The Origins Of Diminished Agency Value

by Roy Phillips and Dan King

What factors contribute to the reduction of an agency's value? In our experience of evaluating hundreds of terminally ill agencies over the past decade, some common threads have emerged.

It appears that the No. 1 cause of diminished agency value is poor management. An agency with skilled leadership is likely to be healthy. In the hands of its existing owners, the agency will probably continue to operate with consistent financial and market profiles, and hold its value. The relationships that develop between clients and owners over the years have an intangible, but real, value in goodwill.

Conversely, a sick agency with plummeting market value might look to the following contributing causes:

1. The agency suffers image damage with carriers due to underwriting losses, poor payment patterns, and sub-par knowledge of insurance coverage.
2. Skill levels of staff personnel, including CSRs and producers, are below acceptable standards, and the agency doesn't conduct proper recruiting and training.
3. Growth and attrition rates are inferior, with little emphasis on retention and account rounding.
4. The agency depends on single-industry business and/or large-revenue accounts.
5. Data-processing systems are absent or antiquated, with no online capability.
6. Staff and producers are working without employment contracts.
7. Agency owners and managers have few credentials in the areas of finances, sales, compensation, and marketing.
8. There's a history of E&O allegations, arising from a lack of training and proper procedures.
9. The agency's book of business is poorly balanced in the areas of size, type, and market placement.

Other sources of diminished agency value include such controversial areas as bankruptcy, tax consequences, divorce, piracy of expirations, and violation of contracts. Situations that may cause general mayhem between owners and/or shareholders include:

• The departure of an owner, who, in absence of a contract, is free to compete for business and enjoys enough goodwill to take clients with him or her
• The departure of non-owner producers who control accounts, and operate in a non-contractual or contractual vacuum
• Termination of the agency by a major carrier that held majority volume and provided competitive products
• Financial mismanagement of the firm, culminating in a virtual fire sale
• The untimely death or disability of the owner, without the benefits of perpetuation planning or the funding for such eventualities
• A promise from amajor long-term carrier for competitive products, competitive pricing, and underwriting latitude for the long haul-if the agency will roll over existing business or give the carrier first shot at new business

Just how does the consultant address and evaluate the ailing patient-or forensically examine the corpse-of an agency that has a distressed fair market value? Let's examine each of these scenarios in the light of Section 2031 of the estate and gift tax code, which is found in Rulings 59-60 (evaluation of a closely held corporation):

'I'll just take the business and move across the hall, and then it won't be worth a tinker's damn.'

In the divorce scenario, one spouse may have the goodwill of the client base, while the other has a vested interest in the value of the community property. Section 2 of the ruling addresses whether a firm or an individual has goodwill; it also deals with the evaluation challenge, should a key manager depart. Stir into this brew the fact that the goodwill bearer serves in absence of contract, and therefore has no compulsion to continue labor just to pay the ex-spouse.

If the bearer of goodwill leaves, the agency's value is diminished. Some jurisdictions have considered personal professional goodwill as a commodity that belongs solely to the owner. Few owners limit themselves with employment agreements that preclude self-competition; if they're disgruntled, nothing prevents them from walking across the hall, opening another door, and using their own customer list and trade secrets, without restriction.

An evaluation consultant would calculate the separate value of professional goodwill by determining the extent to which the departing agent controls the agency's major accounts. It would also look at how dependent the agency is on this individual to retain quality carriers and personnel. The results would be factored into the total reduced value of the agency

'They never appreciated me and wouldn't even give me a share in the fruits of my labor. I'll just open my own shop and contact my clients. Let's see if their lousy employment contract is any good.'

The only sure thing about employment contracts is this: Maybe they're good, and maybe they're not. Courts in various states have determined the reasonableness of the covenants in such contracts. For example, a contractual stipulation that won't let producers practice their 'common calling' has been ruled unenforceable. Producer are free to join another agency or open their own, as long as they don't attempt to pirate the business subject to the contract. To restrict them any further would be considered restraint of trade.

This leads to the subject of ownership. Employment contracts can provide equity-but what if the non-owner departing producer doesn't have such a stipulation in his or her contract? Who owns the business? We believe that the agency owns the business in absence of any equity provision granted to the non-owner producer. The expirations are, in fact, the agency's trade secrets: Any attempt by a competing agency to employ the customer list is piracy, and may be estopped by the courts.

What's a 'trade secret'? The Law Journal defines a trade secret as confidential information that provides a business with competitive advantage. Types of information that may constitute trade secrets include formulas, manufacturing techniques, customer lists, pricing information, cost information, and supplier identity.

Why elicit trench warfare over a departing producer who enjoys a goodwill relationship with his or her accounts? The clients' main concern is, 'How can I trust an agency and their producer to take care of my business when they can't even get along?' Such disputes are often resolved with a 'buy-sell parachute' agreement, in which the agency allows departing non-owner producers to buy out their accounts, subject to fair market value pricing, terms, and conditions.

The same solution can be applied in the case of a producer with contractual equity. In this case, the agency allows the owner-producer to acquire the remainder of his equity, subject to a pricing formula, terms, and conditions; or the agency buys out the producer's equity.

'The carrier pulled out, with the excuse that we weren't a 'good fit' with its agency marketing thrust. This isn't fair!'

Once the perfume of new premium volume is overcome by the stench of earned loss ratio, the carrier will make a decision based on what's good for their business. In this case, the evaluation consultant must review the history of production and loss runs, paying close attention to the tenure of the carrier and spread of business, and compare earned to incurred loss ratios for the current and previous three years. If the evidence indicates bad times, the predicted departure of this major player will diminish the value of the agency.

The consultant must realistically review the entire book of business to determine if it can be replaced in an existing market or with a new carrier. Replacement might result in marketability problems with existing clients, for reasons of increased pricing, underwriting restrictions, payment plans, or coverage availability.

'We'll make it up in the next quarter, so there's no reason to panic and tighten our belts.'

Many expenses cause agencies to go broke-labor, occupancy, producer compensation, perks, incurred bad debt, and that mysterious visitor to the income statement, 'miscellaneous expenses.' People who are the least cost-effective resist change the most, feel overloaded, cause trouble with underwriters, can't get along with fellow employees-and will stay with you as long as you house and feed them!

An experienced consultant can determine an agency's financial condition simply by thoroughly examining the income and expense statement. Unfortunately, most agency owners don't have the same expertise. The reason is simple: Most of us grew up in a production mentality, which doesn't require any accounting expertise. Sales and service carried the day, and the only numbers that peaked interest were those relating to revenues-or even worse, premiums. That attitude leads many agents into the hazy world of premiums versus commissions, versus trust accounts, versus going broke.

'Dad was the original owner, and never wanted a partner. We kids worked in the business while we were in high school and college. Dad complained that the business wasn't what it used to be, so we decided to pursue other careers. When Dad died, we liquidated before local competitors could cannibalize the accounts. We had no choice but to get the business appraised for tax purposes, but the lawyer said that the book value didn't indicate much net worth.'

Book value-what a tragic analysis of the worth of their father's life in business! The attorney was unaware of the intangible value of expirations, the bricks and sticks of insurance. Granted, the lack of any perpetuation planning resulted in diminished agency value, but exactly how much? The evaluation consultant was challenged to determine the answer to this question.

If one of the children had been involved in the agency, we would only have to turn to Case A. However, the IRS has a vested interest in the determination of fair market value, diminished or not.

'We represented the carrier for years and trusted their management. For years, we'd been on their trips, received good profit sharing and commissions, and provided good loss ratios and increasing premiums on a well-spread basis. They said they'd be there for us over the long haul, and we believed them. But when they left the state, they said they had to look at the entire territory, and not just at our book of (profitable) business. Afterwards, the companies we'd reduced didn't want to have much to do with us when we tried to remarket the business.'

This is a worst-case scenario: The agency without available markets for its client base has the greatest degree of mortality. Dependence on single marketing sources is never a good management decision.

Conversely, the agency with too many markets runs the risk of creating 'also-rans.' Think about it from the viewpoint of a carrier: Why would it want to be at the bottom of an agency's premium totem pole, with adverse selection working against its loss ratio?