Amid the merger and acquisition frenzy, many agencies believe the value of their businesses might never be higher. Sharon Cunningham points out that there are other factors to consider when determining the value of an agency.
When agency principals ask me if the merger and acquisition frenzy is continuing, I tell them that this market continues to be robust and doesn’t appear to be slowing down. During the past five years, an average of 173 deals have been announced each year. The hard market, with its higher revenues and profits, is driving this accelerated merger and acquisition activity.
Many agencies believe the value of their businesses might never be higher. The competition among buyers has also generated more attractive offers and more creative structuring of deals. Smaller agencies are being driven to mergers or acquisitions by carrier pressures for volume and by carrier consolidation. And for many agency principals nearing retirement, selling is the best perpetuation option.
Public brokers — the traditional buyers — were for several years overshadowed by larger and better-capitalized banks. However, in 2003, public brokers have taken the lead in number of deals announced, accounting for almost 40% of deal volume, compared with 30% in 2002. Historically, banks have been interested in acquisitions to increase fee income as a way to offset interest rate risk. They’ve used their excess capital to pay more than most public brokers.
Recently, however, a more level pricing field has emerged. The public brokers have been able to attract more acquisition candidates to grow their revenues and maintain high price-to-earnings multiples. Small and mid-sized agencies also see acquisitions as a key growth strategy and necessary to maintain carrier volume requirements.
When determining value, acquirers look to such factors as mix of business, account longevity, retention rates, and average account size. Agencies experiencing exceptional growth tend to receive the highest multiples. However, the most important factor is sustainable earnings capacity, indicated by pro forma profit. Two similar agencies with the same revenue could differ greatly in their ability to generate profits.
Conversely, sellers should consider price vs. after-tax cash flow when structuring their deals. For example, if the agency is a C-Corp and the buyer wants to do an asset purchase, there’s double taxation to the selling shareholders. The agency will first pay tax on the gain from its sale of assets to the buyer. Then the shareholders will pay tax on the liquidating distribution from the agency. However, if the deal is a stock sale, the selling shareholder only pays capital gains taxes once. If the buyer will structure an asset-only purchase, then the price should be adjusted accordingly.
Besides price, sellers should consider whether payments are made up front or retention-based, as the highest price might not produce the highest value. Sellers want more of the payment up front, while buyers like to delay payments as long as they can. Receiving a slightly lower purchase price but significantly more upfront would provide greater value. However, if the buyer structures a retention-based deal, there’s less risk and the buyer should be willing to pay a higher price. If the seller will remain active in the business for the duration of the retention period, then a retention-based payment might make sense. However, if the seller plans to retire, then they should consider whether the new owner can retain the accounts.
Another factor to consider is stock vs. cash. In selling an agency for stock, capital gains can be deferred. If the acquirer’s stock is undervalued, there might be an opportunity to gain greater value when the stock price increases. Employment contracts should also be evaluated, as they can affect the purchase price. Some buyers want the seller to stay for a significant period of time, while others might not. Generally, the more favorable the employment contract, the lower the upfront payment.
Selling an agency is both a financial and personal decision. For many agencies, it provides an opportunity to become part of a larger organization that can provide them with the resources or capital to grow, expand, or diversify. In going through this process, agencies should understand how they’re valued and what a realistic price might be. It’s also important to understand how deals are structured, what options sellers might have for payment terms, what tax implications the deal will have, and how sellers might gain the greatest value from the business that they’ve worked for years to build.