Agency Financial Management
Examining an agency ownership transition
A case study for an agency sale
By Tom Sukay and Paul Vredenburg
Recently our firm has become deeply involved in agency perpetuation planning. We rarely get a call from someone who says, "I want to sell my business." The most common call is from an agency owner in his early 60s who needs some help valuing his business so he can perpetuate internally. We have found that most owners believe they have a clear idea of their goals. Our challenge is to ensure that their goals are achieved.
In this article we will analyze the goals and strategies of an agency whose principal owner wishes to sell to an outside firm. The situation that we discuss in this article is based on an actual agency's circumstances. Names and locations have been changed. In subsequent articles we will take the same approach for two agencies whose owners wish to perpetuate internally.
In each article we will provide three perspectives. The first comes from the agency owner. The second is our perspective as an advisor. Sukay & Associates is engaged to help the selling owners achieve their goals. We are not hired to help them sell the agency or create an internal perpetuation plan. The owner decides the course of action once we have agreed on the goals. One challenge is to make sure that each client is aware of all of his options and understands the risks and benefits associated with each strategy, including the human element.
The third perspective is from an independent third party. Paul Vredenburg, senior vice president of AssuredPartners, Inc., has agreed to provide this perspective. Paul has experience as an advisor and is now an active buyer of agencies through AssuredPartners. We think his observations will be helpful because many internal perpetuations are done at a lower valuation than an external perpetuation and the owner undertakes a significantly greater risk of funding in an internal perpetuation. We also want to provide a buyer's perspective on the timing of a sale and the attractiveness of each agency.
Case Study: Duncan and Associates
Duncan and Associates has been a part of its community for more than 100 years. The agency is located in an affluent suburb of a large city in the eastern United States. Three individuals own the agency, and one owner effectively manages the firm. The managing owner, who is now 65, purchased the agency early in his career and now owns 45% of the stock. The other two shareholders are in their mid-50s and own 45% and 10% of the agency, respectively. The 10% shareholder has made a commitment to act in the best interest of the managing shareholder. As a result, the managing shareholder has the ability to act as the majority shareholder.
Duncan and Associates has revenue of approximately $5 million. The agency offers businesses and organizations a broad spectrum of insurance products and services. Its highly trained staff of insurance professionals has the expertise to design programs of insurance that are tailored to meet the needs of the agency's commercial clients. The managing owner feels a strong commitment to the people who have helped the agency achieve its goals, especially his two partners.
Duncan and Associates enjoys premier contractual agreements and relationships with the nation's foremost insurance carriers. It also has relationships with many national and international insurance wholesalers, which gives the agency broad access to both domestic and foreign specialty markets.
Managing owner's perspective
I believe in the independent agency model, and in an ideal world I would have tried to perpetuate my business to the minority shareholders. They have helped me grow the business, and they continue to service clients and provide meaningful value to the agency. Many of the people who work here are like my family.
The other shareholders do not have the financial means to acquire my interest in the agency. The agency is very profitable, which translates into a high value for the business. I would not be comfortable accepting a note from the minority shareholders for my interest in the agency, and I don't believe that they would be willing to give me any personal guarantees. I also have some concerns about the other shareholders' ability to manage the agency as a team without my oversight.
As a result, an external perpetuation seems to be my best alternative. My goal would be to continue playing an active role in the agency for an extended period of time. I have no anticipated retirement date, as I would prefer to maintain ongoing relationships with my key clients. My schedule and hours worked would diminish over a period of time. I don't see myself spending the rest of my life playing golf, traveling with my wife and playing with the grandchildren. These activities will be a part of my life, but I want to continue my professional life as long as possible. I would expect the two other shareholders to play a more active role with the new owners, and I would expect to keep most of the current employees who have helped me become successful.
My primary concern about a sale is timing. During the last several years, the economic climate has resulted in a few lost clients and a significant decline in revenue because of the soft insurance market. Although no one can be certain when or if the market is going to harden, I believe it makes sense to wait another three to four years before selling the agency.
Sukay & Associates: Advisor's perspective
The managing owner of Duncan and Associates has done an effective job of assessing the situation, and we concur that an external perpetuation is the best alternative. The key issue is the timing of the transaction. Just as interest rates eventually will increase, the insurance market will harden. The questions become: When, and by how much?
We see no evidence that Duncan and Associates would benefit from an enhanced agency value if the owners waited another three or four years to sell. Although the market may harden, the possibility exists that it will remain soft or even become softer. By waiting, the owners run the risk that the market will continue to soften and that the agency's value will decline.
Sellers sometimes fail to realize that they will have access to the deal proceeds. These proceeds can be invested in various ways depending on the seller's tolerance for risk. Even a conservative reinvestment of the proceeds would compensate for the increased value of the agency that would result from a moderate increase in insurance rates over a three- to four-year period. Let's make the following assumptions:
Revenue 2011 $5.0 million
Premium volume 2011 $50.0 million
Profit margin 30.0% ($1.5 million)
It is difficult to determine a valuation without understanding the specific characteristics of the agency, but we can assume a conservative valuation of 6.0 times the projected earnings of $1.5 million. Based on this multiple, Duncan and Associates would have a value of $9 million.
What would happen to the valuation if the market hardened and premium rates increased by 5%? In this scenario, premium volume would increase to $52.5 million and revenue would increase by $250,000. The agency would certainly incur some costs associated with the enhanced revenue, most likely in the form of producer compensation and marketing expenses. For our analysis, we have assumed that earnings would increase by 50% of the enhanced revenue, or $125,000. Based on our 6.0 multiple, the value of the agency would increase by $750,000.
The question is simple: Should the owners of Duncan and Associates wait for the market to harden, or should they sell immediately? In our example we can assume that the owners' proceeds would be approximately $7.2 million. The $7.2 million was obtained by reducing the gross proceeds of $9 million by 20%, which should cover capital gains tax, state income taxes and other transaction costs. The increased valuation of $750,000 would be reduced by these same costs and would net approximately $600,000. The question then becomes: Would you rather wait five years for the market to harden or sell now and realize the $7.2 million and reinvest the proceeds? We have simplified this example. In all likelihood, the owners would receive approximately 90% of the proceeds at closing whether they sold the agency immediately or at the end of five years.
The agency owners could reinvest the proceeds at 2% and realize the same after-tax income at the end of the five-year period. Different investment strategies carry widely different risks, but we believe that an owner could execute a very conservative investment strategy over the next five years and still exceed a yield of 2%.
The real problem for Duncan and Associates is the age of the managing owner. We don't believe that it is in his best interest to wait any longer because of the impact of his age on the agency valuation. We have a saying at our company: "Uncertainty diminishes value." By waiting any longer, Duncan's managing owner is increasing the uncertainty regarding the deal. Will he continue to have the same impact on the business as he has had in the past? Most likely he will not. Will the existing staff step up and assume his role? The reality is that nobody knows for sure. As a result, uncertainty is created and the value of the agency will be reduced.
Would we be able to find a buyer for Duncan in five years, and what would happen to the multiple if the managing owner waited another five years? Most buyers likely would pass on the deal. Alternatively, a buyer would decrease the multiple or structure the deal so that the guaranteed payment would be significantly reduced.
We recommend that the seller entertain proposals immediately and structure a deal where an earnout would capture some of the value of the hardening market. Even without the benefit of hindsight, we would have recommended the same strategy five years ago. We believe that it is not generally in the owner's best interest to wait to market the agency after he reaches age 60.
AssuredPartners, Inc.: Third-party potential buyer's perspective
The biggest challenge of working with a seller is helping him or her make the mental leap to accept an external sale. Duncan's managing owner has made that leap and understands that there is a tradeoff in making the transition from being an independent owner to becoming part of a larger organization. Once that decision has been made, the buyer and seller can focus on the issues that will allow both parties to achieve the highest return.
The first discussion for Duncan and Associates should be with the prospective buyer to understand how the agency will be operated after the sale. While the sale proceeds are important, the selling shareholders must understand the operating model of each potential buyer as well as the targeted goals for both profit and growth. Because a significant portion of the proceeds will be tied to achieving goals after closing, the sellers should ensure that they are connected with the buyer on all aspects of life after closing: financial, operational, quality control and information technology.
The second area for Duncan and Associates to address is the timeline for the majority owner with regard to his interest in continuing to manage the day-to-day operations. This timeline will give the buyer an idea of how to structure the earnout so that it matches up with the seller's expectations. The second reason for the timeline is to prepare for a transition of management by identifying the person or persons within the agency who will run the business after the earnout. It is important for the seller to guide a buyer toward understanding where the management talent lies in the organization. A strong bench will increase the likelihood of a buyer paying a premium for the agency.
Once an operating model has been created, both parties can focus on determining the correct value for the agency and work toward structuring a financial transaction that makes economic sense. It is essential to complete the steps we have outlined above. Otherwise both parties will get consumed by the price issue and lose sight of the fact that the purpose of the transaction is to allow both parties to create an agency that will continue to serve their clients and carrier partners in a consistent manner.
Duncan and Associates is an attractive opportunity for buyers because of its size and market location. The age of the managing owner is a big concern. A potential buyer needs to understand how important this owner is in terms of retaining existing clients and continuing the agency's growth. In evaluating this or any proposed transaction, the buyer must acquire detailed knowledge of all aspects of the agency's operation, both tangible and intangible.
Tom Sukay is president of Sukay & Associates, Inc., a financial advisory firm that represents insurance brokers, banks and other financial services companies (www.sukayassociates.com). Paul Vredenburg is senior vice president of AssuredPartners, Inc., which was formed in March 2011 by two former Brown & Brown Inc. executives (www.assuredptr.com).