Why nine out of ten agency acquisitions end up losing money.
If you’re considering buying, merging, or selling an agency now or in the future, consider this: Preliminary results of a current study show that 90% of all insurance agency acquisitions lose money! A primary reason is that buyers and sellers are using “average agency value” or “fair market value” as the price. We’ve all heard these terms discussed at conventions and on golf courses, but how do they contribute to unprofitable acquisitions? Let’s discuss both terms and take a brief look at what goes into an agency valuation.
AVERAGE AGENCY VALUE
First, average agency value is exactly that: An average. If you have a perfectly average agency, this value is for you. However, all agencies are not created equal, and chances are good that your agency has certain features that are better or worse than average. Agencies that are growing, are being managed professionally, and have large books with their companies are worth more because their futures are better. Similarly, agencies with riskier futures are worth less. Total agency values usually range from .5 to 4.0 times revenues — a huge range. To assume that your agency falls exactly in the middle is simplistic and unrealistic.
For example, an agent recently said that his agency should sell for 1.5 times revenues because that’s what agencies in his area were selling for. What if his agency is better managed (and thus less risky) than other agencies in his area? In that case, he should sell his agency for a higher price. Do the other agencies have a lot of Life income? If they do, he should sell his agency for even more. If he sells his agency for the average agency value, he priced it too low!
Average agency value is great for generalities and discussions over the eighteenth hole, but let’s leave averages on the golf course!
FAIR MARKET VALUE
This is the most common valuation method, based on IRS rules and a presumption of what a hypothetical “reasonable” person would pay for an agency. Fair market value is determined by the agency’s book of business value and the agency’s tangible assets.
Book of Business Value
The book of business value is the value of the agency’s client list, client files, relationships, and so forth. The possession of these assets enables the agency to generate future sales, and because of these future sales, reasonable people are willing to buy the agency in hopes of pocketing some cash sometime down the road. This expected profitability is critical to determining an agency’s value. High sales volume is not important if the owner doesn’t make a profit. Thus, the key to agency value is to determine, first, how much cash will be generated by future sales and, second, the riskiness or probability of ever receiving that cash. In other words, how much cash can the buyer pocket and what are the odds that something will go wrong?
A variety of factors affect future cash flows and the risks of actually generating them. One of the most important is retention. Renewal sales are three to four times more profitable than new sales, and renewals have hit ratios of 85% and higher, versus 25% and lower on new sales. Other factors affecting profitability and risk include companies, personnel, and image.
Profitability
“Profit” for an agency valuation is different from profit for income statements and taxes. Valuations are based on a pro forma profit. For a fair market valuation, this means that income and expenses are adjusted for changes a reasonable buyer would make. Adjustments are made to reflect probable increases and decreases in income and expenses, as well as the riskiness of certain revenues. For example, Life commissions are often discounted 80% or more because Life policies don’t produce much future revenues. Extraordinary income and expenses, including those for such owner perks as personal vehicles, are also removed.
Contingencies are another area that requires adjustments, since contingency bonuses are a far less reliable source of revenue than commissions. If the agency had $50,000 in contingencies last year, those bonuses might be discounted to $25,000 on the pro forma. However, some contingency contracts are far better than others, and an agency valuation should reflect this information. My company, Growth Planning (Pueblo, CO), has the largest database of contingency contracts and more experience with contingencies than anyone in the industry. For a more accurate valuation, we’re able to adjust contingency income based on an agency’s particular contingency contracts.
Risk Models
Once the agency’s pro forma profitability is calculated, it’s time to factor in the riskiness of those profits continuing into the future. Again, a variety of factors — including retention, profitability, companies, personnel, and agency image — determine the odds that future cash flows will be higher or lower than estimated on the pro forma income statement. These factors determine the agency’s risk. Are the companies solid, and does the agency have a solid relationship with them? If not, the business will probably be rolled and the deal is riskier. The riskier the deal, the less valuable the agency. If the producers are young, good, and likely to stay, the agency is less risky and thus more valuable. If the agency has a professional image and appearance, it’s more valuable.
Three generally accepted mathematical models exist for applying risk factors to the pro forma cash flows to determine an agency’s book of business value: (1) Price/earnings ratio (P/E ratio); 2) Capitalization rate; and (3) Discounted cash flow (DCF) model.
1. Price/Earnings Ratio (P/E Ratio)
The P/E ratio is the simplest method — and the least accurate — because P/E ratios are, at best, educated estimates. P/E ratios are available for publicly owned companies whose stock is traded daily, such as those on the New York Stock Exchange. Since the nation’s 40,000 privately held insurance agencies are not traded publicly, P/E ratios for these organizations are not available, and any P/E ratio used to value an agency is an educated guess. To calculate the book of business value, multiply the pro forma earnings by the P/E ratio; the riskier the agency, the lower the P/E ratio.
2. Capitalization Rate Model
The capitalization method is more accurate because more public information is available. The capitalization rate is similar to the return on investment (ROI) that an investor would demand if buying the agency. It consists of the risk-free rate and the risk rate for independent insurance agencies. The risk-free rate is the rate on U.S. Government Treasury Bonds of proper duration. Currently, the risk-free rate is approximately 6.3%; for independent insurance agencies, it’s usually another 9 to 19 points, for a total capitalization rate of 15% to 25%. Divide the pro forma cash flows by the capitalization rate to calculate the agency’s value. The riskier the agency, the higher the capitalization rate.
3. Discounted Cash Flow (DCF)
The DCF method is the third and best method. In fact, for buyers, it’s the only method to use because it allows using different pro forma cash flows each year. For instance, in Year One, the pro forma cash flow might be $200,000, but in Year Two it could be $250,000. As we all know, cash flows vary from year to year, and it’s important to use a valuation method that acknowledges this. Also, DCF is the only method that totally captures the time value of money. With these two advantages, it’s by far the more accurate method. The drawback is its complexity. I’d recommend using a financial calculator or spreadsheet such as Lotus or Excel for this kind of calculation.
Many people calculate the agency’s book of business value using each method and then averaging the three. Sometimes this makes sense, but for an agency owner buying another agency, the DCF method is the only method that matters.
Tangible Assets
The final step in determining an agency’s fair market value is to total its tangible assets (such as vehicles, computers, furniture, cash, and accounts receivables), and subtract liabilities (such as accounts payable). Certain adjustments might be necessary here, too. For instance, if many accounts receivables are more than 90 days old, it’s unlikely that the agency will ever collect all the money — so accounts receivables must be adjusted downward. Furthermore, such assets as cars and computers should be valued at market value, not book value.
Add the agency’s tangible assets to the agency’s book of business value. The total equals the agency’s fair market value.
The Buyer’s Value and Structuring the Deal
As already stated, fair market value is based on an assumption of what a reasonable buyer would pay, following specific IRS guidelines. This makes a good starting point and a good value for internal perpetuation, estate appraisals, buy/sell agreements, and other such purposes. When it comes down to a deal with a buyer, however, the value calculated for the specific buyer is even more important than fair market value. Every buyer is in a unique situation and will assume different risks. For an accurate valuation, the pro forma adjustments and the risk calculation must reflect these differences.
The key to a successful transaction does not stop with an accurate valuation. On the contrary, the structure of the deal is more important. The buyer and seller should not focus on price, but be more concerned with the structure of the deal. When structured properly, the deal can maximize the buyer’s and seller’s profits and goals regardless of the price.
CONCLUSION
Buying, selling, or merging an agency is a huge undertaking. Usually, the goal is to make a profit, but more than 90% of all deals lose money. Even if profits are not the final goal, the buyer and seller can both maximize their goals by valuing the agency and structuring the deal correctly. Average agency value is never the answer, and fair market value is not a buyer’s answer in most situations. Every agency is unique, so treat every merger and acquisition as a unique opportunity to maximize your profits and goals.