People pay dearly for simple answers. And many insurance agencies pay dearly for 'voodoo valuations' because they offer a quick and inexpensive way to pacify an agency owner’s desire for a simple, quick answer. In this document, Chris Burand warns that you’ll pay dearly in the long run.
According to a Louisiana legend, a voodoo queen, Marie La Veaux provided simple but costly answers for people in search of hope. She’d concoct a potion that caused a man’s heart to change with just one short kiss from a girl’s lips. Forever after, he’d be devoted only to her. For 1,000 Spanish bits or possession of the woman’s first born, Marie would undo the spell. Marie became a rich woman.
Voodoo valuations aren’t easy to recognize; they often appear legitimate. Here are a few keys to recognizing voodoo valuations:
THE FINAL PRICE DOESN’T CONSIDER TERMS
I’ve seen many agents agree to such terms as '1.5 times commissions based on retention,' while earning less than 1.0 times. They never would’ve sold for 1.0 times even if the deal was cash. But they heard a favorable multiple and that was all they needed to hear. The answers they sought were simple. Unfortunately, the real answers were complex and required a complete valuation, thorough due diligence, and an analysis of cash flow and ROI based on a number of terms and scenarios. It’s funny how in the long run the complex answers would’ve actually earned these sellers a higher multiple.
I researched a group of sellers recently. They received excellent prices, but significantly less than they expected. They didn’t consider the terms of the deal and the result was great financial pain. None of them had hired anyone beyond their local accountant.
THE VALUATION ISN’T ACCURATE
We expect answers to be a mouse-click or phone call away. Many valuation practitioners pretend that valuations are simple affairs. They give agents a simple formula to follow, or suggest that agents complete a do-it-yourself valuation. The answers are quick, but seldom accurate.
Hardly a week goes by that I don’t get at least one e-mail from an agency owner asking, 'Is 1.5 (or whatever multiple) still the appropriate multiple?' I could get rich quick if I was willing to dispense sugar pills or Cajun spells!
Agents should recognize practitioners who don’t understand the complexity of valuations. For example, before you even start a valuation you must agree on the correct definition of 'value.' Consider it a warning sign if the practitioner never discusses the appropriate definitions. Seek assistance elsewhere.
I’ve helped several agencies dig themselves out of deep financial holes that resulted from a series of acquisitions. The consultants that these agencies hired used the wrong definition of value for the acquisition targets, failed to consider working capital (which caused the buyer to severely deplete their own capital), and did not complete adequate due diligence. Of course, the consultant did supply seemingly simple answers!
I once saw a sign in a retail business that read, '50¢ for an answer. $2.00 for the correct answer.' Why pay even 50¢ for an answer if it’s wrong?
THE BUYER’S FINANCIAL STRENGTH ISN’T CONSIDERED
Many agency sales involve a seller-carry loan and/or are based on retention. This means that sellers are incurring significant risk when they sell; yet they don’t adjust their price for this risk adequately. Again, this results from searching for simple answers.
If the buyer’s risk of default is high and they’re not paying cash up front, they should pay more to compensate for this risk. For example, a fair price for an agency with $750,000 in revenue might be $900,000 for a buyer with strong financials and a minimal risk of default. However, if the buyer has poor financials and is requiring a seller-carry note and/or a retention factor, then the price should be at least $1 million or more, depending on the buyer’s financials.
Two financial aspects worth careful consideration are cash flow and companies that stress EBITDA (earnings before interest, taxes, depreciation, and amortization). I’ve recently met several buyers possessing what I consider extremely weak financials. They each touted their positive EBITDA while downplaying their negative cash flows. A January 24, 2002 Wall Street Journal described the risk well. The author wrote, 'A telltale sign of trouble is negative cash flow from operations while the company’s so-called EBITDA is positive.'
The SEC released a warning to investors regarding companies that report or stress pro forma earnings or EBITDA earnings. If a seller is carrying risk, then the buyer should have a positive operating cash flow. Otherwise, they probably have financial problems. When buying an agency, the buyer must achieve positive cash flow, not just positive income, within a very specific period to make the acquisition profitable.
THEY FOCUS ON GROWTH FOR GROWTH’S SAKE
Quite a few agency owners dream of going public. Others just want to get big. Still others are tired of running their agencies and/or selling insurance. Instead, they decide to go after bigger fish, so they begin acquiring other agencies. Acquisitions can be exciting. They drive the ego. One study of acquisitions involving publicly traded companies 'noted that the undeserved premium paid is linked to the number of magazine covers the acquiring boss has graced before the deal' (The Economist, January 9, 1999). It doesn’t require much skill to buy an agency if a person is willing to overpay (which a lot of buyers seem willing to do).
Disney CEO Michael Eisner recently commented, 'I spend my life being Odysseus. I tie myself to the mast, and I don’t listen to the Sirens. The Sirens in my business are agents, investment bankers, the media, people saying that your testosterone level is gone because you haven’t made an acquisition in the last ten minutes' (Fortune, January 7, 2002). Many agencies feel the same pressure to grow by acquisition regardless of profitability. This might explain why every study I’ve seen, read, or heard in the past 27 years has shown that 50% to 80% of all acquisitions fail. If being profitable concerns you, be strong in your convictions to grow profitably.
Marie La Veaux made a lot of money giving simple answers to desperate people. Her magic potions were hard to resist. Agency owners are often just as eager for voodoo valuations, but the cost for quick, easy answers is often steep. You have the experience, wisdom, and alternatives. Don’t purchase or practice voodoo valuations.