What Is Your Agency Worth? A 'Magic Formula'-Plus 10 Ways To Maximize Value

by Blaine Price, CPCU, CIC

'What are agencies selling for today?' is a question frequently heard by agency business consultants. Another is, 'Can you give me a simple formula to calculate my agency's value?'

As you may have guessed, there's no one-size-fits-all measure of an agency's value. But you should understand some general guidelines before approaching a qualified valuation professional to set a value on your agency.

The most important concept to grasp is that an insurance agency's real value is its ability to continue generating income for its owners over an extended period of time. This ability to generate profits makes one agency more valuable than another.

In the past, agencies tried to peg their value to a multiple of gross commissions. A common formula was gross commissions x 1.5 = agency value. The problem with this formula is that it doesn't measure the agency's potential profitability, which is the primary interest of most buyers because purchases are usually funded from future profits. It's also extremely important to the seller, who uses the ongoing payout from the sale to fund retirement.

The only time a multiple of gross commissions makes sense is if the agency goes out of business and is simply liquidating its primary asset: its customer list. Agencies that use only this measure in any other type of sale could face serious problems.

For example, if an agency's selling price is based on assets, and that price is higher than its ability to generate profits, it could jeopardize the sale later on because the buyer might not be able to meet the payout obligations to the seller. This could force the seller to take back a deteriorating business to protect his or her interest. Conversely, if the agency is worth more based on profitability (as opposed to assets), the seller could lose serious money by settling for just the asset value.

If there's one magic formula that can be applied to agency value, it's this: Every one dollar of adjusted pretax net earnings (profit) is worth approximately $6 in agency value. This measure should be adjusted for principals' salaries, non-insurance activities, and certain excessive or nonrecurring expenses.

Although simplified, this formula is a useful starting point for agents hoping to track their progress. Of course, agents who need to establish a workable selling price should consult with a qualified professional to ensure an accurate value.

Agency principals need to recognize early on that it's the agency's ability to generate profits (not just the value of its book of business) that will make for a successful sale or perpetuation. They must manage their agencies with an emphasis on creating value that can be transferred at the time they sell their interest.

How can you do this as an agency owner? Here are 10 general rules to follow:

Good staff and producers are a necessary ingredient in a profitable agency. They provide the knowledge and professional expertise necessary to generate sales and provide customer service effectively. They're a source for future agency management and future agency ownership.

Low staff turnover can reduce expenses by lessening the cost of constantly hiring and training new people. Compensation levels must be affordable for the agency and fair to staff and salespeople, providing motivation for growth and high productivity. Good people are crucial to the success of the next rule.

Real growth generates income, which covers expenses, generates profit, and provides the ability to invest in the agency's future. Agencies that aren't growing will inevitably decline in production and income, resulting in a diminishing value and less profit.

Owners commonly show a small profit at the end of the year for tax purposes. That's OK as long as the agency is retaining enough earnings to provide for capital needs such as updating automation and adding producers. The important thing is to be able to identify real adjusted pre-tax net profit to justify the value desired.

Examples of additions to reported pre-tax profits would be excess compensation paid to owners, amortization of purchased books of business, and the excess cost of driving a Lexus instead of a mid-sized Ford. Others are excess rent paid to the agency owner who also owns his or her own building, and one-time expenditures (such as remodeling or legal fees) that aren't repeated on a sustained basis. Similarly, adjustments must be made by subtracting nonsustainable income or income not related to the insurance business.

Manage with the objective of having agency income grow faster than expenses. Although office payroll and benefits are the largest items of administrative expense, all categories of expense can contribute to increased profit in a well-managed agency. Track and control each category of expense with the objective of looking like a high-performing agency in the Best Practices or other peer studies.

Accounts receivable that are older than 60 or 90 days could be considered bad debt and will detract from profit. Collect receivables when due. One way to minimize potential problems is to use direct bill or similar payment programs whenever possible.

Renewal business costs less to handle, so agency profitability rises when retention rates are increased.

Lower carrier loss ratios, combined with growth and retention, can significantly affect contingency commission payments. Even though they aren't totally dependable from year to year, sustainable contingency income is an important factor in agency profitability.

What's more, these same factors attract and retain high-quality, stable markets, which reinforces agency growth and profitability.

You can't value what you don't control. Producer contracts with well-written non-piracy provisions protect the agency and its primary asset, the book of business-thus protecting the agency's value to its stockholders.

High-performing agencies are characterized by high staff and producer productivity. High productivity allows the agency to pay good people more for the work they accomplish while lowering the agency's total compensation costs. This can be accomplished by maximizing the use of agency automated systems and eliminating redundant or unnecessary activities through standardized written practices and procedures.

Producers can be more productive by concentrating on bringing in business based on a marketing plan that focuses the agency's resources on classes of business or programs that have the greatest chance of success. They can also seek business that doesn't require excessive service costs for the income generated. Generally, cross-sold accounts are more profitable because they require proportionately lower service costs than smaller accounts of the same type.

Errors & Omissions (E&O) problems are an indication of an increased risk of operation, which can affect agency value dramatically through loss of income and loss of reputation with customers and carriers. A good E&O-prevention program will contribute to increased agency productivity and profit.

Begin early by concentrating on building agency value as part of your long-term preparation for perpetuation.

Since values change as the agency changes, value your agency regularly to measure your progress, satisfy requirements of buy-sell agreements, and determine share value for purchase or sale of stock. How regularly? I recommend every two to four years, or as required by contract or agreement.

Creating value by building profit in an agency can't be accomplished with an instant fix. Value creation is a long-term activity and a challenge to agency owners and managers. It's a challenge that can take years to accomplish, but it can be very rewarding to those who take it seriously.