In agency merger and acquisition discussions, balance sheet issues typically are the last to be dealt with. Whether characterized as tangible net worth or working capital requirements, the basic issue revolves around an important consideration in merger and acquisition discussions, which is the buyer's expectation of receiving a certain amount of working capital as part of the transaction. In a stock purchase, the buyer may expect to receive, in the classic definition of working capital, an agreed amount of current assets over current liabilities; or the buyer may be satisfied with an agreed amount of tangible net worth.
Let's clarify the difference between working capital and tangible net worth. With regard to tangible net worth, the operative word is, of course, tangible. Perhaps the easiest way to define tangible net worth is to identify what are considered to be intangible assets. Intangible assets typically include the net value after amortization of assets such as account lists or expirations, noncompete covenants, and goodwill. Intangible assets also may include unamortized leasehold improvements associated with leased space that have been capitalized on the seller's balance sheet.
Tangible net worth requirements encompass working capital consideration from a broader perspective. Tangible net worth requirements usually come into play in agency stock acquisitions. The basic theory in valuing an agency's tangible net worth is that if the agency's assets were liquidated, all of its assets should ultimately be convertible to cash, which in turn would be used to liquidate agency liabilities. Intangible assets such as the ones described above are not convertible to cash. Although certainly account lists have value, the value of those lists is already reflected in the agency's cash flows that a buyer is purchasing and therefore would be valued twice if considered part of tangible net worth.
In a stock sale, a buyer will end up with the assets and liabilities of the purchased agency; accordingly, it is possible for a buyer to ascertain how much working capital and/or tangible net worth is being transferred in the transaction. What happens in the case of an asset sale where no balance sheet is being transferred? In this case, the buyer typically would structure an offer so that a level of working capital would have to be provided to handle the acquired book of business. The buyer typically addresses the lack of working capital by reducing the offer price for the book of business by the required amount.
In an asset sale, the working capital issue may not be apparent to the seller because the buyer constructs the offer so as to give consideration to the lack of working capital. The buyer's cash flow worksheets, which compute the expected return on investment, are not usually made available to the seller. In a stock purchase, the working capital issue is apparent because the buyer will make an offer for the agency's stock that stipulates that the balance sheet will include a certain amount of working capital.
In an agency stock purchase, the assets and liabilities of the selling agency should be carefully reviewed as part of the buyer's due diligence. At that time the seller will be asked to demonstrate and warranty the collectability of balance sheet receivables. Typically there is a right of offset if those receivables prove to be uncollectable.
Adequate working capital or tangible net worth is a matter for negotiation. Typically 30 to 60 days of agency expenses is considered an acceptable range. We must be careful to distinguish between adequate tangible net worth and adequate cash balances. In some transactions, the seller's balance sheet may have little or no cash but show an adequate amount of tangible net worth because of investments in furniture and equipment. The lack of cash may point up problems with the agency's collection procedures. The buyer in such a case may consider it necessary to focus more on working capital adequacy than on tangible net worth, because the buyer will certainly need to inject additional amounts of working capital into the acquired agency even on a temporary basis.
The issue of agency trust balances, which are required by most state insurance departments, complicates the discussion of working capital. In some extreme cases where an agency may be out of trust and actually have an upside-down balance sheet, the buyer may be required to allocate a substantial part of the purchase price to cure the out of trust issue.
All of these issues point up the importance of negotiating a comprehensive transaction from the start. After a price has been established, it becomes more difficult to start discussions related to the balance sheet, especially when there are problematic balance sheet issues. Of course, until due diligence has been performed, the buyer cannot be sure of the exact amount needed to address balance sheet issues. Based on our experience at Harbor Capital Advisors, all of the relevant components of a transaction should be put on the table as early as possible to avoid any problems as the negotiations proceed.
We have addressed potential balance sheet issues in a broad manner. In more complicated transactions, other issues must be considered in assessing tangible net worth. An example is producer equity stakes in a book of business, which may need to be viewed as an off-balance sheet liability. In summary, when making an offer to purchase an agency or when responding as a seller to a proposal, be aware of all aspects of the proposal. It is easy to have one's imagination captured by what seems to be a high multiple. Be aware of possible balance sheet issues that may accompany the offer.
As a part of its merger and acquisition consulting services, Harbor Capital Advisors carefully evaluates balance sheet issues on behalf of both buyers and sellers and advises on the most equitable method of addressing what can become thorny issues in a transaction. *
The author
Paul J. Di Stefano, CPA, CPCU, is managing director of Harbor Capital Advisors, Inc., a national financial and management consulting firm that offers services to the insurance industry. Services include agency appraisals, merger and acquisition representation, and strategic and management consulting. The firm can be reached in New York at (800) 858-2732.