By Paul J. Di Stefano, CPA, CPCU

DEALS: PRICE VS. STRUCTURE

The issues of price and terms become
inseparable when negotiating a deal

There tends to be much mythology regarding what agencies actually sell for. For instance, at times rumor will have it that an agency was sold for three times revenues. Unfortunately, that limited information may be misleading unless the seller received the proceeds in cash at the closing. The question that really needs to be answered is: What were the terms of the sale? Was the sale made on a contingent basis for a percentage of commissions over a period of years, or did the buyer write a check at closing? Usually the actual terms are somewhere in between an all cash deal and an all contingent deal.

An additional complication may be introduced when the seller takes back notes from the buyer. That complication is the element of credit risk, which relates to the financial strength of the buyer. In simple terms, this is the buyer's perceived ability to perform and pay off the notes. The value of the notes issued by a marginal buyer would normally be discounted because recourse to the buyer realistically may be limited to taking back the book of business.

The purchase price and deal structure offered for the purchase of an agency typically bear a direct correlation to the sustainability of the selling agency's business model. When we talk about sustainability, we are referring to the probability that the agency will continue to produce cash flows or EBITDA (earnings before interest, taxes, depreciation and amortization) consistent with current levels. Accordingly, buyers look at acquisitions in a somewhat critical and pragmatic manner in ascertaining the risks that the buyer will be assuming in maintaining cash flows after making the acquisition.

EBITDA is critical

Calculating EBITDA is a critical factor in all negotiations. While the use of multiples of commission in the structuring of deals has become less relevant, buyers still make this calculation when deciding on the appropriate multiple to apply to the seller's EBITDA. When a seller's profit margins get exceedingly high, placing a multiple on EBITDA will typically result in what may seem to be a high multiple when comparing purchase price to commissions, at times pushing the purchase price multiple to nearly three times commissions.

When the price gets to those levels, buyers tend to build more significant earn-out components into their offer. Sellers should be aware of that potential and be prepared to discuss the agency's future growth prospects in great detail to minimize the buyer's concern that he may be overpaying for the acquisition. In general, buyers look at risk factors when deciding how to structure an offer. For example, in today's environment, buyers may also be concerned that, with the market softening, commission revenues will not be sustainable.

Risk factors may include the existence of large accounts that an agency may have written for years. As we all know, accounts do not always remain with an agency into perpetuity. Any account is vulnerable to being lost if the relationship with the client is not maintained. This is a good example of a tradeoff between price and structure where a buyer may want to pay the seller on a retention basis on specific accounts that are deemed vulnerable.

Carriers and producers

Producers are another area of concern for buyers. A rational buyer will want to be assured that key producers are locked into the deal with non-compete covenants. In cases where producers control a significant amount of the seller's book of business and where non-compete agreements are not typically enforceable in the jurisdiction in which the agency does business, the buyer may seek to address that risk factor in the terms of the deal.

Buyers obviously will look at the carriers the agency represents and evaluate the viability of those markets. An example is personal lines, which in some states may present the risk of alternative market availability. In a case where much of the agency's personal lines business is concentrated with one company, a buyer might be justifiably concerned about the ability to replace that book if that company decided to stop writing new business or, worse, decided to exit the state. If a book of business has to be replaced, there will likely be a significant dislocation in that book. As we are all aware, any disruption in the relationship with insureds carries the risk of losing accounts, with pricing and coverage issues motivating the insured to consider alternatives. Our experience with clients that have been forced to move books of business is that between 20% and 30% of the book may be lost.

Another perceived risk factor is the issue of profit-sharing income. It is generally recognized that the level of profit sharing an agency receives may vary significantly from year to year. If the profit sharing received in the current year is significantly higher than in previous years, the buyer may seek to discount current profit-sharing levels when determining EBITDA or choose to structure the deal in a different manner. In this case an earn-out structure may be to the seller's advantage if profit sharing received in the current year is low, since the seller has the potential to enhance the ultimate purchase price.

In general, when a deal is structured, sellers are usually focused on maximizing the upfront consideration while buyers, on the other hand, try to balance the desire to get what they believe is an adequate return on their investment with a desire to close the deal. These sometimes-divergent goals must be reconciled before a transaction can be closed. In some cases, the seller's desire to maximize the purchase price is tempered by other issues, such as the desire to have family members partnered with organizations that present the best opportunity for the future. In those cases the optimal deal may be one that has a lower price but offers more significant future financial opportunities for those individuals.

In summary, the issues of price and terms become inseparable when negotiating a deal. The actual purchase price paid, if dependent on future performance, may remain undetermined until the end of the payout period. Setting the terms of a deal to a large extent involves reconciliation of the buyer's perception of risk and the seller's negotiating leverage. The ultimate leverage in negotiating the best deal is attracting a number of buyers who are motivated to make the acquisition and have the desire and means to structure a deal that benefits all parties. *

The author

Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a New York-based national financial and management consulting firm serving the insurance industry. Services include agency appraisals, merger and acquisition representation, and strategic and management consulting. Harbor Capital Advisors, Inc., can be reached via their Web site (www.harborcapitaladvisors.com) or by calling (800) 858-2732.