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Finding A Compatible Business Combination
  FINDING A COMPATIBLE BUSINESS COMBINATION by Catherine Oak Over the past few years, many firms have entered into a merger, acquisition, or some type of cluster arrangement with another firm or a producer with a book of business. And often the venture has turned out to be unsuccessful. Many mistakes are made because the participants don't take enough time to effectively evaluate the business combination they're considering. This can cause real problems for all parties involved. Firms make the wrong decisions for many reasons. Among the more common reasons are: (1) not having enough information about the other party to make an astute decision; (2) searching for a quick fix for a loss of markets, or (3) finding a deal with a price that 'seems' good. A recent IIAA study reported that only 46,000 independent insurance agencies exist now, compared to 53,500 five years ago. The study also indicated that 26% of these remaining businesses have been acquired or merged with another firm in the past few years. COMPATIBILITY ISSUES The most difficult part of creating a successful business combination is determining whether the parties are compatible and if a combined entity will be an improvement. Many firms think the key to a good deal is the price. This is far from true. Determining the appropriate price is much easier than finding a suitable party to conduct an ongoing business relationship with. It's like trying to find a good mate-it isn't easy! To find a suitable, compatible business combination, several key areas need to be discussed in the 'schmoozing,' 'romancing,' or 'courting' stage. The parties can explore these key areas themselves, but it's advisable also to have a third party involved, who is respected by the parties (a consultant, board member, CPA, or attorney, etc.). This article addresses the key areas that all parties need to explore, and the steps that should be taken to accomplish a successful business combination. KEY COMPATIBILITY AREAS TO EXPLORE 1. Major Strengths and Weaknesses of Each Party Each party should list its major strengths and weaknesses and then exchange the lists with each other. The goal: to see if each party will complement the other by minimizing weaknesses and maximizing strengths. Such an analysis may make it apparent that the combination will not help improve the problems each firm faces-may even make each party's weaknesses worse. 2. Personal Goals and Wish Lists of Owners Each owner in each firm should make a list of personal goals and wish lists for the future. If the owners are nearing retirement, they should also be very specific about when they expect to retire, what future duties they want to have, what price they expect for their stock, and what 'perks' they expect to continue receiving until full retirement (for instance, office, car, travel and entertainment expenses, and so on). If the owners want to perpetuate internally, their expectations for their buyout need to be realistic in relation to the cash flow available from the firm's activities. Internal perpetuation might not be an alternative if the appropriate perpetuation candidates aren't available to manage the firm and sell and service new accounts. Moreover, the firm might not be able to support the financial burden of the buyout of the retiring shareholder. In either case, a sale of the firm to a third party or a merger or cluster arrangement may be necessary. 3. Operational Structure of Each Firm If two firms' operations are set up too differently, a business combination might not work. A firm's organizational structure often reflects the philosophies of management and the talents of the individuals employed. A successful business combination combined into one location can merge the best of each party's organizational structures and employees. Melding the best structures and employees is the most difficult aspect of any business combination. Each party is usually too close to its own operations and employees to be able to pick and choose which ones are better for the new entity. A third party can greatly assist. Examples of varying operational structures include the following: Having a small commercial accounts unit that services and sells all accounts under a certain size, instead of having all CSRs handle small accounts Functioning on an alphabetical basis instead of by producer unit Centralizing the marketing/placement function instead of having producers doing their own marketing Having separate individuals handle claims, versus producers handling most servicing of accounts-or hiring qualified technical CSRs to support producers, freeing them up for new sales The philosophies on these operational issues need to be explored, and an agreement reached on how the combined entity would handle each of six functions for Life, Group, Personal and Commercial lines: sales, marketing, placement, client service claims, accounting, and administration. AUTOMATION In conjunction with the operational issues, the extent to which automation will be integrated with the systems and procedures of the firm need to be determined. Which computer system will survive the business combination? 4. Financial Strength and Productivity Ratio for Each Party A number of ratios should be calculated separately for each party to assess how well run each firm is before joining together. Combined ratios can also be calculated-but if ratios are determined separately first, each party will know whose firm is adding to the efficiency of the new operation and what weaknesses need attention. The ratios should be compared to those of other agencies of similar size and agencies writing comparable accounts. The results should also influence the values placed on each entity, since they reflect the management of the current operations (profitability, staffing, expense controls, working capital, and so forth). The ratios should include the following as a minimum: Expenses by line item as a percentage of revenues Revenue, expense, and profit per employee P&C or Life/Group commissions per producer and per CSR For each line of business: Commissions per account Commissions and accounts per CSR Servicing cost per dollar of commission Return on investment Collections (aged accounts receivable history) Working capital Trust ratio Debt to inquiry And so forth 5. Market Analysis Each party should create a list of the top 10 insurance companies it represents, along with certain information on each carrier: premium or commission volumes, three years of loss ratios and contingency commissions paid, volume commitments made, preferred status or special profit-sharing agreements, solvency of carrier, and years appointed. This helps the parties understand the current situation and their weaknesses before getting together with the carriers to renegotiate contracts for the new entity. 6. Book of Business Analysis The book of business written by each firm should be analyzed. What split does each firm have by line of business? A complimentary combination may be the best, rather than more of the same. For example, one firm might not have any Life and Group business, and may need in-house experts to sell the leads. What target markets, areas of expertise, and specialties do the producers in each entity have? How well developed are the existing accounts written by each firm? What's the attrition rates of the accounts by line of business? What classes of business are the top 10 commercial accounts, and how much volume do they represent? Is there much non-owned or brokered business that may affect markets represented? 7. Compensation, Perks and Contracts for Owners, Producers, Managers, and Other Employees Each party needs to know the compensation and perks the other party provides to its producers and employees. How the owners compensate themselves is also extremely important. It's essential to determine a new compensation plan for owners before putting the new entity together. It's often difficult to change compensation plans, especially for key employees (owners, producers, managers), without adversely affecting their desire to stay in the new entity. On the other hand, it's also difficult to have one entity support two very different compensation plans for owners, producers, and key managers-or salary differences for employees having similar jobs. Each firm should also share the contracts signed by the firm's partners, producers, and other employees. Today it's also becoming more common for all employees to sign non-piracy agreements to protect the firm's book of business and trade secrets. Some contracts may allow producers to vest in their books of business, some may have covenants not to compete or non-piracies, and some may actually allow producers to obtain equity (stock options) in the firm at a later date. The new entity should come to an agreement about the standard contracts that need to be signed by producers and all employees. 8. Growth in New Production What kind of real growth (in number of accounts versus commissions) has each firm experienced for the last three years? Where is the growth coming from, and can it be expected to continue? Is there anything on the horizon that will lead to a real decline in revenues (such as loss of a market, change in a commission structure from a carrier, loss of a program)? 9. Perpetuation What kind of perpetuation plan is currently in place in each firm? Are there any employees who are good perpetuation candidates and who could continue the current owners' management and production capabilities? When will the existing owners be retiring, and what are their expectations for a buyout? Is there a buy/sell agreement currently in place for a buyout that the parties will have to live with? 10. Reputations and Synergies of the Parties Last but definitely not least are the reputations that the firms (and especially of the principals) enjoy in the community, with carriers, and with insured clients. It's important for all parties to have similar morals, philosophies, goals, and desires. These things are difficult-if not impossible-to change later on. Also, the parties need to feel a certain synergy when they're all together in the same room 'romancing' or 'courting' each other in the compatibility discussions' various stages. As with a romantic relationship, the chemistry has to be there. SUMMARY If the 10 key areas in this article are explored from the beginning, it should be clear whether compatibility exists and the business combination will work. These issues should be identified and discussed honestly and openly. A good business combination will result only if this process is followed and these 10 areas are determined to be workable. A third party may be needed to facilitate this process. Catherine Oak, along with Bill Schoeffler, runs Oak & Associates in Glen Ellen, CA. Their consulting firm specializes in agency management, automation, clustering, errors and omissions, evaluations, mergers, and producer compensation. You may E-mail Oak at [email protected] or call her at (707) 935-6565.

Business Combinations: Surviving/Thriving With A Merger
BUSINESS COMBINATIONS: SURVIVING/THRIVING WITH A MERGER by Carol Hammes These guidelines will help you meet the challenges of merging your agency. Most industry observers believe that the number of insurance companies will shrink by 50% within this decade, as the strategic need to reduce loss and expense ratios fuels mergers and acquisitions. Achieving economies of scale by reducing geographic spread or focusing on more profitable lines and products has become imperative for national and regional companies alike. In the long term, the trend of carrier consolidation and spinning off non-core business will probably be good for the Independent Agency System. But in the short term, it will create even more challenges for most independent agencies. Faced with consolidation among insurance carriers, the resulting change in operating/placement strategies, and the need to further streamline their internal operations, merger activity has also increased among independent agencies. Current business combination activity is so widespread that experts predict that the number of independent agencies will shrink from approximately 40,000 at the end of the year 2000 to only 20,000 by the end of 2005. Many small to medium-sized agencies are finding that they cant compete in a marketplace where insurance companies are requiring far larger premium commitments every year. Larger agencies, faced with perpetuation concerns and growth plateaus, are increasingly receptive to merger and acquisition overtures from larger agents/brokers, insurance companies, or financial institutions. Although the pressures of premium volume commitments, marketing opportunities, and perpetuation issues lead the list of reasons for entering into a merger, a number of other strategic opportunities might make such a move viable for an independent agency of any size. These reasons include: achieving economies of scale and reducing expenses (particularly service/support staff) adding management or technical expertise expanding the geographic marketplace rounding out part of its book of business (such as Personal Lines) that might not be large enough for existing personnel to handle efficiently developing or expanding a niche or specialization obtaining new producers with established books often just nullifying the competition If your sole motivation for merging with another agency or agencies is to grow, think again. Bigger isn't necessarily better sometimes it can be far worse. There's no doubt that management headaches increase with the size of an organization. Once all of the agency principals have determined that a business combination will complement their strategic plan and you've identified one or more potential merger partners, schedule a 'chemistry' meeting so that all the owners of the agencies can get to know each other better. This will give you an opportunity to discuss some of the softer issues that are generally more critical to the success of a merger than the financial aspects. Is there a compatibility of management styles, underwriting and risk management viewpoints, organizational structures, personnel management disciplines, and personalities? Are there significant differences in ethnic, religious, or political backgrounds that could impact account retention and future management/ownership decisions? Have the parties competed so fiercely in the past that some bad blood might linger? Does one of the agencies have a questionable reputation in the industry or community? For any new venture to succeed, all the partners in the new organization must respect each others honesty and integrity. There'll surely be some rough spots along the way. Without an initial assessment of a common purpose and ethics, those bumps will derail the success of the merger. Assuming that this first meeting between the principals goes well, its time to start sharing specific information on each of the agencies. Because most of this data is confidential financial statements, expirations/large accounts, employee compensation, and so forth have all of the parties sign a Confidentiality Agreement. This legal document will provide protection if the merger discussions terminate or if one of the agencies pulls out. Signing such an agreement doesn't mean that you don't trust the other agency principals; its simply prudent business practice. This chart presents a synopsis of the type of data to share in preparing for the next step in the merger: Five-year review of income and expenses Details on how much of the business has been purchased and how much has been generated internally over the past five years Description of affiliations with other agencies or special marketing programs Review of the most recent balance sheet: the current ratio, receivable ratio, trust ratio, debt, and tangible net worth. Its important to remember that by merging all of you will be jointly taking on the debt of the other agencies. List of stockholders/partners with types of ownership and percentages History of changes in ownership for which outstanding notes or agreements exist Existing Buy/Sell Agreement and other commitments such as deferred compensation/vesting for principals and/or producers Review of non-piracy or non-compete arrangements with non-owner producers Accounts receivable aging and general collection practices for agency-billed business E&O policy limits and claim history History, details, and disposition of EEOC or other litigation against the agency Current list of employees: names, titles, years of service, age, licenses, designations and current compensation Total commissions handled by each producer and each CSR (if available) Review of compensation and employee benefit plans for owners, producers, service, and support staff Three-year review of leading insurance carriers including premiums, loss ratios, and contingents received. Can the important contracts be assigned to the new entity? Review of product mix by line of business (Personal/Commercial/Life/Group) and details within each category Review of special programs or services provided by the agency, including: underwriting/MGA services for carriers; third party administration; joint ventures with carriers or banks; special target/niche markets; and so forth Review of 20 largest accounts: who's handling them and how long they've been with the agency After the agencies have shared this information assign someone to organize it to create a picture of what the new organization will look like. This 'combination document' should include: a profit and loss statement; balance sheet; list of major companies with their respective volumes; distribution of premiums/commissions by line of business; average Personal Lines, Commercial, and Group commissions per account; and productivity measurements compared with each of the agencies and industry standards (see the previous Middle ton Letter for averages). Once the principals have put together a picture of the new agency, each party needs to assess whether the result looks better than each agency does individually. When you evaluate the new organization, characteristics that initially appeared to be complementary might indicate an underlying incompatibility between the various agency operations or management objectives. At this point, its time to re-assess your goals and the feasibility of the proposed merger. After all parties agree that the picture of the combined agencies looks good, start making some key management decisions jointly. Discuss every issue that you can think of and decide how you'd handle them before you make the final decision to merge. DO NOT assume concurrence on anything. Talk about it. Something as simple as picking a new phone system or accountant can be a breaking point. Do all of you agree on the vision for the new organization and on how you're going to reach it? Its imperative for everyone involved to discuss the issues openly. Use this decision-making process before the merger to determine whether you can all get on the same wavelength and work together to resolve problems. And if you're hoping that the merger will help reduce expenses you could well be disappointed at least initially. For the first year after the merger, the additional work and expense of joining the agencies, the enhancement/change to the automation systems, the inevitable personnel issues, and the consolidation of markets will keep productivity down and the profit margin slimmer than you'd like. Recognize that the true economic benefits of the merger will only come after this initial period of adjustment. To build a strong base that leverages the growth potential of the combined agencies, you'll need to invest in personnel, systems and equipment. If your primary reason for merging is to realize an immediate enhancement to the bottom line, rethink and reconsider. To make the merger successful you must agree on how to set up the new organization and which parts of each existing agency systems the new organization will adopt. Although each firm might currently be doing some things well, the new agency must perform better than the sum of its parts. Its essential that you agree on creating a new and better way of doing things. Otherwise, you'll end up with a larger agency that gives all the principals more hassles than they have now with a smaller bottom line. PRELIMINARY ISSUES TO DISCUSS Basic strategic plan. What growth rate do you expect from internal production and what role will acquisitions play? What will be the initial geographic expansion plan? Where do you want the agency to be in five years: location, size, orientation, and market niches? How much Life and Health business do you want? How will you maximize fee or contingent income? What type and size of Group, Commercial and Personal Lines accounts are you going to target? Are there potential new owners in the current organizations and what are the criteria and timetables for nurturing them? Name of the new organization. Although there are often reasons to try to capitalize on existing corporate or personal name recognition, it might be too cumbersome to do so. You might be wise to contact a good public relations firm to set up a new name. Remember that this process could take some time because you'll need to check (especially with state insurance regulators) that no one else has the name you select. Organizational Structure. Define the scope of each of the top management positions that the owners will handle. How much authority will each have in making decisions before they must go back to the Board (group of owners)? How often will the Board meet and for what reasons? How many people will you need in each department and what will the middle management structure be? If you have a separate Small Commercial unit, will it be responsible for sales as well as service? How will you define Small Commercial accounts? How will you keep open lines of communication with a larger number of people? How often will there be sales and/or all-agency meetings? Personnel and Compensation. What will be the compensation program for owners? What and how will you pay non-owner producers? Will producers be allowed to vest in their books of business? How are you going to treat travel, entertainment, auto, promotional expenses, and dues? (Although this policy will probably be different for owners and for non-owner producers you'll need to set specific guidelines.) What will be the vacation and other time-off schedule and will it differ for owners and non-owners? What salary ranges are you going to have for each job position? Do you want to make any adjustments as part of the merger? What are the work hours going to be? Will you allow flex time and/or part-time and how much? What employee benefits will you provide? What about a 401(k), profit sharing plan, or ESOP? What kind of sales or other employee incentive programs do you want? Company Relations. How will you approach companies with the news of the merger? Who will be responsible for negotiating more favorable contracts? What's your timetable for deciding which companies you want to work more closely with and for beginning consolidation efforts? What kind of promotional budget and activities will you plan to maintain company relations and communications? Automation. If the agencies have different computer systems, which system will you use? How many new workstations and printers will you need? What about memory and other system upgrades? What will these changes cost and how long will it take to implement them? How will you load the data from the merging agencies all at once or at first activity? How will you handle training? Vendors/Suppliers. From whom will the new organization get supplies, advertising, phones, cars, legal/accounting assistance, and so forth? OTHER ISSUES TO DISCUSS Valuation. There are a number of ways for the surviving principals to allocate ownership (generally based on the size of the agencies as determined by commissions or revenues and the condition of the balance sheet). Employee Involvement. Let the employees know what's happening as soon as you can. Enlist their input and support in the process. Many mergers don't work simply because the employees don't understand what's happening and feel left out or anxious about whether they'll have a job in the new organization. Don't treat employees as obstacles but as partners in creating a new and better agency. If you've identified cultural differences during the evaluation process, recognize, understand, and deal with them. Be aware that many people have difficulty dealing with change some more so than others. Empathize with the stress that employees are facing and try to provide support and relief. Enhanced Management Direction. Agencies often have a seasoned group of employees that know how to do their jobs with little or no supervision. During the merger process its important to provide more structure and direction. Expect uncertainty and unanswered questions about procedures, reporting relationships, job responsibilities, and so forth. Let everyone know how much they're needed and valued, and be ready to step in to resolve problems that wouldn't be occurring in the absence of the merger. Impact on Productivity. Although combining the agencies should eventually increase productivity, this wont happen overnight. Loss of productivity generally results from new direction, uncertainty over procedures, new insurance company relationships, new employee relationships, and so forth. There will also be some morale problems and turnover from people who are having trouble adjusting to the new environment. Be patient. If you've done your homework in putting the merger together and move quickly to integrate the firms, morale and productivity will bounce back quickly. In the meantime, grin and bear it! Attitude of Principals. People who've owned their own business and called the shots by themselves for a number of years often find it difficult to become part of a larger team of owners. Almost every merger requires former owners to share the decision-making process. Some have a hard time doing this and become disillusioned quickly. Their attitude then rubs off on the employees. If the agency principals initially decided that the merger was the right thing to do, they need to accept the changes involved in order to help their employees adjust to them. The late Carol Hammes, principal of the Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed. Reproduced, with permission, from The Middleton Letter.

Valuation And Structuring Of Business Combinations
VALUATION AND STRUCTURING OF BUSINESS COMBINATIONS by Carol Hammes There are three key elements that must be considered when valuing and structuring a business combination between insurance agencies. In the August issue of The Middleton Letter we addressed the first of these items, the growth potential of the agency. Before deciding how much to pay, you need to determine a probable estimated growth rate under the new ownership. In making this determination a buyer has to evaluate historical trends and ownership considerations as well as the type of business that has been written and the effects of the insurance cycles and economy on that business. The second major factor to consider is the risk that the anticipated growth rate might not be achieved. A book of business that has been relatively stable under one situation may have a much greater attrition rate under new ownership. The average agency will lose around 6% of its personal lines clients and 8% of its Commercial lines accounts every year due to normal attrition. Under the best circumstances, the attrition rate will usually double during the first year after the sale of the agency. In situations when the seller is staying on as a producer or when the agencies have merged or clustered with the same personnel, there will probably be less disruption. But if the book of business is being moved to a new location for servicing and if that servicing will be done by different people, attrition could be much higher. The following are some major items to consider in evaluating the effect that the change in ownership could have on the projected commission income. The information necessary to make this assessment should be available if you obtained the bulk of the items included in the Acquisition Checklist that was printed in the August issue. Remember that the purpose of this analysis is to help you establish the element of risk involved in the acquisition of this particular book. Insurance Company Relationships. Review the premium volumes and loss ratios with the major carriers and the relative chances of keeping those markets after the acquisition. If a significant amount of business has to be re-marketed, the attrition rate will be higher. If your income projection contains contingent income, you need to evaluate the source companies and their volume and loss ratio requirements to determine the chances of receiving comparable bonuses in the future. Pay particular attention to specialty companies or to those that write more than 40% of the total volume. Will you be maintaining the same type of relationship with these companies? Are there special arrangements that might not be applicable after the sale? Are contracts and/or exclusive territories assignable? Does the insurance company contractually have the right of first refusal to buy the accounts that you think you are acquiring? Is the seller current with the company payables? Even if you are not taking on the outstanding liabilities you could get stuck having to make good on past obligations to retain the company contract? MIX OF BUSINESS AND ACCOUNTS WRITTEN Examine the relationships with any single account producing more than one percent of the total revenues or any types of accounts that together produce more than fifteen percent of the total income. Are there special connections between the seller and those business that relate to religion, politics, nationality, age, family or some other characteristic that does not apply to the buyer? Is it possible that the seller has retained the business because he or she has not been diligent with collections? So does your personnel have the level of technical expertise required to service this business? Is there a substantial amount of income derived from Health insurance, Workers' Compensation, Malpractice or other lines that are vulnerable to regulatory or legislative changes? Does the agency write a lot of nonstandard Auto or other business that tend to have a shorter than average life span? Is a substantial amount of business handled by a non-owner producer Internal Organization and Personnel Management. Take a look at how the book of business has been serviced in the past. This review is critical if you are planning on acquiring the entire agency but is also important even if you are just buying the expirations. Any change that you might make in the type or level of service provided to the customers will have an impact on the retention rate and therefore on the growth potential. If the existing salespeople and service reps have poor morale or if they have not been adequately trained or managed, the accounts could be in pretty bad shape. You may not want to keep them or, if you do, it may take a lot of extra work to get them cleaned up. This housecleaning will then take time away from the production of new business. After analyzing the agency's external relationships with insurance companies and accounts and the internal relationships with employees, you will e in a better position to assign a risk factor to this transaction. Weigh all of the information that you have reviewed and rank the situation according to the following scale: [ ] Little risk involved and chances of achieving the projected growth rate are quite good - 8. [ ] An 'average' situation that does not have any extraordinary features - 6 or 7. [ ] High level of risk involved with substantial attrition possible 4 or 5. Once you have determined the potential growth rate and the risk that this growth will not be achieved, you are ready to address the third key element in valuing and structuring a business combination, the anticipated cash flow. The price that you can afford to pay should be based upon he profit that you will be able to make from the purchased business. Depending upon what you plan on doing with the book of business or the agency, the anticipated profits may be higher or lower than the current owner has been realizing. It is important to also recognize that your expenses and projected profit margin might be significantly different than other potential buyers could achieve. It is therefore critical in the valuation process to determine what your expenses will be. If you get involved in a bidding war and end up agreeing to a price that requires payments greater than the available cash from the acquired agency, the difference will have to be made up either by the profits from you own agency or by each of the owners personally. This situation might be acceptable for a short period of time but it will quickly become uncomfortable and eventually be impossible to sustain. To determine the anticipated cash flow, start with the revenues that will be generated. Include the direct commissions after figuring in attrition and growth potential and then decide whether it would be appropriate in this situation to also include contingent income, fees, and investment income. Subtract operating and sales expenses as they will be under your ownership (usually between 75% and 85% of the revenues) and the result will be the estimated pretax profit. The anticipated cash flow will be the profit, minus state, or federal income taxes, plus noncash expenses such as depreciation. In successive years the revenues and expenses may increase or decrease so you should do the projection for at least ten years in preparation for valuing the business. The values of this insurance agency to you as a buyer under these circumstances will be the sum of the anticipated cash flow over a reasonable period of time. To determine what is reasonable, go back to the risk factor and convert that factor into years. If the situation is not very risky, use seven or eight years. If it is an average agency, it should pay for itself out of its own cash flow in a six or seven year period of time. If this time period seems short, consider the fact that the average account will stay on the books for seven years. Do you really want to still be paying for business after the revenues that you would receive from it are gone? Once the initial cash-flow projections have been made, adjust the forecast to reflect the way the transaction will be structured. In an installment purchase, tax deductible interest will have to added to the expense projections. If amounts are to be allocated to expirations and covenants, tax deductions will be available that may allow the buyer to pay more for the agency. If the seller is to be paid as an employee, those payments and the associated employee benefits must be included in the cash flow. For planning and pricing purposes, the chart on the following page presents some of the more common structuring options and the tax treatment allowed by the recently enacted Omnibus Budget Reconciliation Act of 1993. The new legislation finally resolved the issue of deductibility of expirations that had been a serious source of disagreement between the IRS and those insurance agents who had taken the depreciation deduction over the past several years. An agent can now write off 100% of purchased expirations and goodwill, making it unnecessary to document the value of each of these allocations. Since the purchased good will wasn't a deductible expense previously and since the IRS had been disallowing most of the deductions for expirations, this guaranteed deductibility is good new. But the bad news is that the deductions must be taken over fifteen years, twice the life of the average book of business. A buyer will probably have to pay for the expirations and goodwill over a much shorter period of time than the tax deduction can be taken. This time lapse must be built into your cash-flow projection and will affect the amount that you can afford to pay for the agency. Another consideration that must be taken into account ins the change in the length of time, that noncompete covenants can be amortized. Previously the covenants could be deducted over their useful or contractual life, usually three to five years. Now they must be written off over 15 years. The buyer will probably have to pay for the covenant during the period of time that it is in force but must spread the deduction out over a significantly longer time span. Because the seller has to pay ordinary income tax on this time and will receive capital gains treatment on the sale of expirations and goodwill, it will probably be in everyone's best interest to minimize the amount allocated to the covenant and place more on the assets, just the opposite of what was advisable several months ago. One way to get around the 15-year amortization period is to allocate a larger portion of the purchase price to a consulting contract or employment agreement. These can be written off as the payments are made but they can involve extra expenses for payroll taxes and employee benefits that must be taken into account. They can also affect the seller's receipt of social security benefits. As part of the negotiation process the buyer and seller will have to weigh the pluses and minuses of each allocation and a compromise will have to be reached. There are many ways to structure a transaction and, with some careful consideration, both sides can be comfortable with the amount of money that is changing hands and the level of risk that they each are taking. Once the negotiations have been completed, the buyer should revise the cash flow estimates one more time to make sure that the deal is still affordable in light of the compromises that have been made. If the seller is willing to take some of the risk by having all or part of the price based upon retention of the accounts, the cash flow can be used to determine what percentage of commissions can be paid over what period of time. In some situations the payments can be as much as 40% of retained commissions over four or five years. But if your cash flow indicates that fixed expenses are going to be high, paying more than 30% a year could be too much of a stretch. In that case you would be better to offer the lower percentage but over a longer time period. Because sellers tend to be more comfortable with the traditional commission multiple, you may find that converting the numbers to such a multiple will make the negotiation process easier. This should only be done, however, after you have determined what you can afford to pay based upon your own plans for managing the acquired agency. Relying strictly on a multiple can be extremely dangerous because it only looks at the top line revenues and ignores expenses that may differ substantially for different potential buyers. You must focus on the bottom-line results as you expect them to be under your ownership. When dealing with multiples, the cash flow projections should still be adjusted at every turn of the negotiations, particularly if there are other prospective buyers. If a competing agent offers 1.5 times the last year's commissions, do not attempt to meet or increase the multiple until you are absolutely sure that you can afford to do so. Remember, the quickest way to bankruptcy is to acquire yourself into it! STRUCTURING OPTIONS The following are general guidelines that may not be applicable to all situations. Professional advice must be obtained from legal counsel in your state prior to and during the transaction. METHOD-ALLOCATION Tax Free Exchange of Stock. ADVANTAGES/DISADVANTAGES Seller defers taxes until new stock is sold. Buyer does not have significant cash outlay./ Sale of stock can be restricted for 2-3 years and seller takes risk of decrease in value. Buyer assumes liabilities of seller. Buyer assumes same basis in the assets as the seller had. METHOD-ALLOCATION Stock Purchase ADVANTAGES/DISADVANTAGES Seller pays tax only on gain. Seller may defer some taxes by electing installment sale provision. Corporate seller does not have double taxation problem inherent in asset purchase. / Buyer must use after tax dollars. Buyer assumes liabilities of seller. METHOD-ALLOCATION Covenant Not to Compete ADVANTAGES/DISADVANTAGES Buyer can amortize for tax purposes. / Tax deduction must be taken over 15 years. Ordinary income treatment for seller. METHOD-ALLOCATION Employment Contract ADVANTAGES/DISADVANTAGES Payments are tax deductible for buyer. Seller can carry medical insurance coverage and other employee benefits through the agency. / Buyer must pay employee benefits, payroll taxes, and worker's comp premiums. Seller cannot receive social security benefits if payments are over the limit. Must withstand IRS scrutiny of reasonable compensation. METHOD-ALLOCATION Consultant ADVANTAGES/DISADVANTAGES Payments are tax deductible for buyer. / Seller cannot receive social security benefits if payments are over the limit. Must withstand IRS scrutiny. METHOD-ALLOCATION Deferred Compensation ADVANTAGES/DISADVANTAGES Payments are tax deductible for buyer. Seller's social security is not affected since this is ordinary income. // Must legitimately be for past services rendered for which adequate compensation was not received at the time. Seller does not receive capital gains treatment. METHOD-ALLOCATION Expirations/Asset Purchase ADVANTAGES / DISADVANTAGES Seller pays tax only on gain. Buyer can depreciate for tax deduction and may purchase on a retention basis. / Tax deduction must be taken over 15 years. Seller pays 'double' tax if C corporation. METHOD-ALLOCATION Goodwill/Use of Name ADVANTAGES/ DISADVANTAGES Seller pays tax only on gain. Buyer can depreciate for tax deduction. / Tax deduction must be taken over 15 years. METHOD-ALLOCATION Fixed Assets. ADVANTAGES/ DISADVANTAGES Seller pays tax only on gain. Buyer can depreciate for tax deduction. / Must be reasonable allocation for tangible assets acquired. METHOD-ALLOCATION Commission Expense. ADVANTAGES/ DISADVANTAGES Payments may be tax deductible for buyer. Buyer does not have to pay for business that does not renew it is set up on a percentage of retained commissions. / Seller cannot receive social security benefits if payments are over the limit. Should not be used if seller is incorporated or if book of business is substantial. Deduction may not acceptable to IRS since it may be viewed as capital expense. The late Carol Hammes, principal of The Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed.