Among marketing gurus, there is the adage: "Perception is reality." In other words, what someone believes to be true is, in fact, true for that person. Marketers understand that most decisions are based on one's perceptions, which may or may not mirror reality.
For example, most people value Internet stocks today based on the perception that revenue and profit will follow from market share dominance, not on the reality of current earnings.
Should determining agency value be any different? Should it be based solely on the reality of hard numbers? Or are there perceptions we can influence to increase value? And should we? In this article, we discuss issues relating to perception vs. reality, the role related issues play in determining agency value, and how both buyers and sellers deal with them.
The table below depicts typical valuation packages for two agencies, using several profile items. Which agency is worth more?
| Selected Profile Data | Agency A | Agency B |
| Personal Lines Revenue | $840,000 | $855,000 |
| Number of Accounts | 1,400 | 1,800 |
| Policies Per Account | 2.5 | 1.5 |
| Revenue Per Account | $600 | $475 |
| Commercial Lines Revenue | $1,160,000 | $990,000 |
| Number of Accounts | 800 | 900 |
| Policies Per Account | 4.5 | 3.0 |
| Revenue Per Account | $1,450 | $1,100 |
| All Lines Revenue | $2,000,000 | $1,845,000 |
| Number of Accounts | 2,200 | 2,700 |
We've seen some sellers insist on a multiple of revenue as the true measure of value. They reason that revenue is the only important number and that, "... when all is said and done the transaction ends up as a multiple anyway."
Once the valuation is completed, one always can go back and compute the multiple as a reflection of the valuation. But we would never recommend using a multiple as the first indicator of agency value, since there is no way to anticipate what factors may influence the multiple.
If a simple "multiple-of-earnings" approach were used for the two examples provided, Agency A would be worth more. However, when evaluated properly, Agency A is worth less than Agency B. Here's why.
Hard numbers expressing tangible assets tell only part of the story. Soft numbers resulting from recognition of intangible assets also reveal important information concerning potential value.
What are these intangible assets? In most agencies, there are a number of functions that may reveal the existence of intangible assets that need to be evaluated, especially since they're often perceived differently by the seller and the buyer. Selected primary intangible assets are discussed below.
All of the questions related to each one need to be answered and evaluated for both seller and buyer so their perceptions are in alignment. The seller strives to ensure that the buyer's perceptions are positive and focused on how the seller's assets add value. The buyer, on the other hand, usually will try to lower the perceived value of the seller's assets so that he/she pays less for them.
Producers
The number of producers and the character of their production play an important role in any valuation process. How many are there? Are their books of business profitable and growing? Do they possess specialized expertise? Do they fit within the agency culture? What is their long-term potential? How do they acquire accounts? Do they cold call or rely on referrals? And are the producers involved in a dynamic business network? How much support do they need? Do they bring company relationships? Are they critical to account retention?
Support staff
Unfortunately, in many agency acquisitions, support staff are perceived as somewhat expendable for the purposes of cutting costs and bringing more to the bottom line. However, excess capacity in many circumstances may support long-term objectives, especially if plans call for aggressive internal growth.
Some of the questions about support staff that need to be answered include the following: What is their education level and special expertise? How productive are they? What is their quality of service? Do they provide any specialization that can be leveraged? Are they capable of growing with the organization?
Company relationships
Many agencies we consult with do not manage relationships with insurance companies as well as they should. When poor company relations exist, the agency's perception is that companies are to blame and the company's perception is that agency principals are to blame. In any case, poor agency/carrier relations often impair agency productivity.
Is a company about to cancel a contract because of low volume or poor loss ratios? Can premium volume be combined to achieve higher commission or contingencies? We have seen situations where the agency was unaware of potential profit-sharing opportunities, simply because the contracts had not been reviewed.
Accordingly, it is important to understand these relationships and their impact on past, current and future performance, especially when there is heavy dependence on one or two primary carriers.
Special niches or programs
Harbor Capital often finds that agencies with one or more niches or specialty programs command higher value than agencies without such niches or programs. The reason is that buyers perceive these niches or specialty programs as opportunities. Usually this is because buyers anticipate that they can manage the niches or specialty programs more profitably than the seller can. While this may or may not be true, sellers should recognize and leverage this common perception.
Account portfolio
The character of the book of business is one of the most important components of the valuation.
Is one or more accounts dominant? Are any of those major accounts tenuous? Are they profitable? Is the book balanced? Does the business come from a growing market sector, or is the market flat or receding? Is the book aging or relatively new? Are the acquisition and service costs reasonable? Is there opportunity to round any of the book? Can the book be leveraged for additional referrals?
In almost all deals that Harbor Capital Advisors has been involved in, the buyer and seller initially have divergent perceptions concerning the character of the book. We have found this to be true largely because the agency management system does not provide appropriate decision support information concerning the book, especially concerning account demographics.
Accordingly, we usually require additional research into the book to facilitate a better understanding between both parties and to ensure a balanced perception of the book's role in the deal structure.
What was the final value of Agency "A" and Agency "B"?
The purchase of Agency A was transacted at a multiple of 1.4 times revenue or $2,800,000. The purchase of Agency B was transacted at a multiple of 1.6 times revenue or $2,952,000.
What was the rationale?
Agency A
The personal lines book was aging and fully rounded in a marketplace that was not growing, thus offering little opportunity for additional revenue. There was no personal lines producer.
A highly compensated producer, who was nearing retirement and was 30% vested in his book, produced a large segment of the commercial book. The two largest accounts were shopped every year. There were no niches or special programs. The book was profitable, but excess compensation was marginal.
Support staff in the agency was excellent, with one commercial CSR having the CPCU designation and all possessing their broker's license. Since the producer was retiring, staff reduction was not possible.
The agency maintained good company relationships, and the buyer would gain two new company contracts in the transaction.
Agency B
The personal lines book was growing through the effort of an aggressive producer who had implemented a sales center for direct mail and telemarketing. The accounts, primarily from an upscale neighborhood, were not fully rounded and offered additional revenue opportunity.
Commercial lines business came primarily from two young producers who specialized in contractors and main street business. Both producers had life licenses and were beginning to produce limited life business from the accounts. The book was profitable, with a small amount of profit sharing from the contractor portfolio.
Most of the support staff in the agency was above average in productivity, but two were marginal and would not be retained in the transaction, thus providing some cost savings.
Company relationships were excellent, with one company offering a bonus for additional premium commitments.
For Agency B, all of the above positive factors, combined with a larger account base, added to the perception of a real opportunity for the buyer.
Summary
As you can see from this overview, while Agency A generated more revenue than Agency B, the perceptions of the buyer were not strong enough to achieve a negotiated multiple above 1.4 for Agency A. On the other hand, the buyer for Agency B perceived an opportunity for increased revenue and profitability and was therefore willing to pay the 1.6 multiple.
In most situations, agency principals and management can position the agency to be perceived positively by the buyer. However, positioning initiatives must be properly planned and executed well in advance of any transaction. Accordingly, as part of their strategic planning process, agency principals and management are well advised to seek the counsel of an advisor thoroughly experienced in merger and acquisition transactions.
With proper planning and execution, agency principals can turn perceptions into reality and gain the benefit of the best deal in any change of ownership transaction. *
The authors
Paul J. Di Stefano, CPA, CPCU, is managing director and G. Edward Kalbaugh, MBA, is director of management advisory services of Harbor Capital Advisors, Inc., an investment bank and consultant to the insurance industry. They can be reached by e-mail at: harborcapitaladvisors@banet.net or by phone at: (800) 858-2732.
©COPYRIGHT: The Rough Notes Magazine, 1999