INTERNAL PERPETUATION PLANNING
by Carol Hammes
One of the consequences of the prolonged period of competition in the Property/Casualty insurance marketplace is that a clear dichotomy has developed between agents and brokers who are surviving and even thriving in this environment and those who are struggling to stay above water. But even those who have been successful in growing profitably over the past five years, whether by internally generated marketing programs or via acquisition, are now facing a new set of challenges. The larger you are, the more commissions have to be generated to achieve a growth rate that stays ahead of inflation and keeps your major insurance companies happy. A 5% increase on $500,000 in revenues is only $25,000, whereas 5% on $5 million is $250,000. When each commercial renewal is coming in at a premium reduction of 10% or more, it's pretty tough to come up with a net increase of $250,000 in Property/Casualty commissions, no matter how good your producers are.
The first hurdle to be met, then, is a marketing challenge. How and where do you find enough new accounts to make up for the commission shortfall on existing business? In some parts of the country, there may still be some opportunities to acquire good books of business, although we've found that many of the agencies 'for sale' now are so distressed that it might not be worth the hassle. In most cases, the growth will have to come from internal production. In an effort to keep sales at a steady pace, many firms have turned to niche marketing, only to find that the competition seems to be just as fierce there as it is in the general marketplace. Some of the more adventuresome agency owners are going further afield and forming captives to tap the alternative marketplace, setting up insurance companies, trying joint ventures with banks, and experimenting with cybermarketing. Others have decided to put much more emphasis on targeting employee benefits business, where the premiums are on an uphill trend and the opportunity to show 'value added' is perhaps greater than it currently is in the Property/Casualty arena.
Most of the agencies that are profitable today are so because the principals are creative, driven, and willing to try something new. They will undoubtedly meet the marketing challenge head-on and find a way to continue to grow in whatever marketplace they find themselves in. But they're often so busy focusing on achieving growth and success that they fail to pay the necessary amount of attention to a potentially more serious problem, the perpetuation challenge. The more successful an agency is, the faster it grows. And the faster it grows, the more valuable it becomes. And the more valuable it becomes, the harder it will be to perpetuate the agency by transferring equity to producers and other employees. Whether they acknowledge it or not, by ignoring this issue until it's too late the principals in more than half of this country's independent agencies have in fact passed up their option to perpetuate internally.
The internal perpetuation of an independent insurance agency does not happen in a single event. It's a process that must take place over a long period of time. A buy-sell agreement that plans for the buyout of an ownership interest in the event of death, disability, or retirement is not a perpetuation plan. It might suffice for estate-planning purposes, and it might even satisfy an insurance company that is demanding such a plan. But most buy-sell agreements do not take into account any (and certainly not all) of these five major criteria of a workable perpetuation plan:
- Desire. The current owners must want an internal sale badly enough that they're willing to take a discount on the selling price off what they might get from an outside buyer. If necessary, they must agree to fund the purchase over an extended buyout period.
- Time. There must be a reasonable amount of time between the initiation of respective major shareholder retirements so the age spread and personal-retirement desires of the principals must be noted and incorporated into the plan. Even in very profitable agencies, it will take at least seven years of cash flow to buy out a shareholder who has more than 50% of the ownership. Most experts recommend that you plan on a 10-year payout to provide a cushion in case there are a couple of down years.
- Potential internal buyers. With today's lower profit margins and reduced cash flows, there must be at least two willing and capable buyers for every one shareholder being retired. Finding these potential buyers among the young people of today may be the greatest challenge of all.
- Delegation of duties and account handling. Most agency principals have substantial books of business and/or perform key management functions in the agency. One or more individuals must be trained and ready to take over these account responsibilities and management duties at least one year before the planned retirement date.
- Money. Most of the time, a 20% to 25% down payment will be required at the beginning of the payout period. Operating expenses must be managed so that enough cash is delivered to the bottom line to strengthen the balance sheet prior to that time. And whether a bank, an insurance company, or the seller will be financing the deal, the lender will be expecting the agency to demonstrate that there will be a reasonable future stream of earnings to cover the payments over the buyout period. Holding the agency stock as collateral is not enough if that stock subsequently becomes worthless.
Developing a Viable Perpetuation Plan
The first step in putting together an internal perpetuation plan is to obtain an honest assessment from the current owners on (1) the strength of their desire to sell the agency to employees, and (2) their own personal timetable for divesting themselves of ownership, management, and account responsibilities. If a major principal or a group of people owning more than 50% of the stock ownership answers 'yes' to one or more of the following statements, your most workable plan may be to forget internal perpetuation and prepare the agency for an outside sale while you still have time to maximize that value.
- I want the same commission multiple that was used when I bought the stock X number of years ago.
- I want to be paid over a five-year period.
- I want to retire at age 55 or 60.
- I want to retire at age 80.
- I want to keep my car/expense allowance during the buyout period.
- The agency must continue to rent space in my building for as long as I say.
- All of the current employees must have a job here as long as they want one.
- Regardless of their qualifications or experience, my children must have key management and/or ownership positions.
- I don't think that any of the producers can handle my book or even my major accounts well enough to retain the business after I leave.
- No one can run the agency as well as I have.
- I want to be on the Board of Directors until I die.
Assuming that the agency can get through this first test of internal perpetuation feasibility, the next step is to review the buy-sell agreement to make sure that it provides the right foundation for the proposed plan. Certainly if yours is one of the more than 40% of independent agencies in this country that do not even have a buy-sell agreement, decide what you want to have included and get one drawn up. Sole proprietors or one-owner corporations need such a document just as much as multiple-owner agencies do. What will happen to the agency, your clients, and your employees if you die without having made any arrangements? Find another agent or a key employee to agree to take over the ownership and management in the event of your death or total disability, and commit this to writing in a stand-by agreement. The last thing a spouse who has not been active in the business is going to need at the time of your demise is to have to worry about the agency. And you're doing your heirs a real disservice if the executor has to sell the agency at unfavorable terms to pay estate taxes based on some arbitrary value that the IRS has assigned.
A buy-sell agreement should cover the disposition of the ownership interest in the event of death, disability, normal retirement, and termination of employment before retirement. Many attorneys also recommend that a divorce provision be included, particularly in community property states. In firms with multiple owners, most agreements call for the stock to be sold at a triggering event with the corporation or other owners as the buyers. At the very least, the other shareholders or the corporation should be given the right of first refusal to buy the shares either in a stock redemption or cross-purchase agreement. Although in rare cases, the contracts may allow for the sale of shares to non-shareholders and even nonemployees if the other owners and corporation decline the opportunity to buy, most often outside ownership is not allowed-nor is it generally desirable in a closely held firm. Many buy-sell agreements also call for mandatory retirement and/or sale of stock at a certain age.
The most critical clause in the agreement will be the valuation basis. For events that can be funded by insurance, such as death and disability, there's often a higher valuation formula than for other occurrences. And a good argument can be made for paying less for the ownership if the individual is terminated before natural retirement or in the event of a divorce. Circumstances of the termination may also have a bearing on the valuation formula. Considering the number of lawsuits that have arisen over such issues, it would seem to make sense to be as detailed as possible in spelling out the terms for each type of buyout.
Buy-sell agreements that were drawn up more than 15 years ago may lack the level of detail necessary to cover situations that can occur in today's more mobile, complex, and litigious environment. Most important, older agreements may have outdated valuation formulas that could literally drive the agency into financial ruin when a major shareholder retires. The valuation formula should be evaluated at least every five years, and more often if the agency is growing rapidly. If the value is based on an outside appraisal, the valuation should be updated at least every other year, and the principals should all agree with the appraiser's results and approach. Owners (other than the first one to be bought out) should periodically test the formula against current agency results and should assure themselves that if they had to start the redemption tomorrow, the agency could afford the payments. Less than one-third of the current ownership of independent agencies will die before retirement. Most of the time, you won't be able to tap into Life insurance proceeds to help you out of a cash flow deficit caused by overvaluation.
Ideally, the valuation formula or appraisal should focus on the agency's profitability and apply a multiple or other valuation formula against the bottom-line results. If you persist in using a multiple of commissions or revenues, define the components carefully. For example, is the same multiplier to be used against contingents, overrides, three-year policies, fees, or Life insurance, as is used for annualized Property/Casualty commissions? Consider using a three-year or even five-year average, particularly if a broad definition of income is included.
Whatever the formula used to come up with the value of the book of business, make sure that the balance sheet is also taken into consideration. If debt and intangible assets such as expirations, covenants, and goodwill exceed tangible assets, the extent of the deficit must be subtracted from the value of the book of business to determine the value of each ownership share. (Note that the calculation of 'debt' must include all obligations, such as producer vesting payments or other deferred compensation, that may not be booked on the balance sheet.) Conversely, if the tangible net worth is more than one or two month's worth of agency expenses, the excess should be added to the book's value.
After making sure that the buy-sell agreement is providing a good basis for the perpetuation plan, start working on the other key elements. Will there be enough time to get the respective buyouts accomplished? If there are three owners, all over age 55, who want to start their retirements by age 65, you have a serious problem. Even if the owners are 10 years apart in age, unless there are already some good younger candidates in the wings, when the first one is ready to get out, there might not be enough time to build the necessary depth of willing buyers. It's hard enough to find good producers, let alone ones that have the entrepreneurial qualities you would like to see in fellow owners. No matter how good their sales performance, unless you're willing to trust your retirement future to them, they should not be brought into a significant equity position.
One of the best ways to find out if an employee should be part of your perpetuation plan is to start delegating duties and accounts sooner rather than later. Give potential candidates the opportunity to participate in servicing some of the principals' accounts. Get them involved in planning and other management functions. Train them and test them the way most of the current owners probably learned from the prior generation-on the job. Hand them enough responsibilities while you're still around to step in and save the ship if they start to sink it. And begin this process early enough to leave you time to find other candidates if the first ones don't work out. The best time to start planning for perpetuation is the moment that you become an owner yourself.
This advice is particularly important if you're the only owner or the one with the lion's share of the equity. It's not uncommon for a major principal to become so closely associated with the agency that he or she starts to identify with it on a personal level. The longer you do everything yourself, the harder it will be to delegate even the smallest of responsibilities. Ego and habit form a psychological barrier that makes it increasingly more difficult to share clients and decision-making with even the best of potential successors. This phenomenon is even more pronounced when family relationships enter into the business environment. The tendency to put off perpetuation planning until tomorrow has been developed into an art form by thousands of agency principals around the country. There's definitely a reason why insurance companies are so anxious to see written evidence of your perpetuation plan-and why many of them are experimenting with distribution alternatives.
In most cases, the money to fund the perpetuation plan will have to come from the agency's future cash flow since most new owners will have little or no capital to contribute. Even if a bank or insurance company lends the cash for an up-front payment, the principal and interest still have to be supported by the earnings of the firm. Since most of them will not have access to outside capital, the financial contribution made by the purchasing employees will often have to be a decrease in their compensation levels to enhance the agency's cash flow. For the five years before the beginning of a major retirement, steps should be taken to accumulate earnings so that the down payment can be made without having to borrow any funds. Insurance agencies can accumulate up to $250,000 in retained earnings, and more with appropriate justification to the IRS. In a 'C' corporation, the lowest federal tax rate of 15% is applied against profits under $50,000, so the tax consequences of retaining $40,000 each year are minimal. Note that the current shareholders will have to take out less in bonuses to accumulate the earnings to fund their down payment. This is part of the discount they must be willing to take for the perpetuation plan to succeed.
Several years before the retirement event, prepare an anticipated cash flow over the period of the payout to see what adjustments may have to be made in expense levels to fund the interest and principal payments. In rare instances, the salary or commissions previously paid to the retiring owner may provide all the extra cash necessary. But in most cases, the new owners will have to take a cut in pay to drive enough cash to the bottom line. Other expenses such as travel, entertainment, dues, auto costs, employee benefits and even office payroll may also have to be adjusted. If the cash flow still will not support the projected payments after all adjustments have been made, it will be necessary to revisit the valuation basis and/or the length of the payout period. The retiring principal and remaining owners (new and existing) all need to be flexible in this process, since there are no winners if the projected payments cannot be made.
The final written perpetuation plan should document how all five major criteria are to be met. When and how will current ownership interests be retired? What are the qualifications to be considered for future ownership, and what financial sacrifices will have to be made by these candidates to earn that status?
The late Carol Hammes, principal of the Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed. Reproduced, with permission, from The Middleton Letter.