Don’t overpay for an acquisition!
When Quaker Oats purchased Snapple Beverage Company in 1994 for $1.4 billion, they believed that Snapple would complement their enormously successful Gatorade brand. How wrong they were! In 1997, after less than three years, Quaker Oats sold Snapple for $300 million. It was estimated that the division was losing more than $2 million a day at the time of divestiture.
You can’t pick up the Wall Street Journal without seeing an article about an acquisition. Acquisition multiples (price EBITDA, price earnings, price revenues, etc.) that firms are paying appear extremely questionable. Are these prices truly indicative of the future value of the target, or is the value artificial?
When developing a valuation of an insurance agency, applying various multiples (such as commission revenue or earnings multiples) to a target’s past financial performance seems reasonable. But since no true homogeneity exists among agencies, these rule-of-thumb techniques often lead to variances in valuation.
We see such examples as the Snapple purchase every day. Firms that are eager to make an acquisition buy into false synergies and high future growth prospects — often going against the very business judgments that made the acquiring firm’s CEOs successful. Why does this happen? Different reasons crop up, but more often than not it’s some combination of: (1) The ego and emotions of the acquirer; (2) assumptions of false synergies; and (3) too much focus on revenue growth.
Ego and Emotion: Some growth-by-acquisition entrepreneurs feel compelled to fuel expansion by consummating the latest deal. Without a deal, the owner can’t justify their existence (ego). How about the firm that lost out in past negotiations and is determined not to lose again (emotion)? Or the situation in which the buyer and seller are friends? These and other examples can easily cause the acquirer to pay for value that doesn’t exist.
Buyer beware!
Assumptions of False Synergies: Some selling firms might try to lure potential acquirers by misstating:
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The speed and ease of financial turnarounds
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Payroll reduction or elimination
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Higher contingencies from common insurance carriers
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Severance agreements with key employees
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Producer equity in their books of business
If the buyer doesn’t conduct thorough due diligence, the seller could convince them that value exists where it doesn’t.
Buyer beware!
Too Much Focus on Revenue: A firm decides that the easiest way to double in size is to purchase a firm with comparable commission revenues. But the same profitability level might not accompany a dollar of revenues in one firm, as does a dollar in another. Value isn’t a top-line-generated number; it’s a bottom-line cash flow-generated number. It can be easy for an acquirer to focus on the top line of the target and pay for value that doesn’t exist.
Buyer, beware!!
THE VALUE OF VALUE
When an agency decides to pursue growth by acquisition, it must realize that the main reason isn’t to add commission revenue, but value. What does this mean, and how is it measured?
“Adding value” means purchasing something that’s worth more than you paid for it. The financial measurement of this is the Net Present Value (NPV) of future cash flows (discounted at the acquiring firm’s cost of capital) compared with the purchase price. When the NPV of the cash flows exceeds the purchase price, value is added.
If it’s that simple, what are the hang-ups? Future cash flows are only estimates, based on assumptions of incremental commission revenue, account attrition rates, agency operating expense costs, effective tax rates, and other factors.
When conducting an acquisition, do your homework. Know exactly what you’re buying. Know who’ll own the entire book of business. Know the retention rates. Know the producer capabilities and all the severance packages and employment agreements. Analyze the combined carrier offering to determine where you can enhance company agreements. Understand areas in which you can exploit cross-selling opportunities. Plan the integration process well before consummating the deal. Understand where the true synergies are and be realistic about possible cost savings.
Conduct thorough due diligence of the target agency. Question each item and assumption in the valuation. Fine-tune the numbers to come up with a reasonable price for the true value of the target.
Thoroughness helps an acquirer determine their purchasing threshold. It might also ferret out hidden value of which not even the seller is aware. Even though most asking prices are too high, you’ll still find an occasional gem that’s undervalued.
Ross Perot pulled out of talks to purchase Microsoft in 1979, because he thought the asking price was too high: Around $10 million according to Bill Gates; in excess of $40 million. according to Perot. Either investment would’ve resulted in a handsome return.
CONCLUSION
The agency acquisition hunt is exciting and can be very rewarding if structured properly. Don’t allow yourself to be placed in poor financial shape because you overpaid for a purchase. Do your homework. Know your true threshold price and don’t exceed it. And above all, remember rule No. 1: Buyer beware!