https://completemarkets.com/Article/article-post/949/MAKING-THE-MOST-OUT-OF-AN-AGENCY-BUSINESS-COMBINATION/
Making The Most Out Of An Agency Business Combination
MAKING THE MOST OUT OF AN AGENCY BUSINESS COMBINATION by Carol Hammes It’s what comes after the handshakes that counts. INTRODUCTION You’ve done the groundwork for a successful combination of agencies (acquisition, merger, or cluster). But what comes after the handshakes will be even more critical in determining the eventual outcome. The initial evaluation and structuring process will determine much of what needs to be accomplished. Parties involved have made an emotional and financial commitment to invest in this course of action. You owe it to yourselves to follow through for as long as it takes to maximize the payback on this investment. Here’s how: KEEP THE SELLER INTERESTED Most transactions involve at least one owner who is selling their ownership interest as part of the deal. In some situations, the buyers might prefer that a selling owner disappear (quickly) after the sale. However, it’s usually better to have the sellers stay involved for a while by building a retention or growth incentive into the purchase price. If you want the seller to take a hike, don’t include any incentive — except perhaps one that pays them to stay away! The simplest and most common incentive is to buy the book of business strictly on a retention basis. Determine the appropriate percentage using the pro forma cash flow that you developed and adjust this for timing considerations. If the seller wants the money over a shorter period, the percentage of renewal commissions paid can be higher. But the total amount paid out might be lower than if the payout period is longer. For example, in a fold-in situation, you might be able to afford as much as 40% of renewal commissions for three years. An alternative that might provide more money for the seller and a longer period of involvement would be to pay 30% for five years. Since the buyer must take the tax deduction for the expirations and covenant payments over 15 years, more and more transactions will probably be structured over longer pay-out periods. If a straight earn-out deal isn’t appropriate, there are a number of other ways to keep the seller involved over a period of time. Here are some suggestions that can work for both external acquisitions and those in which the interest of a retiring owner is being purchased internally: Offer an employment contract that pays the person a percentage of the commissions as a servicing producer on the book of business. Structure a production bonus that pays a certain percentage of total commissions received on the portion that exceeds the cash flow projections. Pay the seller a finder’s fee for new accounts brought to the agency. In most cases, it’s not wise to pay the person as a servicing producer on the renewal of those accounts, but a hefty new business commission percentage might be in order. When a branch is being acquired and the seller is being retained as a manager for a few years, set up a separate profit center with a bonus arrangement that pays a large percentage of the profits that exceed the plan. This will provide a reward for higher commissions, lower expenses, and/or both. Agree to a guaranteed price, but with installments to be reduced if the commissions do not remain at predetermined minimum levels. Hire the person to perform management functions (company relations, computer installation, training of salespeople or CSRs) and pay a combination of salary and results-oriented bonus based on an increase in contingent income, increase in revenue per employee or commissions per producer or CSR, or some other formula that tracks with the tasks that have been assigned. You can also add non-monetary incentives to keep the seller interested in the ultimate success of the transaction. For example, you might want to include them in the agency planning process, hand out a title such as Vice President, provide an office, or simply ask for their advice from time to time. PLAN FOR THE TRANSITION It’s important to anticipate reactions from those parties both inside and outside the agency that the transaction will affect in some way: Agency employees, insurance company managers/reps, vendors, accounts, and prospects. 1. Spread the Word! In general, the more information that you share with employees of all the agencies involved and the more input you solicit in advance of the actual transfer, the more positive the transition will be. Some people handle change better than others, but everyone feels additional stress when facing the unknown. If you can reduce the mystery surrounding your plans, you’ll receive more support from the key players and less disruption from those who are determined to subvert the efforts. Of course, premature announcements can also be damaging, so there’s a fine line to walk Experience has shown that it’s usually better to err on the side of sharing too much, rather than sharing too little. Those of you who have been witness to agency employees hearing about a sale from a company underwriter know what we’re talking about. If the transfer of an insurance company contract is instrumental in the decision to do the deal, the buyer will have been involved in discussions with the branch manager at the outset of the negotiations. Companies that are shared by at least two of the agencies involved should also be contacted before closing with regard to the future treatment of contingent calculations and commission scales. Because most companies have a variety of agency contracts, you’ll want to lobby for the most advantageous one. When the acquiring agency has an important or preferred relationship with a carrier, find out if this company has a problem with the other agency before you finalize the deal. Is the acquisition worth losing an important market? The other companies involved do not need any special advance contact. You’ll need to decide which vendors to use for office supplies, advertising, phone, cars, etc. — but that can usually wait until after the transaction has been completed. If the agencies involved have different automation systems, some advance planning and contact might be necessary. When suppliers are also agency clients, you might need to take special measures before the public announcement to decide what, if anything, might change about the relationship and then to communicate this information to the vendor-clients involved. Most existing accounts and prospects will first hear about the business combination through the news story and/or ad in the local newspaper, cable TV, or radio. How you present the situation will leave a lasting impression so it’s important to plan the announcement carefully. In a merger or cluster, there might be a new name and new management philosophy that can be shared. If one agency is being acquired by another, it might be better for public relations purposes to refer to it as a “merger” or “affiliation,” rather than a “sale.” In addition to the general announcement, each client and prospect in all of the agencies involved should be sent a letter describing the business combination and its purpose. Even if the insured is associated with the “surviving” agency, it’s important to provide reassurance that nothing will change, or that the changes will be an improvement. This would also be a good opportunity to solicit additional coverages on Personal Lines and small Commercial Lines accounts. 2. Review All Accounts: Immediately after closing, review all larger Commercial Lines accounts. Within the first month, the seller and the new producer should visit all accounts in the selling agency that produced more than 1% of the total agency commissions. The purpose is to get acquainted and do a risk management review of the exposures and coverages. Accounts that produced from .5% to 1% of agency commissions should receive a similar visit within the first three months. Any other Commercial Lines accounts that produced more than $3,000 or so in commissions in rural areas, or $5,000 in urban areas, should be visited before the first renewal to let them know that the new agency wants to keep their business. PLAN FOR THE FUTURE Since you’ve done the acquisition, merger, or cluster to enhance your opportunities for growth and profitability, you need to develop a business plan that addresses the new options and defines who needs to do what for the agency to pursue the most advantageous course of action. Use the attached Worksheet as a starting point in the planning process. Add the revenues, total number of employees (including owners, producers, and former owners if they will be working at the agency more than 30 hours a week), number of producers, Commercial Lines commissions, Commercial Lines staff, Personal Lines commissions, and Personal Lines staff. Use these basic standards to compute the productivity measurements for the combined agencies, compare them to the average agency standard, and then project future needs based on anticipated revenue and commission growth. This involves several elements. Staff Restructuring Some employees might not be comfortable with the new organization and decide to leave. If you determine how many people you need in the agency and in the major departments, you’ll know in advance whether you’ll need to replace those who quit, and, if so, what type of candidates you should look for. When several stand-alone agencies are being combined, certain positions will invariably be redundant. In a cluster or merger situation, you’ll also face the problem of who is to be in charge at the top management level. Each agency had its own management structure and now one person must be given the responsibility for managing each of the functional areas of the agency. It’s critical that you discuss this and decide where the responsibility and authority will reside before the agencies combine. Perhaps one former owner can be the Sales Manager, one the Operations Manager, one the Marketing/Company Relations Manager, one the Financial Services/Health Manager, etc. But where will the buck stop for real? Although the new organization will not need two Office Managers, a higher level job position of Operations Manager might be called for. An agency with automated accounting in which the CSRs do the invoicing will probably only need one person in bookkeeping unless it’s larger than $2.5 million or so in revenues. One receptionist with a part-time back-up can handle all but the very largest agencies. You might be able to reduce the number of people handling claims — or you might have the luxury of deciding whether to separate the claims function from the service function and set up a new Claims department. The combined agency might be large enough to have an Administrative department handle the clerical duties of the CSRs. This might also be the time to create a new type of sales position that’s dedicated to servicing accounts (perhaps those of a retiring owner). You might also have the opportunity to differentiate between the types of CSRs, with some dedicated more to sales, others to technical processing, and still others to marketing/placement. Growing so rapidly, can easily compound over-staffing situations and end up adding more of the wrong kind of bodies. Having a management plan will reduce the chance for error. It will also allow the individual employees to see how the business combination can benefit them. With more specialization and differentiation in the types of jobs, they can see the advantage of continuing their education because there is indeed “room to grow” in the agency. Procedures As part of the initial planning for the new agency operation, be sure to conduct a complete review of all procedures. Sometimes organizations are forced into this evaluation because everyone had a different computer system and they are all converting to one. But even if there’s not such a dramatic need, this is an ideal time to track down and eliminate the duplicate work and the lost delegation opportunities. It’s far better to come up with a new “better” way than to force one group of employees to adopt a set of procedures that don’t seem to be an improvement over what they did in their agency. The morale problems that can develop from the battle over “ours versus theirs” can literally destroy all of the hoped-for economies from the merger. Company Relations The new strategic plan should also address company relations. Draw up a chart with the combined premium volumes, policy counts, and loss ratios for each carrier represented. Decide which companies you want to grow with in what lines of business, who is hot on what types of accounts, and where there might be sales opportunities for the agency if additional markets were obtained for certain lines or niches. At the end of the first calendar year, present your plan for growth to selected companies, old and new. Renegotiate contracts with the lead companies based on the new volume levels. The agency might now qualify for Top-of-the-Heap status — or, at the very least, you might be able to get some better commission rates. Use the merger as a catalyst to pursue actively the type of company relationships that the agency needs. BUSINESS COMBINATION PLANNING WORKSHEET Average Agency A Agency B Combined 12-Mo. Plan 2-Yr Plan Revenues # Employees Rev/Employees $72,000 # Producers Rev/Producer $240,000 Commer.Comm. Commer.Staff Commiss/Staff $165,000 PersonalComm. Pers. Staff Commiss/Staff 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.
https://completemarkets.com/Article/article-post/1003/VALUATION-AND-STRUCTURING-OF-BUSINESS-COMBINATIONS/
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.