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Building Equity Value
Strong balance sheet, stronger agency
Building retained earnings produces long-term rewards
By Craig C. Niess
Many in the financial and investment communities recommend distributing cash out of your agency versus retaining the earnings to reinvest in growth. The many arguments against retaining earnings include double taxation (C-Corps) and low yields on cash balances. Historically, personal investment advisors touted the growth available in the real estate and equities markets, but this has been tempered in the last several years by the stagnating economy and wildly fluctuating stock values.
Real estate can, and has recently depreciated, and the retirement horizons for many agency owners are no longer sufficiently long enough to capture 10% returns on stock market investments. We at MarshBerry have long been proponents of a strong balance sheet. And while double taxation on corporate earnings remains a legitimate concern, we believe that paying a little tax today is a worthwhile expense when you consider the benefits of building your balance sheet and increasing tomorrow's agency value by retaining earnings.
Why retain earnings?
Agency owners must ask themselves a fundamental question when defining their agency strategy: "Is my agency a 'right-now lifestyle' asset or am I building a viable asset for tomorrow?" Neither answer is more correct than the other, but the answer to each will chart a dramatically different course for the agency. For those agency owners interested in building a long-term asset that builds stock value and annual dividends/distributions, retaining earnings is a critical component for multiple reasons:
1. Continued and consistent reinvestment in your most valuable asset—your agency. Independent agencies have dramatically outpaced other investment returns over the past eight years when compared to alternative investment funds (The Dow Jones Industrials, S&P 500 Index, and public insurance broker composites). Continued agency reinvestment does pay off.
2. Flexibility when considering perpetuation options. Without a strong balance sheet, an agency cannot perpetuate. Having retained earnings creates options for the transfer of ownership, such as providing the down payment for seller-financed notes, collateralizing corporate and personal notes, and funding share repurchase liabilities.
3. Enhanced value at time of perpetuation. Everyone loves to talk about revenue and EBITDA multiples when an agency sells, but few consider the impact of the balance sheet on the transaction. A healthy balance sheet, in a stock transaction, will increase the value of the agency dollar for dollar, while an upside-down balance sheet will negatively impact the final price paid. In an asset transaction, the selling shareholders are still responsible for liquidating the agency assets and liabilities once the customer list (income statement) is sold. Thus, a negative balance sheet will still reduce the cash dollars the sellers ultimately take home.
4. Swift action when considering producer hiring or reinvestment. Good talent is hard to find and can be difficult to land. Having resources available gives your agency a leg-up when opportunities arise, and better yet when consistent hiring strategies can be employed.
5. Collateral or tangible assets necessary for bank borrowing and satisfaction of loan covenants. The days of unsecured, uncollateralized, nonrecourse bank loans are gone. Banks are more likely to lend to those who have capital as opposed to those who do not.
6. War chest for unforeseen needs. We do not know how long this economic downturn will last, and we do not have a clear vision as to how legislative changes may affect our industry. But, we do know that most consumers have a personal savings account. Can the same be said for the corporate savings account?
Is my balance sheet weak?
In order to know where you are going, you must first determine where you are currently. MarshBerry uses two key ratios as indicators when analyzing an agency's balance sheet, as noted in Table 1 on page 12. If you find that you are below one or more of these targets, you are not alone. As of 6/30/2010, MarshBerry data revealed the following:
• 17% of agencies had a tangible net worth deficit
• 18% of agencies had a working capital deficit.
The reason the aforementioned ratios must be key metrics for any agency rests in the substantial valuation impact that they will have on organizational value. The tangible net worth ratio is used by valuation experts (and thus financial buyers) to measure the overall value of a firm's balance sheet, which is then added or subtracted from the earnings value.
At the same time, buyers will typically demand at least 30 days of working capital when acquiring an agency to fund short-term expenses post-transaction. The overall value or purchase price of an agency is adjusted up or down according to these metrics. To best prepare for and fund perpetuation, the target working capital ratio should be 20% of net revenue. Using data from the MarshBerry database, Chart 1 (page 82) shows the average Tangible Net Worth Ratio over the last five years, broken down by agency size.
The weakness of the overall economy combined with the poor financial management of many agencies has led MarshBerry to forecast that 17% of independent agencies will not survive the next five years. Why?
• Thinly capitalized balance sheet to fund internal perpetuation
• Limited growth
• No perpetuation plan
How do I strengthen my balance sheet?
We are not suggesting that every dollar of profit be retained or that strengthening a balance sheet can be done overnight. Rather, building a balance sheet is a long-term, ongoing process that could take three to five years. It takes time and discipline to accumulate capital, create a plan, and monitor results.
We recommend that you set a timeline and tangible net worth ratio goal, estimate revenue growth and tax rates, and forecast how much capital must be retained each year to meet your long-term value enhancement objectives. The following items suggest some traditional ways for building a stronger balance sheet through enhanced earnings power.
1. Optimize workflow. Periodically auditing or validating that procedures are consistently followed will also help gauge the effectiveness of those procedures.
2. Invest in technology. Consistently question how technology can help drive efficiency, allowing your agency to become increasingly lean.
3. Optimize staff. An agency can cut staff, reduce or freeze pay, or maintain the status quo while growing into the current staff by increasing revenue.
4. Assign profit/loss responsibility to department heads. Design budgets by department and assign metrics to department heads. All functional areas of an organization should have a vested interest in the financial performance of the agency and some influence over how to optimize that financial performance.
5. Set goals to retain targeted amounts. Make a commitment to earmark some level of revenue or profit to be retained by the agency.
6. Enforce producer accountability. Set minimum new business sales requirements necessary to validate the producer position each year. Set goals that support and confirm the agency's revenue targets, and establish a compensation plan that rewards over-performance and penalizes under-performance.
7. Always be recruiting. Review the average age of employees and assess risk associated with employee retirement waves. Continuously build and manage your pipeline of producers and service staff just as you build and manage your prospect pipeline.
8. Mentorship, education and training. Formalize a mentoring program for producers, service and support staff, as well as training curricula for each.
9. Institutionalize the strategy. Incorporate all levels of personnel.
10. Incentivize behavior. Quarterly bonuses for non-producer staff based on performance objectives that tie into the business plan and objectives will help keep the staff focused and motivated.
Increase your likelihood of success
Building a balance sheet is a process that takes discipline and commitment. Involving the agency's board of directors or executive committee will help maintain the focus required to establish that discipline. Executives and owners need accountability just as much or more than employees in order to guarantee future organizational value returns and viability. Prioritizing the use of funds from the agency is an important step for ensuring that all stakeholders are in agreement with the distribution of funds.
Limiting owner distributions to tax liabilities is an effective way to retain earnings, but often difficult to institute. The mindset has to be that the owners are interested in building the value of the agency, which is how they will be rewarded long-term. The owners can certainly take distributions beyond their tax liabilities, but only to the extent that the agency has already achieved its retained earnings objective. Herein resides the delicate balance of the owner's decision to reap the financial rewards via current return (annual dividends or distributions) or long-term return (the sum of current return and stock appreciation over time).
Rebuilding or strengthening a balance sheet does not happen overnight. The objectives must be tied to the business strategy, which must be monitored and adjusted as necessary throughout the year. The owners of the agency must lead by example and make sacrifices first before asking that of any others in their agencies. Communicate with your stakeholders and staff on a regular basis.
Strengthening the balance sheet is not simply about the owners and their personal return. Rather, balance sheet strength is also about maintaining a sustainable agency that can continue the gainful employment of employees while best serving clients. Strong balance sheets benefit all stakeholders. The commitment is ongoing, so it must be cultural and systemic to be successful.
A strong balance sheet certainly drives long-term value by serving all stakeholders. And the decision to build a balance sheet ultimately resides with owners. Some choose to build an ongoing enterprise and others choose to run the agency as a current lifestyle asset. Either way is fine—as long as you understand the implications to value.
The author:
Craig C. Niess is a consultant with MarshBerry.
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