Maximizing Ownership Return

by Carol Hammes

During the past several years, a relatively conservative investor could have achieved an annual investment return of 25% or more in the stock market through dividends and capital appreciation. If sold today, that stock would have increased value and would be taxed at the new 20% capital gains rate-and the happy investor would be walking away with a handsome return on the investment.

What would the results have been if the money had been invested in a privately held insurance agency rather than in publicly held stocks? Although the agency is many principals' greatest asset, the vast majority of them do not think of their ownership position as such an investment. They should. What kind of yield would they be receiving every year if they chose to pay dividends out of the agency? And what type of after-tax return would they get when they retire?

At first, the answer may seem rather bleak. The average independent agency in this country has grown at an annual compound rate of 5% over the past 10 years. At best, the value of the agency would have increased at that same 5% rate, and in many cases somewhat less than that. And if the agency is taxed as a regular 'C' corporation, the double taxation imposed on a sale of corporate assets would cut the already paltry gain to less than half. Even if the transfer is handled as a sale of stock, a buyer can't afford to pay top dollar for an agency because after-tax dollars must be used to fund the purchase price.

There are, however, a number of things that can be done to maximize the after-tax return on an agency ownership interest-as long as there's enough time remaining before the sale date. Most of the actions that can be taken will be the same regardless of whether the transfer will be done internally or the entire agency will be sold to an outside party. At least a preliminary determination of whether the principals want to perpetuate internally or build the agency up to sell it to a third party should be made before embarking on a program to maximize ownership return. This preliminary decision should be reviewed every year so that a directional change can be made if necessary. Almost every major marketing and operational decision should be viewed within the context of improving the owners' eventual return. This should be the driving force behind the agency's business plan. Keeping the current owners satisfied with their investment is only one part of the equation. It's even more important that prospective buyers see a reason to invest their time and money in this organization rather than in the NYSE.

One of the advantages of being an owner in a privately held firm is that part of the return can be taken out each year on a before-tax basis. This return can be viewed in much the same way as the yield is measured on publicly held stocks: by relating the annual dividends back to the cost. For those who are trying to build up future value, the yield will often be low or even non-existent because it's necessary to reinvest profits back into the organization. In these situations, a balance should be struck between current and future return. In some cases, however, the agency principals may have decided that their best bet is not to build up value for an eventual sale to others but, in effect, to sell the agency to themselves over a period of time. These owners will seek to remove all the available profits every year, invest that money elsewhere, and take whatever they can get on the depreciated agency asset when they retire.

The practice of treating some of the agency profits as compensation, selling, and operating expenses is so ingrained in most agencies that it's often difficult to identify the actual return. Frequent havens for hidden profits are the expense categories of travel, entertainment, auto, dues, owner salary/bonuses, and employee benefits. From a management and planning point of view, it's important to get a handle on how much of this expense would be treated as profit if this were a publicly held corporation. Start with actual income and expense ratios for 1997 and add to the bottom line the expenses that could more accurately be classified as profit. (Note: as far as the IRS is concerned this computation never took place.)

The most crucial decisions will revolve around the appropriate classification of agency principals' W-2 compensation. Honestly assessing the actual contributions of each owner and putting a price tag on them can be difficult and often emotionally charged. Figure out what each of the principals would have been paid for sales if he or she had been a non-owner producer, and allocate an aggregate amount of 5% of total agency revenues for management compensation. To help you make these calculations, the following chart presents the pro forma profit adjustments for an average agency with between $600,000 and $1.5 million in revenues.

Expense and Profit Actual Results Pro Forma Results

Travel, Entertainment, Auto 3.0% 1.5%

Other Selling Expense 3.3% 3.3%

Office Payroll 22.6% 22.6%

Sales Payroll 11.4% 11.4%

Executive Payroll 20.5% 16.4%

Employee Benefits 8.1% 7.0%

Dues & Contributions 0.9% 0.4%

Officers Life 0.7% 0

Other Operating/Administration 22.7% 22.7%

Profit 6.8% 14.7%

The average agency of this size had an approximate pro forma profit of 14.7% of revenues. At a 35% tax rate, the earnings would be 9.6% of revenues. If the agency principals had paid 1.5 times revenues 15 years ago for their interest in the agency, they would have received a return of 9.8% before taxes or 6.4% after taxes (14.7/150 and 9.6/150). To maximize this annual return, the owners could operate with fewer or less expensive office and sales personnel and reduce operating and selling expenses, such as advertising and data processing, that represent a reinvestment in the agency's future growth and value. By doing this, they'll be taking out a portion of the future value every year and must recognize that the eventual selling price will be lower. Most buyers don't want to bail out a guy who is retiring and leaving little behind.

As long as all the owners realize the consequences and accept the 'value now' approach, this option is certainly available. It might be particularly attractive to older one-owner agencies, where death and disability can be insured against and/or where the lower residual value can be beneficial in a family transfer or for estate tax computation.

Most agency principals, however, would rather maintain a reasonable annual return without relinquishing a substantial portion of the future value. They're willing to plow some of the profits back into the operation to develop people and systems that ideally will enhance the return from an external or internal sale and end up putting them financially ahead in the long run. Developing a good balance between current and future return is not easy. A detailed plan must be in place to allocate resources effectively, with as little waste of time and money as is possible. To develop this plan, it's important to focus on and strengthen the aspects of the agency that are important to buyers when they're determining value and price.

The two key elements in value for all buyers are the potential for profit and growth. The price that they'll be willing to pay will be based on the amount of cash that the agency can produce over the next six or seven years. The higher the growth rate and the higher the profit margin, the higher the value. Some buyers will also be looking for specific characteristics in an acquisition to enhance their own business plans. Many larger brokers and insurance companies that are buying agencies are looking for specialty or niche operations. Over the last several years, the national brokers seem to have been particularly attracted to firms specializing in employee benefits. Banks tend to want more generalized operations with a wide range of products that will help them solidify relationships with existing clients. Internal buyers want an agency structure that can support their own production well.

The first step in developing a plan to make the agency more attractive to either internal or external buyers is to evaluate critically its strengths and weaknesses as a potential purchaser would perceive them. Using the factors discussed in the balance of this article, pretend that you're a prospective buyer of the firm, and evaluate it. Principals who have acquired agencies in the past already have a good idea of what buyers look for, and even those with little acquisition experience can rely on common sense. At the end of the analysis, you'll be in a position to take corrective actions to shore up the value.

If the decision has definitely been made to sell to an outside party, you can customize the action plan for several of the most likely candidates. If the owners are not yet sure that they want to give up hope of an internal perpetuation plan, rest assured that most of the evaluation criteria will also be important to the employees who will be buying the agency from you. They, too, will need a strong organization with a stream of sustainable earnings to be able to make the payments.

Motivated and capable people are the most valuable asset that a running insurance agency can deliver to a buyer. Intellectual capital in the form of a strong management team and visionary leadership can also be a key for many buyers. The level of the service staff's education and professionalism and the sales ability of the producers are instrumental in the estimation of value. The ability of the current ownership group to deliver a top-notch staff and group of producers easily will be crucial. This means that employment contracts with non-piracy and non-solicitation restrictions should be enforceable and capable of being assigned. Buyers will be less enthusiastic if producers have deferred-compensation vesting agreements that allow them to purchase the unvested portion of their books, or if there's some question regarding the ownership of expirations-particularly if they have to negotiate separately with the producers they want to keep.

Productivity levels directly affect profit and are therefore an important measure of value. High-value agencies will have above-average productivity measurements. But if they're too far above the norm, there may be some question as to sustainability and perhaps even to the quality of service being provided to the clients. In general lines agencies, revenues per employee should range from $85,000 for smaller firms to $125,000 for those with more than $4 million in revenues. Profitable specialty operations often have somewhat higher results. Buyers will also review the service staff's levels of productivity in each of the major departments. Here are reasonable targets for high-value agencies, presented by average commission size of the agency's accounts:

PL Comm/Acct $100 $130 $160 $200

Accounts/Person 1,200 1,000 875 800

Comm/Person $120,000 $130,000 $140,000 $160,000

CL Comm/Acct $500 $800 $1,500 $3,000

Accounts/Person 300 267 150 100

Comm/Person $150,000 $210,000 $225,000 $300,000

EB Comm/Acct $1,000 $1,500 $2,000 $3,000

Accounts/Person 180 167 138 117

Comm/Person $180,000 $250,000 $275,000 $350,000

 

Whether or not the buyers will be taking on the liabilities of the corporation, they'll often review the agency's procedures to make sure that proper E&O loss control and risk-management practices are being followed. Poor documentation procedures and sloppy files can adversely affect retention and client servicing, and reflect the overall quality of the people and the operation. The investment in and utilization of automation have also become much more important than they once were. Agencies that want to keep up with technology must now budget 2% or more of annual revenues for data processing. A firm that is operating totally on transactional filing with extensive carrier upload and download has more value to most buyers. If they need to invest heavily in bringing the agency up to a state-of-the-art environment, the cost for doing so will be directly subtracted from the price being paid.

Even though it may add to cash flow, a buyer will often totally disregard brokerage business when the seller does not own the accounts. If the firm receives more than 5% of its commissions from brokers, a further discount might be applied because of the lack of control over underwriting issues and retention. Brokerage business also tends to be much less efficient to handle.

The historical growth rate and retention levels will be of considerable importance in projecting growth for the future. Agencies that can show an annual 8% to 10% increase in base commissions will fetch a higher price than those that have been running at or near inflationary growth for the last five years. An extremely high growth rate (more than 20%) might be viewed favorably, but most buyers will not feel comfortable expecting such a level of activity to continue in the future and will adjust the future growth rate downward for pricing purposes. There might also be a concern about the stability of the book due to the lack of longevity.

Unless the buyer is interested in a specialty area, the best mix of business is one that does not have an inordinate amount of commissions derived from one line, such as Workers Compensation. Agencies that have at least 25% of their income from employee benefits with the balance in Personal and Commercial Property/Casualty accounts often throw off higher values. In general, having a higher average account size will be viewed favorably because the business can be handled more efficiently. But if more than 25% of the revenues are derived from the 10 largest accounts, or if one account produces more than 5% of total revenues, the price might be adjusted downward for the added risk. Similarly, if a number of key accounts have been written and retained because of a special relationship with an owner or producer (church, family, childhood friend, jogging partner), there can be increased concern about attrition.

At certain times in the market cycle, acquiring insurance company relationships may be of paramount interest to buyers. If your agency has contracts that they want or additional volume for one of their major carriers, they might be willing to pay more for the opportunity. Regardless, the strength of your company relations and particularly the loss and contingent history will be of great interest. If more than 40% of the agency's volume is with one carrier, there may be concern over higher attrition rates if something were to happen to that relationship. If there are a lot of companies all with low volumes, the agency might not have the opportunity to get preferential treatment. As a point of reference, the average agency places 35% of its volume with the top carrier, 18% with the second, and 12% with the third. Many companies now want at least $1 million before they will grant 'preferred' attention.

Even in a situation where the buyer is acquiring assets only-and particularly when a stock purchase is being made-the balance sheet will be a major element of value. Buyers will look for an agency that has good pre-billing and collection practices, with a receivable/payable ratio under 55% and with less than 5% of receivables aged past 60 days. Poor receivables management translates into higher attrition rates when the new owner tightens up on collections. The agency should have an adequate float, with a trust ratio (cash and receivables divided by company payables) over 115%. Working capital (current assets minus current liabilities) should be equal to at least 45 days of expenses. Ideally, the tangible net worth will be at least 25% of revenues.

The agency's reputation in the community will be a key factor, particularly for third-party buyers such as banks. Most agencies spend between 1% and 2% of total revenues on advertising and promotional activities. Firms that have historically spent a lot less than that might not have developed sufficient name recognition or goodwill. And it goes without saying that a reputation of churning and/or burning insurance markets is also a negative.

With enough time (usually five years), agency principals can develop and carry out a plan to make the firm significantly more attractive to potential buyers. The picture that's presented can mean the difference between a value of 1 X revenues and 1.5 X revenues, or even more.