I would venture to say that 80% of the agencies represented by the readers of this column could really benefit from thorough perpetuation planning- either through a new plan from scratch or a major tune-up. And of the remaining 20%, most would benefit somewhat.
Why, you might ask, should so many need so much on a subject that's been around for so long? Three reasons. First, independent agencies are dynamic organizations in a dynamic business world. The need for occasional course corrections and tune-ups would be the normal state of affairs even if most agencies had excelled at perpetuation planning. Second, the reality is that most agencies have not excelled at perpetuation planning, even though most principals acknowledge its importance. Why not?
Well, that gets philosophical. My guess is that it's like our growing national debt. For most of us, until recently, the consequences of procrastination haven't really hurt day to day. Pressing business tends to take precedence over important business. (Of this, more below.) And third, a lot has changed recently. That is, even if most agency principals had been diligent in their perpetuation planning over the last couple of decades, the recent changes in the industry and the economy would have many of them back to the drawing boards. We're all familiar with these changes. Let's just review the basic ones.
- Revenue Growth: My company's annual agency analysis service recently revealed the following growth averages for a group of about 60 agencies:
- P/C commission growth in 1992: 0.1% (flat)
- Operating revenue growth in 1992: 0.7% (barely more than flat)
- Compound annual growth in P/C commissions since 1988: 1.4% in operating revenues: 2.4%
While many of these agencies were in the Northeast, the group represented most regions of the country. Remember the days when 10% growth constituted a conservative plan?
- Agency Values. Are agency values down? With lower (or negative) revenue growth, lower profits, less capital, and more uncertainty, how could they not be? At least on average. But acknowledging the logic of declining value isn't enough. In many agencies, perpetuation planning is up against the agency owner's understandable ambivalence about ratcheting down a buy/sell value, the primary casualty of which is his/her own retirement income.
- Commercial Pricing. We used to be comfortable with the term 'underwriting cycles,' describing a sine-wave pattern of Commercial Lines premiums. From the looks of things lately, maybe we should call it a premium-hiccup cycle -- long, low lines with occasional spikes. Will the entire Commercial field become niche-marketed? And can even the best service and good P/C pricing overcome a competitor who has a better answer on Workers' Compensation?
- Personal Lines Stability. Just when the private passenger auto market seems to have stabilized in most regions (apologies to our friends in southern California), now homeowners looks like a troubled line. And not only in windprone areas. Can we really continue to give that much coverage for a few hundred bucks? A little price firming in this line would not be unwelcome news to most agencies if it were smooth and stable. How likely is that? Even if it were to be smooth on an industry-wide basis, the way many agencies have been paring down their Personal Lines carrier base, it could be highly unstable for individual firms. Our system is becoming less and less diversified.
So for all these reasons, I believe that the vast majority of independent agencies could benefit by a major review of perpetuation plans. In the balance of this article, I'll stress two basic principles, foundation points to the entire exercise; and in a following column, I'll offer some planning techniques and practical guidelines.
As for the first two principles: First, I mentioned above that pressing business takes precedence over important business. 'We can't get to that long-term stuff when we have these fires to fight,' the complaint goes. That's a trap. The lines between 'the long-term stuff' and today's fires are blurry at best. Perhaps the biggest benefit of perpetuation planning is that it forces a focus on all the things that make day-to-day operations more manageable-organizational structure, delegation, marketing and sales management, compensation, management information, contracts, training . . . and the list goes on. It's fire prevention.
Second, keep your definition of perpetuation broad. At least initially. Narrowly defining it as selling the agency to Mary at Jo's retirement puts too many out of the game. A better definition is preserving the business value that has been built for the better part of a lifetime, maybe several lifetimes, so that it can provide economic benefit and financial security to those who are responsible. This will lead to a fundamental decision on ownership-keep/sell/merge/cluster/split-and then to an operating plan that is in keeping with that decision.
Two hikers set off to cross a great wooded expanse. One has prepared by getting the best equipment-the best shoes, light gear, etc. The other, through personal energy and endurance-conditioning , trail food, etc. Which one wins?
The one with a compass.
BEYOND FATHER SELLING TO SON OR DAUGHTER...
As I've said, readers should define agency perpetuation broadly. Again, the exercise should not be limited to: 'How does Sr. sell to Jr. and save on taxes?' but rather: 'How best do we protect, enhance, and ultimately transfer business value that has been built up over a lifetime or more?' Accordingly, the initial steps to any good perpetuation planning are these:
- The first is a candid assessment of the retirement needs and objectives of the senior people of the agency, followed by a candid assessment of whether these objectives and needs can reasonably be met by a combination of the senior principals' insurance-agency holdings and other financial resources. This step is critical whether retirement is imminent or not. Some people are quite adept and experienced at making such assessments, but for others it is new territory. Some need a lot of help with it; others, very little. But whatever the planning experience of the participants or however easy or difficult the task, make no mistake about it-the perpetuation plan will be on a weak foundation without this first step.
- The second is a candid assessment of the financial needs and objectives of the younger people in the agency (i.e., the potential buyers), but in addition to that, a candid assessment of their business competencies.
As with the first step, this will be easy for some and tough for others. For some it might take five minutes; for others, five months. Regardless of the situation, however, we need to answer honestly whether the future owners of the agency have proven sales competency, proven technical competency, proven administrative competency, and proven leadership competency.
- The third step, somewhat easier because it involves less personal introduction, is to assess the readiness and adequacy of the agency's other key resources-staff, carriers, systems, and capital.
This three-stage critical assessment leads to an identification of gaps. What are the gaps and what do we do to close them? It is only at this point that we can decide whether the agency should continue as an independent, freestanding entity that simply needs to add a key carrier, add a key person, or commit to some management development, or on the other hand, whether its competency gaps or resource gaps really call for it to seek a merger or cluster partner.
And let me assure you, the chances are at least nine out of 10 that you will end up with an effective and properly designed plan if you follow these steps. Take it from me, there is no shortage of tools (financial, organizational, legal, and tax-related) to customize a plan for your use, once a thorough and candid assessment has been made.
And let me also stress that all this is not code wording for 'you've got to be big to survive.' There is no doubt that you have to be bigger now than a decade ago to do certain things in this business, but you do not have to be big to survive. You just have to know what you're doing. And when it comes to failure, the bigger they are, the harder they fall.
NOW TO A FEW OTHER PRAGMATIC TIPS.
- Valuation. Be sure you have a realistic valuation of your agency. And if you don't have one, get one. And not at the time of transfer, but now. If for no other reason than objectivity, most agencies should get an external opinion of value. But most of all, remember that agency value is not simply a number. Don't be lazy. Work to understand the valuation. Demand an explanation of how agency value is related to cash flow, to risk, to debt, to quality, and to growth prospects.
- Value Sharing. If your valuation is done properly, then the agency, if properly capitalized, should be able to buy itself with its own resources and cash flow. But for a whole lot of reasons that go beyond the scope of this column, planning to sell 100% of the agency's value upon the retirement of the senior principal(s) is usually a bad idea. I find that if the 'buying group' has the equivalent of at least a 30% equity position on the date of transfer, the plan will be manageable and prudent financially. There are lots of creative tools to allow this value sharing to take place in such a manner that the senior people are not simply giving it away. I've long been a proponent of so-called phantom-stock and other deferred-compensation arrangements to bring this about.
- Taxes. All business should manage their costs and expenses carefully. And taxes, mainly income taxes, need to be managed just as closely as those for compensation, benefits, occupancy, and overhead. But I urge you in the strongest possible terms not to cross the line from being tax-efficient to being tax-driven. Being tax-driven so often leads to bad business decisions.
- A Word on ESOPs. A retired, widowed relative once told me that she was planning on shifting a large portion of her rather modest nest-egg into municipal bonds, having listened to a mutual-fund sales pitch that was evidently quite persuasive. The fact is, she needed this like a hole in the head. If there was one problem she didn't have, it was an income-tax problem. The salesman was a missionary for his product and not a problem-solver.
An ESOP is not inherently a good thing or a bad thing. It is a financing tool that fits some situations particularly well and others not at all. It is a complex, highly regulated, usually expensive proposition that you must want for the non-tax reasons. If an ESOP fits your culture, then there are tax benefits to be gained, and in some circumstances these tax benefits can make a significant impact on the financing of an ownership transfer. But the negative consequences of an ill-conceived ESOP or an ESOP implementation in non-fit situations are usually whoppers.
Also, when evaluating the ESOP tax benefits that might apply to your agency, don't fall into the trap of comparing those benefits to a simplistic example that shows no tax planning. All good perpetuation planning involves the use of techniques that help manage the taxes associated with an agency transfer. Be sure to judge the ESOP for its marginal benefits, i.e., the added benefits over an otherwise reasonably well-designed perpetuation plan; and then subtract from those benefits the other costs associated with installing and maintaining the ESOP.
In conclusion, let me remind you of a point I tried to make in my last column. Don't think of perpetuation planning as long-term stuff that doesn't bear a relationship to the day-to-day operating problems of your agency. Again, I know of no exercise that will have a more helpful impact on day-to-day operations than a commitment to honest and realistic perpetuation planning. For those who remember the end of the previous column, the perpetuation plan is your compass.