Mergers: The Six Key Issues

MERGERS: THE SIX KEY ISSUES

by Larry Morrison, CMA, CLU, ChFC and Gary Jacobson, JD

Before considering an agency merger, read this article.

INTRODUCTION

The pressure to grow has never been greater for independent P/C insurance agencies. That pressure will continue to increase for the foreseeable future.

In many cases, internal growth isn’t rapid enough. One solution is to grow by acquisition, buying either books of business or other agencies. Another solution is to merge, combining two or more agencies into a single, larger agency. Unlike an acquisition, the original owners continue to work in the business, and each owns a portion of the new business. In a strict legal sense, some acquisitions are technically mergers, but that’s not what we’re concerned with here. This article focuses on the six key issues associated with mergers — many of which are almost always overlooked or misunderstood.

In another article, “Mergers: A Case Study,” we tell the story of an actual merger, including sample associated legal documents (the actual agencies’ names have been changed, of course). These documents would make implementing a similar plan far easier for your local legal counsel.

CAUTION: Do not attempt to implement a similar plan without the help of experienced legal and other advisors!

THE SIX KEY ISSUES

1. Why Are We Merging?
2. Negotiations
3. Agency Valuation
4. Financial/Legal Structure
5. Merger Business Plan
6. Future Plans

ONE: WHY ARE WE MERGING?

Because 2 + 2 = 5 (or 6!).

In terms of money or some other factor, the combined agency must be worth more than the sum of its parts — the “synergy factor.” Obvious benefits are increased volume or access to new carriers. Other benefits might include adding expertise or management succession, spreading out the workload, or allowing the owners more free time.

Before you decide to merge, you should be able to answer this question clearly and decisively. If you can’t, you’re probably wasting your time and money.

TWO: NEGOTIATIONS

Keep the big picture in mind. Remember, you wouldn’t be merging unless you believe that the total would be more than the sum of the parts. Merger negotiations concern two issues: (1) How the parties will work together; and (2) How you will divide the benefits from having merged.

Factors in a successful negotiation should include:

• A non-adversarial tone: Remember, you plan to spend years working with your merger partner(s); you aren’t buying a car. If one side feels that they have “lost” or been forced to give in unfairly, the future relationship will be poisoned from the get-go.
• Emotional issues: You’re not negotiating with a computer. Almost every merger involves emotions on each side, including yours. Be willing to give a little, even if logic seems clearly on your side. A merger is a lot like a marriage: You won’t always see things the same way. If you have to be the winner whenever disputes arise, the merger will end in divorce.
• The final say: Who will be the boss is often a major issue. A common cop-out is the “We’ll do it all by consensus” approach. Except in very small firms, this is a formula for a confused, demoralized staff and angry partners. Major decisions can be handled by consensus or some other way, but someone needs to have clear responsibility for day-to-day operations.
• Dispute resolution: It’s imperative to establish a clear procedure for resolving disputes. Decide on this is in the beginning, before the dispute happens. Since we hate to see people end up in court, we recommend mandatory, binding arbitration.
• Skeletons in the closet: Do your “due diligence.” Even though negotiations are cordial, you still need to check for skeletons in the other guy’s closet. Don’t limit your review to the financial records (accounts payable, accounts receivable, trust accounts, etc.). Within the bounds of confidentiality, check with the other party’s carriers, clients, and employees. Run a credit check on both the company and the principal personally.
• Ownership equality: In almost all mergers, one agency is worth more than the other. Sometimes this means that the merged agency is controlled by the owner of the larger agency, but not necessarily: Partners might have identical votes even if they have different ownership percentages. This can be achieved using a combination of voting and non-voting stock, guaranteeing each partner a seat on the board of directors, or giving each director one vote. Each partner’s share in the growth in value of an agency is another issue. Again, this can be handled without giving each partner an equal number of shares. For instance, customized deferred compensation plans can be designed to not only spread the gain more fairly but to reap important tax advantages. If, despite all the alternatives, equal ownership is still required, then the owners of the smaller agency can buy stock from the owner of the larger agency. Be sure to remember that pricing stock in a merger is not the same as pricing stock in a typical acquisition.
• Win/win: Never forget the big picture. Both sides should feel that the final result is fair and leaves them better off than they were before the merger.

THREE: AGENCY VALUATION

Valuation, an integral part of the negotiation process, is so important that it deserves separate treatment.

• Subjectivity: Although valuation is an art, not a science, it has some basic guidelines. Essentially, the value of an agency is based on the future net cash flow that it can reasonably be expected to generate. This cash flow is discounted back to the present using the appropriate time value of money.
• The time-honored multiples used in the industry (1.5 times commissions, etc.) are useful as rules of thumb because they’re based on reasonable cash flow expectations from a typical book of business. However, the value in any given situation will vary, depending on the risk and expected net cash flow.
• Merger valuation: Merger valuations should not be done on the same basis as a valuation for an acquisition. First, the absolute value assigned to each agency is not nearly as important as the relative value that the agency will represent as a part of the whole. Second, ownership equalization payments, if any, must leave both the buyer and the seller in a better position than if they had not merged. If the price is based on typical sale prices, the effect is to penalize the seller and help the buyer. This point is almost always overlooked or misunderstood, but a little reflection should help make it clear: In a typical agency sale, the agency sold is expected to generate enough cash to pay for itself, “plus a little.” That’s fine in a typical sale because the seller is leaving. But in a merger, the seller is staying and earning that “plus a little” himself. Taking this extra amount away from the seller means that the seller loses and the buyer wins.
• Surplus assets: Many agencies have surplus assets of various kinds, such as surplus cash or real estate. Regardless of the asset, it raises the value of the agency. If the new, merged agency does not need this asset, it might make sense not to include it in the merger.
• Closing adjustments: Because both agencies continue to operate during the merger negotiations there will be a normal variation in the accounts of each agency. This variation must be adjusted at closing to reflect actual balances as of that date. The closing adjustments serve an important additional function: They remove the financial incentive for a partner to strip assets out of the company just before the merger. Since any reduction in assets is reflected in the closing adjustments, the financial incentive to remove assets goes away.
• The price isn’t the price, anyway! Just to make the topic confusing, remember: The price is not the price! You must also look at the risk and overall terms. For instance, it’s often possible to raise the after-tax cash flow for both the buyer and the seller by changing the terms and lowering the price.
• Conclusion: Expected cash flow and risk determine value. Merger valuation is not the same as acquisition valuation. You have to look at terms and after-tax cash flow, not just price. Since none of these factors can be known for sure, valuation is subjective in nature. Fortunately, there’s a way to check the valuation actually used for reasonableness: After-tax cash flow scenario testing.

FOUR: FINANCIAL/LEGAL STRUCTURE

• Survival: The most important factor in structuring the financial details of the merger is survival: Always having enough money to keep the lights on. The most elegant financial and legal structure is worthless if you run out of cash. The best way to improve the chance of survival is to use cash flow scenario testing.
• Cash flow scenario testing. Test the after-tax cash flow that the business and each partner can reasonably expect as a result of the merger. Since a poorly planned structure can easily generate taxes of more than 60% available cash flow, be sure to do this on an estimated after-tax basis. No one can predict the future, so test this cash flow under a variety of assumptions (scenarios). This obvious, but rarely followed, step helps make sure the after-tax cash flow from the merger is likely to be a “win” for all partners. It’s also the best way to make sure that the valuation you selected actually makes sense. The merger should pass the “sleep test.” It should still make sense under a pessimistic scenario. You should be able to sleep comfortably. Cash flow scenario testing is your merger insurance policy.
• Risk: It should come as no surprise (although it does) that the financial and legal structure of a merger affects the risk. If cash flow scenario testing reveals a situation that does not pass the sleep test, the problem can often be solved by changing the terms.
• Taxes: The taxes owed on a transaction can vary enormously, depending on how the transaction is structured. In an extreme case, it’s possible to reduce taxes from over 60% to zero. One advantage of a merger, compared with a sale, is the increased availability of potentially massive tax savings. This requires complex, specialized planning. If you use advisors who lack the unusual experience that this requires, you’re likely to get a solution that gives money to the IRS unnecessarily. This holds even truer if you do it yourself, so don’t be penny wise and pound-foolish.
• Legal agreements: These can be quite complex. Depending on the specifics of your situation, a variety of state and federal notifications are also likely to be needed. Do not do this on your own. Handling the attorneys can be particularly difficult. They are bound by training and legal ethics to take a biased position in favor of their client. Never forget that you have to work with your future partners for years. You might even find it preferable to get a new attorney than sacrifice your future working relationship over a narrow legal issue. Both sides need to make this clear to their respective attorneys.

FIVE: MERGER BUSINESS PLAN

The plan requires these elements:

• Personal involvement: This is the business end of the merger. Your advisors might bring things to your attention, but this is a part you should do yourself.
• Contracts: Contact all your carriers to make sure that there won’t be contract problems. The last thing you need is to lose a key carrier after the merger is too far along to stop. There are other contracts to check, such as leases, producer agreements, purchase agreements with previous owners, etc. For instance, a change in control is a frequent trigger in a purchase agreement that could accelerate all future payments on some previous acquisition of an agency.
• Operating nuts and bolts: Where will your office be? Will you keep all of both staffs? If not, who will be let go? When will they be told? How much will all this cost, and where is the money going to come from? Monthly cash flow projections help.
• Morale: Staff morale deserves special attention during a merger. Your staff knows that mergers frequently result in layoffs. If they don’t hear anything, they’ll assume the worst. Rumors can be far worse than fact, and there’s a good chance that the owners will not even know what the rumors are. To compound the problem, the merger itself results in a temporary increase in workload on the very people who expect to lose their jobs. To the extent possible, you, the owners, need to go the extra mile to show your staff that they’re appreciated and will be treated fairly. Don’t overpromise, though, especially about job security. Culture shock is a hidden intangible. Very few agencies have identical cultures, and forcing them together requires a period of adjustment. I have seen a multi-million dollar merger almost fail because one set of owners was used to expensive desks and the other used metal army-surplus desks. Similarly, it really does not matter if the company provides free soft drinks or makes the employees buy their own. You should not merge if you cannot design it to be a win for each of the owners. For the best results, the merger should be perceived as a “win” by the remaining staff as well.
• Producers: What happens if you merge and your producers all leave? You have a number of tools to reduce this possibility, such as employment contracts, incentives, non-compete agreements, etc. Plan to use these tools at the same time as the merger.
• Name: The name of the merged agency can be an intensely emotional issue. Clients will be less confused if a name can be arranged that retains identification with each of the previous agencies.
• Client notification: Do not notify your clients until you’re absolutely positive the merger is going to happen. If you can wait until the contracts are signed, great! When you send out notifications, be sure to stress that both agencies are now stronger, customer service will get even better, and the new agency will be able to meet client needs even more effectively.

SIX: FUTURE PLANS

• Ownership transition: Now is the time to lay the foundation for your next ownership transition. For instance, future taxes depend heavily on how the merger is structured today. In many cases, the owners will be retiring at different times. Default terms for valuing and buying out their interest should be decided now. Circumstances might lead to changes later, but it’s essential to have a default position as a starting point. If you expect to bring current or future producers in as partners, now is the time to plan. This can do double duty. For instance, a “golden handcuff” plan can be created for a key producer, spelling out how they will gain ownership in the future, providing a forfeitable financial incentive, and creating a binding non-compete agreement if the producer leaves.
• Family: Family issues can be especially difficult, especially if some partners hope to bring family members into the business and others do not. Treating family members strictly on a merit basis sounds good in theory but is difficult to achieve in practice. One solution (for larger agencies, anyway) is to have all sensitive family employment issues handled on a confidential basis by a committee that excludes the child’s parent. The IRS is deathly afraid that a parent might try to give a child an especially good deal on the sale of a business. So if family members are involved, your planning automatically becomes more complex.
• Estate/retirement planning: As a business owner, you have a more complex estate and retirement planning problem than most people, and you have more options. The business itself creates part of that problem and provides some of the opportunities for solution. In some cases, the best solution involves decisions that must be made at the time of the merger.

CONCLUSION

The merger process sounds complex because it is. The penalty for doing it wrong is severe. Which brings us back to the original question: “Why merge?”

Because 2 + 2 = 5 (or 6!).

It helps to step back and ask, “What are we really doing?”

1. Defining how we are going to work together.
2. Defining how we are going to divide the benefits from the merger.
3. Defining what steps we are going to take to get there from here.

Professional help is available to deal with the technicalities. Merging needn’t be so complicated, after all.

Gary E. Jacobson, JD can be reached at Vander Wel, Jacobson, & Bishop PLLC, Bellevue Place/Seafirst Bldg., 10500 N.E. Eighth St., Ste. 1900, Bellevue, WA 98004, Phone (866) 498-0008, Fax (208) 361-5064, e-mail [email protected].

Larry Morrison, CPA, can be reached at the Business Transition Network (Bellevue, WA) Phone (425) 957-4754, Fax (425) 603-9149, or e-mail [email protected].