There’s no such thing as a risk-free acquisition.
Deals fail for a myriad of reasons. One is that the principals are unfamiliar with the dynamics of the negotiation process, failing to understand that they must make a credibly structured offer. It is difficult for them to understand the concept of intelligently assuming risk.
Understanding how to make an offer is essential to a successful negotiation. In many instances, the buyers unrealistically expect a deal to pay for itself out of cash flows. The buyers then make an offer that the seller thinks is being paid for out of his or her own pocket, with the buyers taking little or no risk.
Risk is an important element in any acquisition. It relates to the rate of return that a buyer expects in a transaction. The more risk a buyer sees in a transaction, the higher the rate of return. Buyers with an eye to their rate of return should recoup their investment in a shorter period of time to protect themselves from perceived risk.
Retention Vs. a Guaranteed Deal
Many buyers will buy a book of business or an agency only on a retention basis. This is unrealistic in many situations because the seller expects the buyer to assume some level of risk in the transaction. The retention of a book of business will depend to a significant degree on the competence of the acquiring agency. If the acquiring agency does not assign appropriately trained individuals to help service that book of business, it is unlikely that the retention ratio will be high, regardless of the client relationships the seller may have developed.
When structuring an acquisition, the buyer should focus on mechanisms for rectifying future uncertainties rather than on totally protecting him- or herself. First, the buyer should determine what those uncertainties or contingencies are, the possible nonrenewal of key accounts, the possible loss of markets due to loss of ratio or volume considerations, or misrepresentations made by the seller.
In addition to downside considerations, the seller might not want to lose the value associated with prospective new business that will be closed in the near term. Sellers are sometimes unrealistic with regard to non-owned books of business. One cannot expect to be paid for books of business that are not owned. Ultimately, the buyer will have to buy the subproduced book of business by negotiating with the subproducer, effectively buying that book of business twice.
Right of Offset
Some of the things to consider when dealing with future negative development include the right to offset against notes outstanding, and the value of lost business (whether due to competitive situations, or lack of markets). Misrepresentations made by the seller should be dealt with, too.
Adjustable Servicing Compensation
If the commission volume realized after the sale is considerably less than presented, the seller's compensation can be adjusted by use of a sliding compensation scale built into the seller's employment contract.
The ability to adjust seller servicing compensation should not be overlooked. In many cases, the compensation level is a significant continuing expenditure to the buyer and can easily look excessive if the serviced book of business experiences significant attrition.
Again, the ability to adjust is important if the total acquisition package was constructed around a specific amount of gross commission income to be realized after the sale. However, in assessing the amount of gross commission income expected, the purchaser must recognize the normal attrition associated with the sale of a book of business and of the reaction of key clients who are loyal to the seller only while he or she continues to own the business.
Post-Closing Adjustments
A useful mechanism for dealing with positive and negative development is a post-closing adjustment, which should be spelled out in the purchase agreement. It allows the transaction to be adjusted financially for a specified period before the closing of the transaction, because of increases or decreases in the book of business.
The typical period for a post-closing adjustment or look back is one year. This lets the book go through a full renewal cycle, in which time questionable accounts are likely to be lost and prospective accounts can be courted and closed by the seller.
To conclude, the purchase of an agency is a business decision. In making a business decision, the principals should expect to assume some level of risk. If one's goal is to be successful in the acquisition process, trying to eliminate risk completely is unrealistic; besides, any competitors out there are usually willing to assume risk.
By using some adjustment mechanisms and accepting some risk, agency purchasers will have a higher degree of success in the acquisition process.