Internal perpetuation is a realistic option for owners of healthy agencies to exit the business. In most cases, the desire to keep control of the business in the family makes internal perpetuation preferable to selling or merging. As Alfonso Ventoso describes in this document, internal deals can deliver the best of all worlds if they’re done right.

Let’s assume that you want to sell your agency to a relative in the business, a group of producers, or some mix of both. What do you need to watch out for? Although no article can address every one of the many issues that can arise, some of the major questions, both financial and emotional, are universal. Many of the steps taken to prepare an agency for internal perpetuation might also assist in a third-party sale, if that’s the eventual outcome. Note: In discussing a typical parent–to-child perpetuation, we use the terms “seller” and “buyer” respectively, because your employees, insurance companies, clients, and the IRS define your roles in this way.

REVISITING WRITTEN AND UNWRITTEN AGREEMENTS
As the time to perpetuate approaches, owners often find that the terms of buy/sell agreements and producer agreements signed with partners, successors, and producers 10 to 20 years before can raise thorny questions: How is the business to be valued? If there are non-family producers who might leave when the next generation takes over, do they own their books of business? Does the agency? Are these agreements written and signed, or “understood”? What’s the worst-case scenario? If producers leave and take their business, will this sink the deal?

Make revisiting these agreements part of the checklist of items addressed in the years leading up to the internal buyout or third-party sale. Many producers perceive any change in (or initiation of) producer contracts as a threat. Explain that in preparation for a change in control, these things need to be addressed. Avoiding the issue won’t make it go away, and reducing uncertainty will be better for everyone.

VALUATION: A CRITICAL COMPONENT OF AGREEMENTS
Where valuation is concerned, we often see buy/sell agreements that include formulas based on multiples of revenues that have little relationship to the current value of the agency’s equity. Years down the line, this disconnect can favor either the seller or the buyer: An inequitable and avoidable outcome.

Remember, value is a function of sustainable profits (earnings, not revenues), together with the balance sheet position of the entity on the day of the deal. Although a multiple of revenues is a widely used rule of thumb in the industry and a way that valuations are

often expressed, revenue forms only one part of how value is actually derived. Such major profit margin drivers as producer contracts (compensation, book ownership and more), company relationships, and retention have changed significantly over time. Because these changes impact the dynamics of the valuation, the buy/sell should be revisited periodically.

One healthy way to head off this problem is to agree to a third-party independent appraisal, or even an average of two or three appraisals, to determine value. A relatively modest investment in this area can prevent months or perhaps years of dispute. It will also reveal things that you might not know about your business, and prepare you for questions that will probably be raised by internal candidates, their financing sources, or outside buyers.

TAX EFFICIENCY
“S” corporation vs. “C” corporation; stock sale vs. asset sale; amortization benefits; earnout vs. fixed price; cross purchase; ESOP; pension obligations. Each of these issues warrants an article (if not a book) on its own. Failing to plan for these items can end up leaving a lot on the table for the seller, the buyer, or the government. Each affects both perpetuation and outside sale. Don’t underestimate the return on investment in objective advice from business, legal, estate and tax experts when selling what’s probably your largest asset.

For example, employee stock ownership plans are an often-overlooked tool. ESOPs can provide a very efficient way for the seller to save on taxes, while giving new management financial flexibility. Be aware that there’s a fair amount of time and expense involved in setting up and administering a plan and that your agency culture should lend itself to employee ownership. That being said, every agency should at least consider an ESOP. As a rule of thumb, your agency might be an ESOP candidate if you have at least 15 to 20 employees or $2 million in annual revenues.

Another overlooked tax planning tool is a pension obligation created in advance in which the agency pays the former owner after the sale. This can achieve two ends: The seller enjoys enhanced predictability of cash flow, while the price paid for the agency is reduced to the present value of the liability at the time of the transaction. Keep in mind that the guidelines for this arrangement must be reasonable; in family situations where the seller would prefer to give the agency away, the price and structure will have to pass muster with legal and regulatory authorities.

GIVING UP CONTROL
Many agency founders argue that they need a place to go every day. We hear time and again, “My spouse won’t want me sitting around all day” and, “There’s only so much golf I can play.” There’s a benefit to having a smooth transition of operational oversight and of accounts. Because account retention plays a key role in a successful transfer, it is in everyone’s interest to make sure it works.

Your financial bottom line is to maximize your after-tax cash while minimizing uncertainty. Your emotional goal is to be sure that you can handle not being the decision maker. You’ve already done the right thing in initiating the passing of the baton. It’s fine to show up at the office; it’s even better to produce new business while ensuring a smooth transition of the book. It is not all right to unintentionally sabotage the efforts of the buyers by continuing to exert control over the business. You’ve probably financed part or all of the sale — which is a vote of confidence in the buyers. Let them do their new jobs. Make sure that you’re ready for the mental shift from president and CEO to producer, consultant or retiree.

A WORD TO THE BUYER
Resources (articles, advisors, etc.) seem to be geared to helping sellers. You’re the buyer, you have a growing book of business, and you’re excited about the opportunity to own all or part of an agency. You’re willing to pay a fair price for the agency, and you’re thankful that the owner isn’t selling to a broker or bank. You’re willing to “sweat,” but you don’t want to lie awake at night thinking about foreclosure on your business or your house.

The answer: Write a business plan. Think of the agency you’re buying as a new venture in which you’ll have to convince skeptical bankers or venture capitalists to invest. This will help if you do talk to a bank. It will also reinforce the seller’s feeling that you’re a competent buyer. A business plan will also act as your personal guide after the deal, to measure whether you’re doing what you said you’d do to make it work.

We mentioned earlier that such rules of thumb as multiples of revenue can be useful, but can also be misused. Another helpful rule of thumb: If the balance sheet before the buyout is neutral, then healthy pretax margins (earnings as a percent of revenue, plus excess owner compensation) of 25% percent or more will probably enable you to service any reasonable debt resulting from a buyout. Although this will vary depending on your agency’s situation, if you as the buyer are having serious trouble making ends meet at home, something’s wrong. However, if, you have more time for golf than you did before you bought the agency, you might have underpaid.

RELATIONSHIPS
In family situations, the relationship can become strained; some internal deals start to resemble arm’s-length transactions as the discussion of price and terms get tense. This often is because assumptions were not communicated well at the beginning. As the process unfolds, both sellers and buyers will become more educated on matters such as the tax consequences of different deal structures that can change the outlook for both parties. Buyers might expect a “free ride,” rather than taking to heart the term “sweat equity.” In most buyouts, the first few years are supposed to be tough. You own the business as much as you own a house after a modest down payment and earn equity as you make the mortgage payments. If you don’t deliver on your business plan, then the seller or bank can step in.

CONCLUSION
Buyers, keep in mind that if a seller wants to, they can call a few large buyers, hold an auction, and get top dollar. Sellers, keep your goals in mind as well as buyer’s expectations. In private transactions, the deal needs to be fair to everyone — or there’s no deal. As the transaction date approaches, interactions should feel more like discussions and brainstorming sessions than negotiations.

There’s no panacea for perpetuation. Plan 10 years ahead. Get help, and bring in the right resources. Most of all, hold open and frank discussions between the sellers and buyers to be certain that all parties understand the process every step of the way. Internal deals can deliver the best of all worlds if they’re done right.