WHAT IS THE REAL VALUE OF MY AGENCY?

Ah the million (or in some cases) multi-million dollar question.

How do I value my agency?
How do I know offers I receive are fair price for my agency?
The offers I have received in the past are too low, how do i prove my agency's valuation?

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VALUATION DETAIL

So, What is My Agency Worth By Catherine Oak

One of the recurring questions we get asked as business consultants and appraisers is “can you do a quick and dirty valuation for my business?” Now we can appreciate someone asking for a ballpark valuation, however, a back of the envelope calculation really discounts calling a professional appraiser to do the job.

Suppose a CFO of a decent size business calls up an insurance professional and says “I am doing my budget and I need to know how much insurance will cost.” The insurance professional immediately thinks of a dozen or more questions to ask.

What type of coverage is needed? What are the limits? What industry is the business in? What are the firm’s revenues? What is the loss history? What companies will quote this risk? We all tend to think that professionals in other industries can just “wing it” and answer on the phone.

Rule of thumb

Most owners are aware of a general rule of thumb for valuing insurance agencies. A multiple is applied to the earned commission to arrive at a value for the business. This approach is the Quick & Dirty method. Yes, it is quick—1 to 1.5 times commissions is easy to figure out. But, it is also dirty.

Any rule of thumb assumes uniformity of the businesses within an industry. Although there are similarities in many firms, the differences are what counts. For example, two firms each generate $500,000 in revenue; the rule of thumb says they should have about the same value.

Firm One is run by a young producer with an energetic staff that does most of the work after the account is sold. The firm just added two new markets and is growing by 25 percent a year. Firm Two is run by a seasoned professional who is past retirement. The accounts are all old friends. The firm has shrunk 10 percent in a hard market and a key carrier is demanding more volume, or they will be terminated.

Pop Quiz—are these two firms worth the same? Oh, we forgot Firm One has no debt and Firm Two is out of trust. Are the problems with a multiple of commission becoming clear?

This is not to say that a rule of thumb is invalid. It merely is to illustrate that there are limitations. This method ignores risk factors, profit margin and the balance sheet. Do not blithely use this approach in circumstances when the real value of the business matters.

Why values can differ

This may surprise some and seem obvious to others, but a business valuation is subjective. Two appraisers using the exact same overall assumptions and information will arrive at different numbers, although hopefully they should be close.

In any valuation, the assumptions made will impact the value. The purpose of the valuation should drive the structure of the approach that the professional appraiser will use to calculate value.

One of the first questions asked is “What is being valued?”—The whole business entity, a partial interest in the business or only a book of business? The whole business entity would include the value for the operation (book of business) plus the tangible net worth from the balance sheet. Including the balance sheet could swing the value of the business one way or another, depending upon such items as the debt situation or if there is excess cash.

If a partial interest is to be valued, discounts for lack of control and lack of marketability or even a control premium may apply. These discounts or premiums can be as much as 15 percent to over 50 percent of the pro-rated fractional value of the whole entity.

Next, the standard of value needs to be established. A Fair Market Value tends to be the benchmark valuation standard most commonly used. However, there are other standards—Investment Value, Fair Value, and Hypothetical Value. Again, the purpose of the assignment will mandate the standard of value that should be used. Statutory law also may dictate the standard of value that must be used.

A Fair Market Value has a specific definition. It assumes a willing buyer and seller, neither are under any compulsion to act and all relevant facts are known. On the other hand, Investment Value assumes one specific buyer and usually synergistic affects are factored in. The same agency could have drastically different values between these two valuation standards.

Finally, the date of the valuation needs to be determined. The concept is that only the relevant facts known as of the valuation date should be factored into the equation. A valuation that is being done today for a valuation date of June 30, 1998, woulc not include hard market conditions or any unplanned changes that occurred after that date.

The valuation process

Once the “housekeeping” issues are settled, the appraiser can move into the specifics of the assignment. Financial records are reviewed. Historical trends are analyzed and comparisons to industry standards are made. This provides insight into the financial strengths and weaknesses of the firm. A pro forma financial statement is generated to determine the true sustainable profitability of the firm.

Also during this process, the appraiser needs to review the operation of the firm. This would include understanding management’s strengths and weaknesses, evaluating the sales production, determining the productivity of the staff, analyzing the profile of the book of business and reviewing the agency’s carriers.

After all the information is collected and analyzed, the appraiser then uses one or more valuation methods to calculate the value of the business. The most common methods include: Price to Earnings Ratio Method, Capitalization of Earnings Method and Discounted Future Earnings Method.

Tangible net worth

Most agency owners have no problem understanding that excess cash or hard assets (like buildings) increase the value of a business and debt will decrease it. However, some items that are on the balance sheet might not be fully understood. Also, some items that are not on the balance sheet need to be factored in.

For example, some agencies accrue the revenues for direct bill commissions and then use the agency sub-system to reconcile the account. Unfortunately, this process usually posts the commission received against the account rather than the individual polices. After some time discrepancies grow and the stated receivable balance is overstated and not justified.

Another issue is the impact of producer vesting or deferred commissions. This is a great tool to attract and retain producers, but it comes at a cost. The liability, even if contingent, needs to be addressed. In some firms, this can be a huge number.

After all the balance sheet adjustments are made, the firm’s tangible net worth is determined by subtracting the liabilities from the assets. This number (negative or positive) is then added to the value of the operation or book of business.

Value versus proceeds

It must be clearly understood that the value of a business most likely will differ from the proceeds a seller receives. Terms will affect price. Many transactions are done on a retention basis and the final price is not established until the earnout period is complete. Attrition will occur and that 1.5 times commission earned paid over time could end up being less then 1.0 times the commissions from the original book of business.

Taxes also need to be factored in. If the transaction is the sale of the assets of a “C” corporation, the proceeds could be double taxed—first corporately then personally. Partnerships, LLCs and “S” corporations are only taxed personally. This is why we recommend that agency owners avoid the “C” corporation status. A good CPA should be involved in structuring the deal to help minimize taxes.

A Final Thought

The trend in agency values has been a slow decline for the past 30 years. Demand is not the issue, profitability or lack of, is the root cause for today’s lower values. Of course, a seller with the right agency that is in the right place at the right time can reap above market value, as demonstrated by some recent publicized transactions.

So, what is your agency worth?

VALUATION DETAIL

How to Value Small Books of Business & Terms By Catherine Oak

WeBuyInsuranceAgenciesDirect receives many calls about valuing small books of business, and is asked if it is worth doing a valuation when the buyer knows what they want and the buyer does not want to spend a lot of money.

Usually on a small deal — those under $500,000 in commissions — a fair market valuation does not need to be done. Instead, an Opinion of Value basically covers the creation of the pro forma income statement on the book of business, a basic description and the value calculations using three methods of valuation. Cost is usually in the $2,500 to $4,000 range versus a Fair Market Valuation for $4,000 to $6,000.

Hypothetical Example

For example, look at a hypothetical book of business that is $250,000 in commissions in both personal and commercial lines. Assume a strong 95 percent retention rate.

Personnel Expenses. A producer is needed to service accounts totaling only $150,000 of the book. The producer is paid at 30 percent of commission or $50,000. For the servicing expenses, there would probably be half of a commercial lines CSR and half of a personal lines service CSR, probably $30,000 for commercial lines, $15,000 for personal lines and $5,000 for accounting and administrative help. The purchaser will have a little management time, so $10,000 is allocated for that effort. Total compensation expenses is $110,000.

Add in benefits of 15 percent or $16,500 for all these payroll costs, which covers payroll taxes at 8 percent, health insurance, dental and some other employee cost, like a 401(k) plan. Thus, total personnel expenses are $126,500, or 50.6 percent of revenue.

Business Development and Operating Expenses. Business development costs, such as telephone, postage, advertising expenses of about 4 percent or about $10,450, will be assigned in this example. Operating expenses, such as rent, insurance, automation expenses will be assigned at about 9 percent or $22,400. This costs a total of $32,850 or 13.2 percent of commissions.

So, now we have $84,900 in profit or 34 percent on a $250,000 book of business. With this profit do some valuation calculations.

Valuation Methods

First, there is the Capitalization Method, which looks at the rate of return on the buyer’s money in something risk-free and then adds a risk factor for putting one’s money into the purchase of a book of business. The range is usually in the 10 percent to 15 percent range. Then, add an additional 13 percent to a risk-free rate of 4 percent. This becomes 17 percent, and divided by the profit is about $500,000 about 2 times commissions.

Next, there is the Price/Earnings Method of valuation, which uses a multiple of profits to determine value. A typical range for the multiplier is 5 times to 6.5 times pro forma pre-tax profit.

For this example risk has been measured and the potential of sustaining a 34 percent pre-tax pro forma profit is set at 5.5, so the value becomes $467,000 using 5.5 times $84,900, which is 1.87 times commissions of a $250,000 book of business.

Lastly is the Present Value of Future Earnings approach, which is looking ahead at what this book could earn if it is growing and profitability is maintained. It is difficult to explain all of the factors in this method, but the calculations were done, and a 5 percent growth rate was maintained and the same 34 percent profit resulted, and the value became about $500,000.

In all three examples, subtract some working capital for the buyer, which is usually 30 to 45 days, or about $13,000 to $20,000.

These three valuation methods are weighted appropriately, and the value would be about $500,000. This is two times commissions, which may seem high, but based on a profitability of 34 percent in a growing book of business, this is probably right.

Not all books or agencies have this kind of profit. Usually profitability is in the 15 percent to 25 percent range today. If an agency rolls a book of business into an existing agency versus leaving it as a standalone firm, there is usually a much better chance of having this type of profitability. Most buyers would not allow a book to stand alone as a separate office unless there was $1 million in commissions.

Please note that if the pre-tax profit is only 20 percent for this book of business, for example, then the value would probably be closer to one times to 1.25 times commissions, or $300,000 to $375,000, with the three methods weighted again on appropriate valuation for the situation.

Typical Book Terms

If a buyer gives the seller 30 percent down, that is $150,000. Typical down payments are 20 percent to 50 percent for a book of business. Then the buyer still owes $350,000. The balance is usually on an earn-out. That amount that is still owed, which is 70 percent of the money at 2 times or 150 percent is turned into a percentage for the next three years.

The payout rate is 150 percent divided by three years, 50 percent renewed commissions. With an earn-out, interest is usually not paid. That way the buyer can tell the seller no matter what comes in, the seller will receive about 50 percent of renewal commissions. With commercial lines rates increasing, that is great. If an account is lost, the buyer is protected.

The down payment is paid the first year and buyers usually don’t start paying until the beginning of the second year, then can be paid monthly, quarterly or annually.

Letter of Intent (LOI)

It is best to draft a LOI that each party signs before a purchase agreement is drafted by an attorney. Having a well-drafted LOI saves a lot of the attorney’s time and is in layman’s language.