Harbor Capital Advisors is frequently called upon to prepare agency appraisals. Appraisals may be prepared for various reasons: agency ESOPs require an annual valuation; agency buy/sell agreements typically call for either an annual valuation or a valuation at the time the buy/sell is activated; shareholder's estates for tax filing purposes; a division of assets in a marital dissolution; annual strategic planning or litigation disputes.
Familiarity with the appraisal process can prove beneficial to agency principals involved in the strategic development process. Although appraisals are rendered for various purposes, the fundamentals of the appraisal process remain fairly consistent. Our focus here is to discuss, on a macro basis, the components of value utilized in preparing an agency appraisal. Recently, when speaking with agency principals, we sensed some confusion regarding such issues as why a certain range of multiples seems to be consistently used and how those multiples relate to the price earnings ratios (P/E) of the publicly held brokers. There also are questions regarding the treatment of intangible assets and their impact on the agency's balance sheet for appraisal purposes.
First, one should understand that the major component or driving force behind the valuation process is what is called sustainable cash flow or EBITDA: earnings before interest, taxes, depreciation and amortization. While many readers have heard of multiples being applied to the agency's sustainable cash flow of five to seven times, many are confused as to the origin of those multiples. Valuation experts such as Harbor Capital Advisors derive those multiples by typically starting with the price earnings multiples of publicly traded insurance brokers such as Arthur J. Gallagher; Hilb, Rogal and Hamilton; and Brown & Brown.
Public broker multiples are presented in financial publications based upon after-tax earnings. The beginning of the appraisal methodology is to convert those multiples to a pre-tax basis. The resulting multiples are, of course, lower since the numerator in the price earning formula is now pre-tax earnings. The next step in the methodology requires discounts to be applied to the public brokers, multiples for comparability and marketability factors.
With the risk of being too technical, comparability discounts reflect the fact that a relatively small agency does not have the breadth of operations and operational diversity, both geographic and product related, of a large public broker. Marketability discounts, on the other hand, are applied to recognize the difference between the ability to trade shares of a publicly traded broker in an organized marketplace, such as the New York Stock Exchange, instantaneously, and the often lengthy process of selling shares of a privately held insurance agency. The latter transaction encompasses finding a buyer and negotiating a transaction and payment terms.
Public broker multiples may or may not be subject to the application of a minority discount. In litigation cases where, for instance, a corporate dissolution action has been filed, the court may require an appraisal to be rendered on a basis of fair value as opposed to fair market value. The difference in these terms is that in calculating fair value for a minority agency equity stake, a minority discount is not applied, which can typically result in a significant valuation difference.
Another example of a nuance in utilizing discounts to the public broker multiples is the application of what is characterized as a key person discount. The key person discount is a reduction of appraised value, which takes into consideration the potential financial impact that the loss of a key member of the agency may have on the future financial results of that agency.
The balance sheet is the other component of the valuation process. We often find some confusion over how the balance sheet is analyzed. What the appraiser seeks to calculate is net tangible assets. The operative word here is "tangible," which will define itself after we define the phrase "intangible assets." The intangible assets that most readers are familiar with are expiration lists, covenants not-to-compete and goodwill in general. These assets are typically booked on the balance sheet in conjunction with an acquisition. The next logical question is why are these assets not included in the balance sheet component of an agency appraisal?
The value of acquired expirations is captured in evaluating sustainable cash flow. While from an accounting standpoint goodwill is booked on the balance sheet as an offset to the liability incurred, the reality is that what has been purchased is commission income. Thus to avoid valuing this asset twice, goodwill must be eliminated in computing tangible net assets. In addition to eliminating goodwill, any unrecorded liabilities must be incorporated into the balance sheet in computing tangible net assets.
We feel that having a more in-depth understanding of the valuation process is an important exercise since it places agency owners in a position to appreciate the basis behind the process, rather than just accepting, for instance, the idea that certain multiples are generally used in the appraisal process.
In summary, the appraisal process has applications in the real world of merger and acquisitions. Agency principals can apply the same methodologies that are used by professional organizations such as Harbor Capital Advisors, when constructing acquisition offers. The valuation process is, obviously, much more complicated than can be covered with the limited discussion permitted here, and various risk factors must be assessed in any agency acquisition. *
The author
Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a national financial and management consulting firm which offers services to the insurance industry. Services include agency appraisals, merger and acquisition representation, strategic and management consulting. Harbor Capital Advisors, Inc., can be reached in New York at (800) 858-2732.