One Time, One and One-Half Times, Two Times. Multiple of Commissions, Multiple of Revenues, Multiple of Earnings. In this document, Al Diamond tells you why these so-called benchmarks and “thumbnail measures” have almost no bearing on the value of your agency or any other insurance agency.
Just about every agent that’s come to Agency Consulting Group during the past 20 years for a merger, acquisition, divestiture, or stock or book valuation has sought a simplified measure that they could use to generalize the value of their own agency or others. Most have heard that agencies were being sold for one time, two times or some other multiple of commissions, revenues, earnings, or some other gauge of income, gross or net.
Unfortunately, industry averages and benchmarks can measure value only if most businesses in the industry are relatively similar — and insurance agencies just don’t meet this test.
A SIMPLE (AND ALL TOO FREQUENT) EXAMPLE
Two insurance agencies within a few miles of each other both have $1 million in revenue. Each sought a valuation from Agency Consulting Group, and each asked if the multiple of one to one and one-half times revenue was valid. We asked each to complete our Valuation Questionnaire and to provide their financial and book of business documents to support a valuation. Here’s what we found:
Agency One was 50 years old and reached $2 million in revenue about 10 years ago. For five years they were relatively stable. Then their income began slipping regularly for the past five years until they approached us with their $1 million book of business. The owners were both near 70 years old. The employees were either in their late 60s or were new to the agency. The loss of business was a sign of an aging client base, with most lost business due to clients retiring, selling their businesses, or dying.
Agency Two began five years ago with two young producers going off on their own. The owners and staff are in their 30s and 40s, as are most of the businesses and clients they insure. They spend a great deal of time and effort on growth plans and marketing.
Would a benchmark or average sale price of agencies apply to both (or either) of these businesses?
The valuation of an insurance agency differs from that of a commercial building or a service business, such as a dry cleaner. Although changing conditions might render common methods of valuing the building or dry cleaner invalid under certain circumstances, most buildings and businesses of the same type are relatively stable and enjoy commonalities with similar operations. However, insurance agencies differ so widely from one another that industry averages provide only a point of reference, not a measurement tool.
Let’s take three agencies, each with $1 million in revenue. One is a P/C agency insuring primarily Personal Lines, with 1,000–1,500 small-premium customers renewing annually. Another is a Life agency that must continuously sell new business to maintain its revenue level because renewal commissions are small and of limited duration. The third is a specialty Commercial Lines agency with 50 large, high profile accounts. If the last 100 agencies that you valued averaged 1.25 times revenue, would you value each of these three agencies at 1.25 times their respective revenues? Of course not.
The value of an insurance agency depends on its future earnings power under the conditions for which the value is sought. Thus, an agency can have different values under different circumstances. For instance, the value of an agency depends on its historical and projected future performance based on the continued similar performance (or with planned changes) of its owners and staff. On the other hand, the same agency being valued for sale due to its owner’s retirement will depend on the conditions under which the purchasing entity would cause the business to generate earnings for the new owners. If the owners required the agency office to remain open, the revenue potential would be different than if the office were closed and the staff and customer base integrated into the purchasing business.
When evaluating an agency the valuer must consider the agency’s historical performance and create a pro forma of its future performance expectation based on the criteria and specifics of the valuation. This will yield a raw projection of earnings potential.
RISK FACTORS
One part of an agency valuation that novices and amateur valuers often miss is the effect of risk factors on the agency’s earnings potential. The Agency Consulting Group’s list of factors that could impact the value of a book of business has grown to several hundred items. Risk factors are the individual issues in an agency that can cause its value to shrink or to grow beyond the level that averages, historical growth, and profitability would lead one to believe. For instance, loss ratio problems with a carrier could imperil growth and profit that would otherwise be expected from an agency’s historical performance. Conversely, the addition of new, young, aggressive producers would increase the potential value based on data before the new staff members came on board.
Risk factors that refine the value of the soft assets and goodwill of an agency are a prime example of the special knowledge needed for evaluating agencies. Although many other industries provide standardized value methods, insurance agencies vary so widely that only professionals have the expertise to evaluate them.
TANGIBLE NET WORTH
Most agencies have limited net worth outside of the value of the “soft” assets of its book of business (future earnings stream). However, if stock is to be valued, the valuer must also add the tangible net worth of the agency to its goodwill value. Tangible net worth should be calculated from established, prepared balance sheets. Have a competent accountant analyze questionable assets before factoring them into the evaluation.
SUMMARY
Insurance agencies aren’t mysterious or difficult businesses to understand. However, the variations in their operation require specialized knowledge to provide an accurate valuation of their worth. Beware of pundits and publications that report multiples of commission, revenue, or earnings as the “average” value calculation for agencies.
It’s easy to work backwards and take fully matured values and then divide them by commissions, revenues, or earnings (raw or pro forma). But the only way it makes sense is working backwards.
For example, in one recent year, the value of agencies evaluated by Agency Consulting Group ranged from .45 times annual revenues for one agency to well over three times revenue for another firm. However, the .45 valuation (less than one-half the firm’s annual revenue) was for an agency that was functionally bankrupt and was sold for its receivables. On the other hand, the agency valued at more than three times revenue received this valuation because the owner needed a long-term annuity payout for tax and estate reasons. Including agencies such as these (and many other non-standard situations) in “industry averages” skews the results beyond the range of reliability.