The Three-Legged Stool
We have heard over the years from numerous agency principals that perpetuating the private ownership of the firm is one of their primary objectives. If true, why is it that many firms do not survive and make the transition from one generation to another?
To successfully bring an agency from one generation to another, principals must have a heartfelt vision for the perpetuation of the firm. This means committing to develop the right people, exercising proper financial discipline, and trading the equity interests of departing owners at a reasonable value. It isn’t an event, but a process.
A heartfelt vision for perpetuation is one of the prime beliefs that principals must embrace as part of the process. It is at the heart and soul of the firm, the essence of the business, and it is the vision at the very core of all major business decisions. However, only a handful of agency principals can honestly say that internal perpetuation and maintaining private ownership is a key part of their heartfelt vision.
Every successful internal perpetuation plan requires three inextricably linked components: the right people; proper financial discipline; and a reasonable value. This is the “three-legged stool” from which just one weak or missing leg will doom the plan to failure.
The most important leg is people, although this does not mean any warm body will do. The right people represent a blend of leadership, production and executive management talent, with each person possessing sufficient risk tolerance. This is a rare combination that requires an objective assessment of the talent level of the next generation. If deficient, the next generation must be developed and nurtured
Financial discipline means the firm is and has been profitable and, consequently, it has a solid balance sheet and capital structure. It also means the firm has sufficient capital to allow for reinvestment in people and infrastructure. Lastly, it means being very smart about capital investment in people and acquisitions.
A reasonable value is influenced by some of the same drivers as people and capital. However, this element has some key complicating factors: value may be unduly influenced by the principal’s egos and unreasonable expectations, and that can be fatal. Value resides in the firm’s cash flow, not in its gross revenues. Very few firms actually trade for two times revenues or some other unsupportable multiple. High cash-flow multiples, if true and almost exclusively in third-party transactions, are significantly affected by major strategic factors. An internal succession plan is a tactically driven financial transaction without any true strategic value-added as may be utilized by a third-party buyer.
In reality, the only way to make an internal plan work is to have a reasonable value truly supported by the actual results of the firm. Internal transactions are primarily sustained and financed by the cash flow of the firm. It as a simple as that: there are only 100 pennies in the dollar. Departing owners must accordingly accept a realistic value supported by the numbers.
Many principals are unwilling or unable to truly nurture this heartfelt vision. That is tragic. Experience indicates that successful plans are centered on developing the right people, exercising proper financial discipline and establishing a reasonable value. Those principals have nurtured and fostered a heartfelt vision for perpetuation from within. They have built a firm that is ultimately on balance and more valuable than the competition.
The value paid to a departing owner sharing the heartfelt vision may not initially appear to be as high as purported in some of the third-party transactions. However, quality of life, the rewards of ownership, control of destiny and continuing the legacy of the firm will minimally be equal, and more than likely significantly higher, by maintaining the private ownership of the firm than through effecting a sale to a third party.
Firms that are best positioned for perpetuation are the very firms frequently sought as acquisition candidates, principally because they have the first two legs of the stool. They have financial discipline as evidenced by real profits and they have a solid cadre of people. The great irony, however, is those firms are not for sale, much to the dismay of acquiring organizations. Although rarely articulated, the principals of those firms would state they are having too much fun-they are making money and building value and they simply do not have a reason to give it up.
Do you want to maximize the real value of your firm? Make the three-legged stool a heartfelt vision.
Timothy J. Cunningham is a principal
with OPTIS Partners, a Chicago-based
consulting firm. OPTIS Partners pro-
vides valuation, merger-acquisition
and related financial and management consulting services exclusively to firms in the insurance distribution sector.