Have you ever wondered how the agencies in all those magazine articles grow so rapidly? You might be surprised.
Most readers incorrectly assume the subjects of those articles follow all the rules and make reasonable business decisions. Readers often believe that the authors perform due diligence on their subjects. That’s not reality, though. In fact, these agencies are often growing so fast because they’re cutting corners. You can uncover the truth by asking the tough questions – the ones that the authors avoid..
An article describing how an agency is growing quickly by cutting corners is certainly not cover story material. Just think of these headlines:
- “ABC Agency Has Grown By 10% a Year for the Past Five Years! How have they done it? They created a great new marketing program, which they funded by spending trust money!
- “Agency CDF grew 12% Annually In Commercial Lines! How can an agency, not a small one either, outperform the market by 15-20 percentage points? All they had to do was work on zero commission the first year!
- “Agency XYZ Successfully Develops $1 Million Producers Regularly. Of course, they’ve only produced one, but the others will make it someday.”
Part of the problem is that reality gets in the way of sales. This means it’s best if the authors avoid asking tough questions. I’m not suggesting they’re misleading anyone or not doing their jobs, because they aren’t investigative journalists. The problem lies with the readers who believe that these articles tell the whole story. After all, why would any truly successful agency spill all their secrets?
Consider the agency managers who have worked to achieve a high profit margin to drive up their agency’s value. Although this makes sense on the surface, the agency might have achieved its high profit margin by cutting service to the bone, which in turn created huge E&O exposures. Later, those exposures resulted in a major E&O claim due to inadequate service. The claims might be written off as “one-time events” in the pro forma valuation – but what is truly more valuable? Better service that results in an EBITDA of 24% without an E&O claims rather than a 25% return with a hefty E&O claim?
The traditional agency owner would probably prefer the former, but some agency buyers might not. The reason is that with enough volume, one percentage point is worth more than a large claim. For example, one percentage point on $10,000,000 is $100,000. $100,000 times an EBITDA multiple of six comes to $600,000. Even with a $50,000 deductible, it makes more financial sense to incur the mistake and cut costs.
The mistake with this thought process is that just because an agency incurs only claim, doesn’t mean that it will face others, or that the situation doesn’t need fixing.. My experience as an E&O auditor confirms this. When an agency has cut expenses and services to the bone, carelessly, E&O exposures increase significantly; and the agency will be lucky if it faces only one claim. When the market hardens, the agency will incur far higher E&O premiums. Add it all up, and the increase in value doesn’t look so good, unless it’s someone else’s problem by then.
The fact is that our industry grows extremely slowly, except for occasional hard markets. My studies and those by A.M. Best of insurance companies that grow especially quickly show that often these same companies soon develop severe stability problems: the reason, except in rare cases, premiums can’t expand rapidly in a slow growth industry without cutting corners. Because agencies are smaller than companies they can sometimes grow rapidly, but not too quickly, without cutting corners. An agency’s growth is limited to how fast it can develop producers and create effective marketing programs, and how quickly its clients’ exposures increase. These developments all take time and, even then, true organic growth is usually only 2% to 4%. When an agency reports 15% or even 10% organic growth, be very, very cautious.
Finally, don’t be fooled even when everything is on the up and up. A fairly large agency can generate 10% growth once in a while. So when you read articles praising an agency that achieved 10% growth last year, find out if this was a one-time deal or if they can sustain this rate over a number of years. Failing to ask the tough questions can create the impression of consistent high growth. Read between the lines, rather than getting frustrated by reading about how others are more successful than you and you can’t figure out how they’re doing it. I’m not suggesting that everyone is cutting corners, but the more the claims of success, the more you might suspect it.