Calculating Agency Value

by Roy Phillips

When buying or selling an agency, be sure the price is right: base the value on projected pre-tax profit and an expert's opinion.

A Texas agent recently told me, I'm thinking about selling my agency. He continued, 'I have a gross annual commission income of . . .'-pick any amount, it doesn't matter; the question always goes like this: 'Should I ask for two times that amount, or would two-and-a-half times be a better starting place?'

It will come as no surprise to most agents that a consultant would respond by saying, 'It's not that simple these days.' Determining an agency's value is a serious business, and neither the buyer nor the seller should attempt it without professional help.

In our experience, the true formula for valuation of an insurance agency as a going business concern lies in the agency's financial profile and expertise in financial management, business mix, development and retention of personnel, selection of insurance companies, and management and compensation of producers. Almost every consultant's list of agency valuation components contains all or most of these considerations. However, valuations differ in the manner in which these factors are measured and weighted into a final calculation. Our valuation theory, which we call the 'Phillips Theory' for want of a better term, is based on the agency's projected pre-tax profit after the sale, modified by a multiple derived from informed judgment factors, and adjusted by net worth.

Projected pre-tax profit is determined by recomputing the agency's profit and loss statement using the continuing revenue a buyer might expect minus the projected expenses the buyer might incur. For example, if Buyer A wishes to acquire the agency from Seller B and move the operation into A's existing agency, then it is reasonable to expect that the buyer can achieve an economy of scale and reduce operating expenses. It is our experience that the areas subject to the most significant reductions in expenses are those related to occupancy, staff, administration, and executive compensation and benefits. These four prominent line items are most subject to the economy of scale that can result in pre-tax profits for the buyer. Don't forget that some expenses may increase, especially interest on the debt created by the purchase itself.

Projected expense reductions is important, but don't overlook factors that may affect the purchased agency's revenues. As part of the pre-tax profit projection, the buyer must realize that changes in agency ownership, location, and personnel, as well as the buyer's own remarketing and underwriting activities, may cause normal attrition rates to accelerate. Other important considerations are revenue sources and the probability of sustaining those sources after the transfer. In our experience, the primary revenue sources that should be closely scrutinized are life and health commissions, company profit-sharing commissions, commissions from non-contract producers, special commission arrangements with carriers, and revenues in the 'other income' line item.

It is the consultant's job, therefore, to construct a bare-bones revenue and expense projection, relying on his or her experience in reviewing the financial and management profiles of the buyer, the seller, and successfully managed prototype agencies. The buyer should ask himself, 'How much of the seller's revenue can I keep and for how long, and which of his expenses can I reduce and by how much?'

The next step is the valuation process-determining the 'informed judgment factors' multiple-demands the greatest amount of time and expertise. In this step, the consultant develops a numerical multiple by analyzing the agency as a going business concern. Our method is derived from Internal Revenue Service Ruling 59-60 which has created as an acceptable method to determine the fair market value of a closely held corporation for gift and estate tax purposes. The IRS thought so highly of this ruling that it expanded the original application to include actual sales of closely held corporations.

The 'informed judgment factors' analysis examines internal traits such as the financial condition and earnings capacity of the business, the goodwill value of the book of business, company representation, and personnel, as well as external factors, such as the economic condition of the area in which the agency operates and the condition of the insurance industry in general. Each internal and external factor is assigned a grade from 1 (distressed) to 10 (excellent), weighted according to its importance to the agency's valuation, and averaged with the other factors to develop a single 'informed judgment factor' multiple, which is then applied to the projected pre-tax profit developed in the first step.

Why do we use a multiple of pre-tax profit, in lieu of a multiple of gross revenue? Simply because we believe that a buyer wants to determine a fair market value that reflects the purchased agency's projected net earnings-earnings that will be used to pay the debt created by the purchase, earn profit, and increase the agency's equity value.

The list below shows an example of an agency valuation using the 'Phillips Theory.' The agency in the example was in fact a going business concern offered for sale. The informed judgment factors indicated a multiple of seven times the projected pre-tax profit. As expected, the client took my final calculation and immediately computed it as a multiple of gross revenues. In this case, it was 1.75 times gross revenues, considerably more than the 1.5 times he originally asked for the agency. An insurance agency with unfavorable internal and external conditions, however, easily could have developed a factor of less than 1.5.

As a matter of comparison, our staff also computed this agency's value based on the 'discounted cash flow' method and came up with a fair market value only 2 percent less than the value our method produced.

There are certainly other formulas and theories that are available in the agency consulting industry. The IRS ruling we use for our method recognizes that there is no single formula and that much of the valuation process is subjective. Certified public accounting firms with which we have worked have appraised agencies using discounted cash flow, capitalization earning, and future earnings discounted for present value. Some appraisers assign a transfer value based on a composite and weighted compilation of all of the above.