting formulas and their own informed judgment. Both concepts are outlined in IRS regulations, especially IRS Revenue Ruling 59-60, which addresses the tax fate of a closely held corporation. This ruling, used to resolve tax issues concerning estates and gifts, was so widely respected that the IRS decided to apply it to the valuation of other types of businesses (Revenue Ruling 68-609).
Revenue Ruling 59-60 defines fair market value as 'the price at which property would be transferred between a willing seller and a willing buyer, neither with any compulsion to sell or buy, and both equipped with the pertinent, relevant facts.' Revenue Ruling 59-60 makes two major points pertinent to the determination of value:
- The valuation must include all relevant factors.
- There is no general formula that must be employed.
To paraphrase the second point, the appropriate formula for a given valuation may be derived from a consultant's informed judgment about the 'relevant factors.' Revenue Ruling 59-60 mentions eight such factors, considered later in this article.
Also of interest to agencies was a controversial IRS ruling (Revenue Ruling 74-456), which allows one to amortize acquired books of business (expirations) if their value can be established. Congress recently eliminated this truant ruling by passing Section 197, which provides that all intangible assets may be amortized over a 15-year period.
There isn't enough print to analyze all the considerations consultants must make to inform their judgment. Suffice it to say that the black knight of total subjectivity must be challenged with sufficient objective data to win the day-and prevent future lawsuits.
What's the Purpose?
When making a valuation, it's important to establish its purpose first. This article addresses the fair market value of a going business concern in the hands of its current owners. It will close with a few observations about the market value of the same agency offered for sale to third-party owners. Is there a difference? You bet!
The going-business-concern value is perhaps best expressed as the agency's value to the current owners. Such a valuation ordinarily is required for the purpose of a buy-sell agreement or when additional treasury stock is sold. Other reasons include the search for additional capitalization from a lender or passing on the business because of retirement, death, or disability of a shareholder, owner, or partner. When a valuation is conducted for a going-business-concern purpose, the buyers and sellers are already known, and, after the sale, the business can be expected to continue in much the same manner. Generally, an agency's going-business-concern value is greater than its intrinsic market value.
Intrinsic market value is necessare to calculate when one contemplates transferring the agency to an outside party and new management. Let's say that the agency principal is retiring, has become disabled, or has died, and there is insufficient ownership and management in-house to perpetuate of the agency in its current state. In contrast to the going-business-concern transfer, the identity of the agency's buyer or buyers might not be known at the time of valuation.
Whether the objective to establish is a going-business-concern value or a market price for eventual sale of the agency, the agency's value lies in the persistence (historical and projected) of its earnings stream. Both valuations produce 'fair market values' but for different purposes.
A Search for True Earnings
A bare-bones pro forma statement that displays the actual income and expense that a buyer may expect is the basis for all accepted valuation formulas. From that, the true adjusted net earnings must be determined. For instance, agents tend to spend nonoperational revenues. When these revenues are put back into the picture, net earnings increase.
Many buyers are interested only in how much it will cost to operate the agency (given their own expense structure) and how profitable it will be as a result of the sale. The prevailing viewpoint holds that a buyer might reasonably expect 'adjusted net earnings before taxes' (ANEBT) of 15% to 25%, after adding back the nonoperational revenue the seller has been spending, determining the projected rate of attrition, eliminating unnecessary expenses, and taking into account revenue sources that are less than certain.
For example, an agency with commission revenues of $750,000 might be 'shrunk' to reflect such noncontractual revenues as contingent commissions. The consultant also must question the persistence of interest on cash flow, Life and Health commissions, and that mysterious visitor dubbed 'miscellaneous income.' This surgery might result in an expected pretax income of $700,000 -- some $50,000 less than the figure on the income and expense statement.
Income and expense statements normally show two expense categories: selling expenses and operating expenses. Each category is broken down into line items, six for selling expenses and 25 to 30 for operating expenses. It is at this point that the net earnings scalpel grows sharper. Under sales expenses, major offenders that might be trimmed include line items for travel and entertainment, auto expenses and other perks. Operating expenses are often inflated by excessive occupancy costs (the agent owns the building), a disproportionate number of employees, and a cornucopia of executive salaries and benefit plans.
In preparing the pro forma statement, we enhance the line items just mentioned to identify expenses more specifically. For example, principal compensation and benefits are disclosed in several line items (salary, commissions, bonuses, dividends, profit sharing, benefits/perks, and so on), rather than as a lump sum. The consultant must consider all these components when valuing an agency for the acquisition of stock or partnership by a minority-interest purchaser. The owners, under no compulsion to sell any portion of the agency, may take liberties with the pretax benefits. Vehicles, travel, entertainment, education, Life and Disability insurance, and deferred compensation are just a few of the perks that the current owners usually will continue to receive. New people buying into the agency might want to be assured that they will receive those same benefits.
Valuation Formulas
When all is fine-tuned-expenses trimmed and all benefits and revenue disclosed-an agency's projected ANEBT, previously expressed as a mere 6% to 12%, might now be 20% to 25%. (These sample figures come from typical cases in our files.) Let's assume that it's 25%, or $175,000. Now we can use formulas to calculate a value of the business. It should be remembered that we are attempting only to place a value on the book of business (expirations), and that the balance-sheet assets and liabilities should be determined separately. This is best left to a CPA. Let's consider several valuation methods.
The Capitalization Rate of Return Method
After calculating the agency's ANEBT, we apply an appropriate capitalization rate. This rate is determined by combining a risk-free rate of return (such as from U.S. Treasury bills) with a factor based on an assessment of the amount of risk the buyer is assuming. Risk factors historically range from 10% to 30%. For example, if the purpose of the valuation is to set a stock value for a going business whose owners are under no compulsion to sell, and if the business is consistently achieving a reasonable ANEBT, the risk factor would be relatively low-perhaps 10%. On the other hand, if the business is being transferred and is in a distressed condition, the risk factor might be 25%.
In our example, let's assume that it's appropriate to combine a 7% risk-free factor with a 10% risk factor, giving us a capitalization rate of 17%. When applied (divided into) the agency's ANEBT, the rate produces a value of $1,029,412.
Discounted Future Earnings Method
In this valuation method, a compilation of rates of historical growth and attrition are used to determine the future earnings (ANEBT) that a buyer might expect. These results are forecast over a period of time ranging from five to 10 years. (The IRS says the period should be five or more years in Revenue Ruling 59-60, Section 4. 02. [d].) The earnings are forecast using a discount rate that, like the capitalization rate already mentioned, combines the risk-free money rate with an appropriate risk factor.
When using this method, it's important to remember that historical persistence of income and expenses are influenced by the economy's dynamics, changes in the underwriting cycle (hard and soft markets), and fluctuations in the quality of agency management. An example of this method, using an ANEBT of $175,000, an assumed growth rate of 7% after attrition, and a discount rate of 17%, produces an agency value of $1,021,617.
The Multiple of Adjusted Net Earnings Method
Revenue Ruling 59-60, Section 5 (a) indicates that earnings should be given primary consideration when valuing firms that deal in 'services' for the public. This method does just that.
Since agencies are not ordinarily publicly traded, there is no price available from Wall Street that applies. Large brokerage firms do not, in our opinion, represent a true guideline, since the owners are minority-positioned and the price-earnings ratio fluctuates so dramatically from one 'alphabet house' to another. Moreover, the ability of the houses to acquire smaller entities through the employment of stock and/or contingent payments does not reflect the ability of one agency to acquire another.
The multiple of earnings approach also starts with the calculation of an agency's ANEBT. Then an appropriate multiple is determined. In our experience, typical multiples, which usually are expressed on an after-tax basis, range from 10 to 12 times the adjusted net earnings after taxes (ANEAT). In the following example, we use a multiple of 11. But again, the calculation is actually based on ANEBT, not ANEAT. This produces a valuation unaffected by tax consequences to the seller or buyer.
From our after-tax multiple of 11, we subtract a tax base of 34% (the corporate tax rate), or 3.74 (11 x .34 = 3.74). That leaves us with a multiple of 7.26. We then subtract the previously calculated discount rate of 17%, or 1.234 (7.26 x .17 = 1.234). This gives us a pretax multiple of 6.026, which we'll round off to 6.03. When applied to the ANEBT, it produces a book value of $1,055,250.
The Phillips Method
Over the years, we have developed a method to assign values to an agency's components: the Phillips method. We use this method in presentations to courts in actions concerning diminished values of agencies, divorce, bankruptcy and tax liabilities, along with general shareholder disputes.
Using this method, we analyze 23 informed judgment factors along with the eight factors set forth in Revenue Ruling 59-60. This method might not be perfect, but I believe it's more objective than any other method. Here's how it is used to determine the value of ownership in a going business concern not being offered for sale:
Once again, determine the agency's ANEBT first. Then consider the impact of the following issues, taken from Revenue Ruling 59-60:
- The nature and history of the business since its inception
- The economic outlook in general and the outlook of the business' specific industry in particular
- The financial condition of the business
- The earnings capacity of the business
- The dividend-paying capacity of the business
- Goodwill or other intangible assets of the business
- The size of the block of stock to be valued
- The transfer value of similar business, if pertinent
There are several comments I'd like to make concerning these Revenue Ruling 59-60 components. First, it's difficult to measure an area's or agency's economic outlook without being involved in the insurance business in that area. A consultant working as an agent in Texas, for example, would have a difficult time determining the specific economic condition of an agency in Indiana. Markets in central Indiana are historically stable, compared with markets in South Central Texas.
The financial condition of the agency is addressed as we develop the ANEBT from a pro forma statement. The persistence of carrier representation and with the impact of reliance on a specific industry must be addressed. For example, what happened to the ANEBT of Houston agencies with large books of petroleum-related accounts during the 1980s?
As already mentioned, the IRS places a great deal of emphasis on earnings as a valuation basis, so a consultant must recognize the reasonableness of expenses in a given geographic area-for instance, the possible glut of nonoperational expenses of which a consultant must be aware.
The size of the block of stock to be offered is important. A fair market value must be determined for the new minority shareholder. Ideally, this person is a qualified producer acquiring shares of stock in an agency in which he or she is actively engaged. At the other extreme, the new minority shareholder could be a nonagent buyer with no promise of even a job and only an assumption that the other owners will treat him with equity. Such a minority owner would be wise to examine the liabilities to be assumed before signing on the line.
The next step in the Phillips method is to determine the agency's peer group profile in light of 23 informed judgment factors:
- The industry image of the agency
- Management skills demonstrated
- Carrier markets available or terminated
- Condition of aged accounts receivables
- Skill levels and productivity of personnel
- Historical trend of business growth or attrition
- Dependence on large-account commission revenue
- General spread of book, commercial to personal
- History of contingent commissions
- Ability to deliver competitive rates
- Mix of products available to various industries
- The agency's pricing latitude with carriers.
- The agency's underwriting authority
- Errors & omissions history and coverage
- History of prior acquisitions
- Employment contracts with producers/staff
- Ability to configure client product needs
- Control of major accounts, by individuals
- Controlled business of the agency (The insured businesses are owned by the agent or a family member.)
- Dependence on a specific industry for revenue
- Status of any litigation involving the agency
- IRS actions, if any, against the agency
- Litigation involving key agency personnel
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