The days of determining value solely by applying an assumed multiple to gross commission income are long gone. Whether you’re planning on selling out or hanging in, determining your agency’s value has never been more important. In this document, and the Excel spreadsheet that accompanies it, Robert Westin gives you all the tools to make an accurate assessment.
There’s a feeding frenzy going on in the ocean of insurance agencies. Banks and the big guys are on the prowl for local agencies that they can gobble up to expand their territories and increase market share. The food supply is diminishing rapidly as family owned and other closely held agencies join the list of endangered species. Some prognosticators are predicting that more than half of the 42,000 independent insurance agencies currently operating in the U.S. will be gone in 10 years. Those appetizing agencies that are well managed and profitable will be targeted for consumption — the others will be shunned like rotting flesh.
Local agency owners need to do some deep soul searching and accept the reality of change. If you’re an owner, ask yourself whether you want to remain in the agency business. If you do, you must decide whether you want to maintain your identity or become part of a larger organization. If you want out, sell before it’s too late.
Whether you decide to remain on your own, join a larger agency, or sell out, you need to find ways to enhance the value of your agency. The days of determining value solely by applying an assumed multiple to gross commission income are long gone. Values are now driven by agency earnings before interest, taxes, depreciation and amortizations (EBITDA). The price-earnings multiple is influenced by the ratio of EBITDA to revenue, the ability to sustain earnings, and the expected return on investment (ROI). The rate of return on investment typically includes a risk factor. As the estimated risk increases, expected ROI increases and the multiple decreases. Regardless of the value produced by the EBITDA multiple, liquid working capital equal to between 30 and 60 days of operating expenses is expected. If the tangible net worth exceeds the liquid working capital requirement, the value increases by $1 for each $1 in excess of the required amount.
This table will help you put the value of your agency into perspective. Assume your revenues are $500,000. A fair rate of return is two times the prime rate, or between 16% and 17%. A multiple of six times EBITDA will produce a 16.67% rate of return. If your agency generates a 10% EBITDA, the indicated value of your agency is $300,000 or the equivalent of 60% of your revenue. Between $37,500 and $75,000 of liquid working capital would be required. A 20% EBITDA results in a value of $600,000, or 1.2 times revenue, with a working capital requirement between $33,300 and $66,600.
EBITDA ROI Multiple Multiple of Revenue =
10% 15% 20% 25%
20.000% 5 .50 .75 1.00 1.25
16.667% 6 .60 .90 1.20 1.50
14.286% 7 .70 1.05 1.40 1.75
12.500% 8 .80 1.20 1.60 2.00
If you haven’t already purchased a copy of the latest Rough Notes’ 'What it Costs,' do so. Rough Notes draws from Marsh-Berry’s database of thousands of independent agencies to provide examples of the cost of running different-sized agencies with average revenues ranging from less than $500,000 to more than $5,000,000. Separate illustrations are presented for the average of all agencies in each size group and for the best 25% of each group. Significantly, the best 25% produce profits ranging between 1.6 and 2.8 times greater than the group average. Even then, pretax averages range from a low of 4.2% to a high of 13%. You can use the data to compare how your agency fares against the averages.
If the line items on your profit and loss statement are formatted alphabetically, you’ll have to reorganize them to match Marsh-Berry’s groupings. When comparing your operating results, don’t be misled by the averages. Numbers don’t tell the whole story. Use them only as benchmarks. Otherwise, you might be lulled into a false sense of complacency if your agency is doing better than average, or unnecessarily depressed if doing worse. Instead, identify where your numbers differ and then determine why.
An easy way to test your numbers is to compare your operating ratios with those presented in Rough Notes’ illustrations. Marsh-Berry’s allocation of revenues into separate groups for Commission and Fee Income and All Other Income, and expenses into Compensation, Selling, Operating, and Administrative groups is fine for comparison purposes. By focusing on the group operating ratios you’ll be able to quickly determine where you’re better or worse than the averages. When your ratio for a particular group is worse than average, concentrate on its line items to find out why. Then take the action needed to get the results you want.
Operating ratios provide management with a great tool for planning, budgeting, and monitoring results. Although Marsh-Berry’s format is suitable for initial comparative purposes, I prefer a format that organizes the groups into a sequence that tracks more closely with the way most agencies conduct business.
Think of your agency from a 'flow of business' perspective. Your mission is to create wealth. Because customers are your primary source of income, each phase of the flow must be customer driven. The first phase is to attract customers by marketing your products and services. Next, your sales representatives turn prospects into customers. Customers are then turned over to your customer service and claims representatives to make certain they receive the services promised and needed to retain their business. The sales and customer service functions are in turn supported by an infrastructure of facilities and administrative services. How much wealth you create depends on how you manage the process — and that’s where operating ratios come into play.
Although I don’t advocate making management decisions based solely on numbers, dollars translated into ratios based on predefined groupings give numbers a different meaning. To illustrate, let’s assume your agency’s office rent is fixed at $50,000 a year. According to 'What it Costs' the average agency spends 4.6% of its revenues for its facilities. To match the average, your agency must generate $1,087,000 of income. If your income were only $800,000, your facility ratio would be 6.25% or almost 36% higher than the average. To bring your expense ratio in line, the most logical option is to go out and write some new business.
For the purpose of calculating ratios, I believe that operating expense ratios become more meaningful when measured separately against commission and fee income only, and against total income. Here’s why: The staffing of your functional organization is correlated with your number of customers, billed commission, and fee income. Too many agencies rely on carrier contingencies, interest on premium trust funds, and other investments to cover their operating expenses. In my opinion, contingent commissions should be treated as found money. Interest and other miscellaneous income simply ice the cake. Measuring operating results against commission and fee income will give you a more accurate picture of what’s happening in your agency.
All of this will come together if you look at the spreadsheet accompanying this article. If you use Microsoft Excel, you should be able to download the worksheet and plug in your own numbers.