Minding Your Business: The Tale of Two Values

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”

This opening line in Charles Dickens novel “A Tale of Two Cities” summarizes the contradictions and differences between London and Paris during the turmoil of the French Revolution.

For the past several years and going forward into the near future, there has been a bifurcation of agency value. This is creating a dilemma for independent agency owners who want to remain privately held and agencies that want to grow through acquisition.

Agency value for many years was looked at as a function of a multiple of revenue. This is an easy concept to understand and has some logic to it. Back in the 1950s and up to the 1980s, most agency transactions were local and consisted of a peer buying a peer. The firms were not all that big, so the buyer just absorbed the seller’s business within its operation, so the expense structure was the same. The traditional rule of thumb was that value was based on one to two times commission revenue. As the insurance industry grew and became more complicated and specialized, the multiple of revenue approach became less relevant.

For the past 30 years, agencies have become much larger and more sophisticated. The book of business can vary significantly as agencies focus on niches. The related expense structure, especially on salaries and commissions, also has a wide spectrum. This means that the multiple of revenue method for determining value became less accurate.

The best way to value any business is based on the profitability of the business. This takes the actual expenses of the business into consideration. Therefore, two firms with the same revenue, but different profit margins are not valued the same, like they would be if only revenue was considered.

In general, the insurance industry is a very profitable industry and can typically generate between 15 percent to 30 percent profit margins, which is more profitable than most industries. For example, retail, trucking and manufacturing firms have single digit profit margins on average. This is why some investors have shown interest in buying insurance firms for the past 30 plus years.

Publicly traded insurance brokers have also been active in acquisitions for the past 30 years. One of the main driving factors has been that stockholders want to see regular growth. Organic growth is often not significant, so growth through acquisitions is the easiest way to post noticeable numbers on a consistent basis.

Typically, these firms have been trading on the stock exchange with PE ratios (price/earnings) of 15-25. Therefore, it is easy for them to justify buying an agency at seven to 10 times EBITA (Earnings Before Interest, Taxes and Amortization). The deals can be cash or stock or a combination. Receiving stock is often a good option for sellers since these publicly traded firms tend to increase in value.

Starting in the late 1990s, banks and savings and loans (S&Ls) started getting into the acquisitions of insurance agencies as the repeal of the Glass-Steagall Act (1933) seemed likely (it was officially repealed in 1999). They believed selling insurance was a good way to improve profits while cross selling existing clients. Their enthusiasm created a buying frenzy during the early 2000s, which forced them to pay top dollar values to sellers. Multiples of EBITDA in the range of seven to 10 were common as the banks tried to lure agency owners to sell.

In the long run, banks soured on buying agencies for a variety of reasons, which included a lack of cross-selling and failure to integrate insurance into their product portfolio, as well as lower profits due to the soft market in the early 2000s. In addition, banks were not used to underwriting criteria and insurance producers making more money than bank presidents.

More recently, private equity firms have been buying up insurance agencies for their investors. This makes a lot of sense because the return on investment is typically 20 percent plus or minus, which is greater than most other available investments today. Private equity firms are paying typically eight to 10 times EBITA and sometimes even more. When the value is translated to a multiple of revenue this means two to three times revenue. Some of these private equity firms have the long-term goal of flipping the business to another private equity firm or going public.

Selling to a bank, publicly traded broker or a private equity held firm can have its financial reward. The downside is that often the seller is doing the same thing before the sale, except that they now report to a corporate management team far away. If the agency is left as a stand-alone and not folded into a larger organization, there might be very little support for the regular issues such as hiring people, generating new sales and planning the succession of the original owner. The agency can also lose its small business culture as it meets the demands of the new owner. This can upset clients and employees.

If commissions are cut to improve the bottom line, the producers will leave and sometimes with accounts. This can impact the seller because deals typically have an earn out component based on retention of business for part of the price. We have seen many deals that promised a high price result in a mediocre final price because producers left with their books of business.

Keep in mind that these firms do not buy just any old agency. They have specific criteria for their target seller, which will vary from time-to-time. These buyers are looking for the right agency, at the right location and at the right time to provide top dollar.

Internal perpetuation and local buyers do not have deep pockets and need to buy an agency based on its cash flow to make it affordable. The typical deal is between six and seven times EBITA and translates to around 1.2 to 1.7 times revenue. Buyers often put less than 25 percent down and terms can stretch from three to seven years.

If all things remain static, a six times EBITDA can be interpreted to mean that it will take six years to breakeven on the transaction. This is one reason that internal and local buyers cannot afford to pay 10 times EBITDA since the breakeven point is too far away.

For sellers, the dilemma is: do they want to maximize their return on equity and sell to a private equity firm or would they like to sell to family, employees or a local competitor at a lower price?

This decision is easier for family run businesses since blood is a strong factor in the thought process. Also, if the agency does not match up with the target acquisition criteria of a well-funded buyer, that eliminates that option. However, there is less motivation to sell to a friendly competitor at a lower price compared to what is potentially available out in the open market.

We have been experiencing this two-tier valuation of agencies for quite a while, and it will continue into the near future. Depending on circumstances, these can be the best of times or the worst of times.