AGENCY FINANCIAL MANAGEMENT

SELLING THE AGENCY

Psychological vs. pragmatic considerations

By Paul J. Di Stefano, CPA, CPCU

Harbor Capital regularly receives questions from agency principals regarding the state of the merger and acquisition market. What we really are being asked is: Is it time to sell? The answer is: Yes, it’s a great time to sell if one is ready to! Thus the real challenge is: How do agency principals know when they are truly ready to sell?

To sell or not to sell

From a psychological standpoint, the decision to sell usually is not based on one event but is the result of a process of reflection. When they see that their competitors are selling, agency principals may view these transactions as threats, opportunities or, in some cases, non-events. For example, an acquisition may be seen as a new competitive threat from a larger, better-positioned agency, especially if a former competitor—armed with the acquirer’s capital resources—contacts an agency principal seeking to initiate acquisition discussions. On the other hand, an agency principal may see the acquisition of a competitor as an opportunity to go after clients that were tied to the selling principal as long as he or she owned the agency.

Thoughts of selling can also be induced by the state of the insurance marketplace. Agency principals may be concerned that the agency lacks critical underwriting facilities and/or that existing underwriting facilities may be losing their appetite for the agency’s bread-and-butter business. Broader industry issues, such as the softening market or the potential impact of recent litigation with regard to the general practice of profit-sharing agreements, could have an impact on an agency’s business model and could lead principals to begin thinking about an exit strategy.

Beyond these external issues and events, a key consideration is whether the agency principal still enjoys being in the business. In many cases, principals would prefer to give up some of the more mundane aspects of the agency operation. In other cases, whether for health or other personal reasons, the idea of slowing down is becoming more and more appealing. We have found that motivation varies by the individual, with some agency principals waiting until they get into their 70s before considering a sale, while others who are only in their 40s decide to take some money off the table and throw in with a larger entity. These personal considerations can drive principals to seriously contemplate selling as a possible strategic move or an exit option.

The issue of an agency principal’s age should be viewed pragmatically when contemplating a future sale. If the principal or principals are heavily involved in client relationships, acquirers would need more time to transition or institutionalize that business. On the other hand, if the agency has put in place a quality management and production team, there probably would be less need for an extended transition period. The seller’s ability to accommodate the buyer with the necessary transition time frame will be a critical factor in structuring a favorable deal.

Who should the buyer be?

The decision to sell gives rise to an important question: To whom should the agency be sold? A key concern is that the seller’s life will change dramatically after the sale. What will life be like with an acquirer? Many sellers find that life after the acquisition is not much different from what it was before the sale. While some of the administrative duties may be centralized, selling principals may be able to focus on areas they enjoy, such as production, mentoring, or developing new programs.

Another part of the scenario is the reactions of key people. Employees may be eager to have an ownership position in the agency, but the principal may believe that a buyout by key employees would not be practical. When an agency is bought by key employees outside of an ESOP structure, the individuals usually must provide a note to the selling principal. The question is whether these individuals have the ability to profitably manage the agency over the period of the buyout. The answer will dictate whether most of the security risk to the selling principal can be eliminated by the realistic potential to generate sufficient cash flow to cover the notes.

The prospect of family perpetuation is appealing to many agency principals. Keeping the agency in the family may sound attractive; however, we have recently dealt with several situations where the family as a whole decided that a sale to outside parties was in everyone’s interest.

Pragmatic considerations

The pragmatic considerations can be dealt with somewhat more objectively than the psychological issues, especially when it comes to cash flow and risk. One analysis that all agency principals should carry out is a comparison of the after-tax cash flows generated in a sale scenario with the after-tax cash flows associated with continued agency ownership. That analysis well may be the tipping point if all other considerations are pointing toward a sale. This analysis reveals that the difference between capital gains tax treatment and ordinary income treatment is quite substantial.

We routinely hear many principals say they think they will be better off delaying a sale because they will capture the profits from the agency for several more years. This sounds like a reasonable strategy, but they may be ignoring an important issue: the principal continues to assume the risks associated with ownership of the agency whereas in a sale, after-tax dollars can be invested in risk-free instruments, such as Treasury bills, to get a guaranteed return.

Harbor Capital has analyzed a number of recent transactions with regard to the impact on the agency principals of selling and investing the proceeds in a risk-free scenario as opposed to retaining agency ownership and continuing to receive the net cash flows from the business. We found that it would take the agency owner anywhere from 10 to 13 years of continued agency operation to receive the same after-tax-dollar amount that would be generated from a sale.

Agency principals may lose sight of the fact that the compensation and distributions they receive from the agency are all pre-tax dollars. To put our analysis into context, principals should calculate the present value of their future net cash after ordinary income taxes and compare that result to the proceeds of a sale after capital gains tax of 15% when those proceeds are invested for a risk-free return of 4% to 5% over that same period.

Deciding whether to move forward with an exit strategy is a major issue for agency principals. Trying to make these assessments in a vacuum is not recommended because the input needed to make these decisions is critical. The prospect of taking money off the table and capitalizing one’s value is enticing, but don’t underestimate the psychological aspects of giving up ownership. *

The author
Paul J. Di Stefano, CPA, CPCU, is the 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. Harbor Capital Advisors, Inc,. can be reached in New York at (800) 858-2732 and its Web site can be visited at www.harborcapitaladvisors.com.