Agency Valuation Issues

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AGENCY VALUATION ISSUES

by Roy Phillips

More and more banks are entering the insurance industry by buying agencies, leading owners to ponder how to properly determine their agency’s value. This document by Roy Phillips summarizes many of the issues you’re likely to face when attempting to put a price on your business.

 

Two days of agency evaluation workshops at a recent IIAT Convention led me to some observations. After categorizing and compiling members’ concerns and opportunities, I concluded that agents are as concerned about their agencies’ value as they’ve always been.

Our industry has attracted some new buyers, primarily community and national banks. This opportunity was a popular subject in our discussions with individual members. Having just completed work for an agency that transferred its book of business to a local bank, I was acquainted with the differences in what I choose to call 'revenue mentality.'

Banks historically have been lenders who emphasize physical collateral; they want an inventory to pick up, or a building to repossess. They’ve had to put this emphasis aside to examine the revenue stream and value of a book of business, best characterized as the customer list. Oddly enough, this paradigm shift came about due to changes in their own industry, as banks merged and acquired their own customer lists. The fortunate result is that the banking community sees the value of an agency beyond its book value and recognizes the value in the revenue stream derived from a customer list, an asset not exhibited on any balance sheet.

Some lenders have paid top dollar only to learn later of the value of other intangibles such as professional management, solid carrier relationships, tenured and dedicated staff, and a historically strong relationship with the community and insureds. State and federal laws that view insurance as synergistic with banking and other financial enterprises are in transition. We founded our assistance on the principles of fair market value transfer of the agency, the perpetuation of management and staff, and the understanding that agency principals often earn more than many bank presidents. In addition, if the bank attempted to micro-manage the agency, the joint enterprise would fail.

Another concern was the lack of contractual perpetuation agreements in buy-sell instruments. No legal foundation exists for determining how to address shares of an agency’s value in the event of a death or disability. This can cause difficulties not only with family members, but with the IRS in their approach to agency valuation.

For example, we were involved in a dispute between the IRS and the survivors of an agency. We had to calculate the agency’s fair market value in order to discuss profit issues. With no buy-sell instrument or valuation method, a survivor would have to counter the IRS’ assigned value if it’s outside the agency’s realistic adjusted net earnings. We demonstrated that an agency’s profit margin is small, and that premiums and commissions are subject to the dynamics of the marketplace.

Another concern is one that we’ve heard for years: the addition of a producer who’s under contract with another agency and doesn’t believe that the piracy of expirations clause will hold up. That horse might never leave the gate, if an attorney has drafted an employment agreement that’s reasonable in time and place. In addition, we’ve experienced situations in which a tainted book of business has been the foundation of equity in the stock of the new employer. What a bad deal for the owner, a stressful experience for the producer under contract, and a choice revenue stream for the litigators!

Our advice was twofold. First, there must be an employment contract with a 'right to acquire' clause for the producer that the former employer is willing to invoke in a manner financially favorable to both parties.

More importantly, the new employer must examine the book of business to determine whether they can market and service it profitably. The answer might bring a dark cloud over all parties. As one judge said years ago, 'The perfume of the deal might be overcome by the odor of the cost of litigation.'

Our final consultations involved the age-old question: 'What are agencies going for today?' A question concerning the multiple of gross commissions usually followed, perpetuating the age-old myth that two agencies producing identical commissions are worth the same multiple. We compared two generic agencies with $500,000 in annualized commissions, then examined the expenses that determine the true adjusted net earning before taxes. In ruling 59-60, the IRS specifically identified the valuation method of a service business such as an agency as the final 'earnings test.'

If you base an agency’s value solely on its book value, it would be profoundly understated. This goes back to the intangible we mentioned earlier, the customer list and associated goodwill that leads insureds to renew and to refer others to the agency.

Despite new dynamics in the valuation marketplace, the final equation in managing and/or transferring an agency remains the same: An agency can increase its value if management sets goals that lead to a hard-eyed review of the profit and loss statement, together with ongoing due diligence by both the agency’s staff and its markets.

Roy Phillips, CPIA, CIC, can be reached at Dan R. King & Associates, 4888 Loop Central Dr., Ste. 100A, Houston, TX 77081, (713) 667-0333, fax (713) 667-1560, or e-mail Rphlconsult@kingphillips.com.

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