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 The degree to which your balance sheet matters depends on its quality, the type of acquisition, and the buyer’s resources.
During the past few years the press has filled pages with details of financial shenanigans by large corporations. Several insurance companies have had to modify their financial reports, too. Many of these misdeeds have involved balance sheets. Almost everyone understands the income statement and how earnings must exceed expenses to have a viable and valuable company. However, many people, including some Wall Street analysts, tend to overlook balance sheets. A few major corporate execs noticed this loophole and discovered ways of moving expenses to the balance sheet to improve their earnings reports. If done legally, this is simply a matter of caveat emptor for buyers of these stocks. If not, hopefully, they will be stopped and have to restate their financial statements.
Even with all the bad press, many agency owners are lulled into thinking that balance sheets only matter to large, publicly held corporations. It’s easy to think this, because as long as the agency is in trust, the balance sheet doesn’t usually impact its day-to-day operations (although there are exceptions). Balance sheets do matter, however. After 20 years of not paying attention to the balance sheet, an agency owner with a poor balance sheet might have a rude awakening when it comes time to sell the agency. In an agency sale, provided that the buyer is knowledgeable, the balance sheet definitely matters. The degree to which it matters depends on the quality of the balance sheet, the type of acquisition, and the buyer’s own resources. But, it always matters!
The most important balance sheet factor is the trust account. A knowledgeable buyer is never going to pay full price for an agency that’s out of trust. Even if a buyer only purchases the seller’s accounts, the seller must still true up their trust account, which effectively acts as a deduction.
Another balance sheet factor is working capital, which is usually closely related to the agency’s trust position. Many agency owners with inadequate working capital don’t understand why their agency value should be docked for having inadequate working capital. Working capital is a firm’s investment in its net current assets [(current assets - current liabilities)/(total annual expenses/365)]. Agencies should have at least 30 days worth of working capital.
Adequate working capital increases agency value by reducing risk. It acts as a cash shock absorber so that the agency can make it through the cash flow bumps that life puts in our way. Eventually, every business will have a month, a quarter, or a year where cash-out exceeds cash-in; when this occurs without a cushion, the business will go out of business (or at least face other unpleasant results) — even if vendors, creditors, ex-spouses, and employees know that the setback is temporary. Also, in some agencies, the lack of working capital is evidence of significant mismanagement.
Adequate working capital also creates opportunities over and above agency value issues. For example, when the opportunity to acquire an agency or producer presents itself suddenly, agencies with adequate cash will usually have an advantage.
Leases are often a contentious topic in agency valuations. The problem arises from accounting rules that don’t require showing leases as balance sheet liabilities even though they are liabilities. Because they aren’t shown on the balance sheet, many accountants and some agency owners don’t think they should be counted as liabilities for valuation purposes. However, as the saying goes, “A rose is a rose by any other name.” In fact, some companies structure liabilities as leases so that they aren’t shown on the balance sheet, which suggests that that they should make a deduction for valuation purposes to reflect the agency’s liabilities accurately. If the lease is too onerous and not breakable, it can indeed decrease an agency’s value significantly. If you’re thinking about selling, consider this before signing your next lease.
Goodwill often results in a balance sheet deduction because any goodwill value from past acquisitions will be considered in the value of the selling agency’s book of business. Failing to eliminate it would result in double counting. This is an unpleasant reality for some owners who have purchased several agencies and are now selling their own.
Loans to the agency from an agency owner(s) are often deducted too because it’s often clear that the loan will never be repaid. This means that it can’t be considered a loan for valuation purposes.
Accounts receivable may be modified if an agency has a long history of bad debt or a lot of old receivables on their books. Because the chances that all those old receivables will be collected are nil the agency’s value will be reduced.
CONCLUSION
Although there are many other potential issues, these are the major balance sheet factors that make a significant difference in your agency’s value. Take 45 minutes to consider these factors and your agency’s balance sheet. Does the balance increase your agency’s value or decrease it? If the latter, the best time to start fixing it is right now.
NOTE: None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.
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