Sustainable earnings are the 'bottom line' of agency value. It’s important for agency owners to understand the nuts and bolts of valuation and its true link to the agency’s bottom line. In this article, Bob Hilzenrath and Brian Keigan take a closer look at how agencies are valued.
An agency’s value is the sum of two components: Earnings Value and Tangible Net Worth.
An agency’s Earnings Value is the value attributed to its ongoing operations. To derive earnings value, we multiply an agency’s sustainable earnings capacity, the 'bottom line,' as demonstrated in its income statement, by a subjective multiple determined through an analysis of the inherent risk factors of the agency. Tangible Net Worth is the sum of the tangible assets less liabilities.
One caveat is that industry convention typically expresses an agency’s purchase price as a multiple of revenue. This often causes people to assume incorrectly that an agency’s value is derived by utilizing a multiple of revenue. However, as we’ve just noted, an agency’s value isn’t based on revenue, but on what that revenue produces in terms of Sustainable Earnings.
In a nutshell, sustainable earnings are the annual earnings that an agency generates consistently, after adjusting for income statement items that are non-recurring or unnecessary.
To determine sustainable earnings, we start with the reported income statement and make pro forma adjustments to eliminate non-recurring revenue and expense items, as well as unnecessary expense items. We also make pro forma adjustments to incorporate certain expenses not included in the income statement but necessary to maintain an agency’s operations.
In either case, the adjustments should use the viewpoint of a potential outside owner. The adjustments result in estimates of an agency’s recurring revenues and expenses, which comprise Sustainable Earnings.
Understanding the nature of these items and adjustments will help owners better understand the value of their agencies. We define recurring revenues as commission and fee revenue related to insurance sales and services. It includes Property/Casualty, Group Benefits, and Life commissions, fee income, contingent income, and investment income.
Revenue that’s not recurring includes first year Life commissions, fees for one-time consulting projects, or bonus income for a book rollover. Commission from brokered business is another example; the outside producer who places the business, not the agency, has control and ownership of the account and determines where it’s placed.
We make adjustments for contingent income as well, since historical levels might not be sustainable. For example, a lead carrier that might comprise the bulk of an agency’s contingent income can pull out of a market or line of business, causing an agency to lose top accounts and volume. From an owner’s perspective, the objective is to minimize the downward adjustments a purchaser might make to revenue.
To accomplish this, you’ll need to demonstrate a track record of generating revenue. For example, a P/C agency that year-in and year-out produces new Life commissions from multiple producers will have a greater chance of sustaining that income than an agency that relies on one producer or almost exclusively on residuals. To lessen the effect of brokered commissions, an agency should limit the business it places through brokers and emphasize the business it produces through its own salespeople.
Revenue can also be vulnerable if producer agreements aren’t in place or if producers have too much control over client relationships. To mitigate producer control, make sure you have strong employee agreements, which include non-compete and non-piracy clauses, even among co-owners.
Another way to lessen account vulnerability is to use a team approach on your largest and fastest growing accounts. Make sure that service people — not just the producer — visit the client, conduct coverage reviews, or identify cross-selling opportunities. With this approach, the client will perceive the entire agency team as servicing the account, rather than one producer, and the agency has a better chance of keeping the account should the producer depart.
We define recurring expenses as expenses necessary to support the generation and retention of insurance related income. We excluded such unnecessary expenses as country club dues, automobile leases for non-employee family members, and season tickets to sporting events. We also exclude non-recurring expenses. These might include professional fees for changes to an employee benefit program, one-time purchases of major office equipment, or producer commissions paid for non-recurring Life income.
TRACKING DOWN EXPENSES
Because adjusting for unnecessary and non-recurring expense items benefits owners when valuing an agency, keeping track of these items is critical. Some expenses, such as country club dues and season tickets, are easy to track and quantify. Other expenses, such as flying first class or staying in luxury hotels, will be more difficult to quantify. Other expense items that you should track include dues, subscriptions, charitable contributions, professional fees, and outside services. These items often contain one-time business expenses.
Another major area of adjustment is owner compensation. It’s important to have a schedule of owners’ income that delineates between production compensation, management compensation, and profit sharing.
Typically, one of the biggest expense adjustments is to eliminate the bonus/profit share compensation paid to an agency owner, which tends to understate profit. The management fee an outside buyer would need to pay going forward is often much less than what the existing owners pay themselves. The result is a large increase to an agency’s sustainable earnings.
These are just some of the revenue and expense adjustments that might be made to determine Sustainable Earnings. The end result is a figure that should accurately reflect the cash flows the business could generate for an outside buyer. To get an idea of how your agency would be valued by a prospective buyer, we suggest retaining a professional valuation analyst to assist you.
A better understanding of how agencies are valued will help you manage operations with a focus on growing sustainable earnings. In the end, the value of an agency today is only as good as the earnings it can deliver tomorrow.