Merger & Acquisition State of the Industry

The merger and acquisition arena has never been this busy. All deals currently on the table and many more sellers now appearing or being thrown into this process want and need to close their transactions by year-end.

Private equity (PE) investors are pouring more and more money into the regional and national brokers. Agency owners are bombarded with offers to sell by telemarketers and consulting firms with their daily badgering by phone, mail and email, even personal drop-ins!

Those of us in the M&A business know that this has made it difficult for local independent agent buyers to compete against well-funded buyers. Despite this disadvantage, privately held firms reportedly did 24% of the transactions in the first half of 2021, up from 17% last year in the same period. For the first half of 2021, there were 339 property/casualty mergers and acquisitions, up from 307 in 2020. This might also be the result of uncertainty during the early stages of the COVID-19 pandemic.

Small Buyers vs. Well-Funded Buyers

The terms in a purchase price that a local independent agent buyer can offer a seller are generally quite different from what the well-funded national and regional brokers can offer. This is because of the difference in access to money and the related philosophy toward the acquisition. Local independent buyers tend to acquire a business for long-term equity growth and base the purchase price on cash flow. Buyers with the backing of private equity money are looking for a nice rate-of-return on investment money in the short term and to build a profitable business that can be sold to another investor in the long term.

Typical Terms for Local/Small Buyers

When needed to get an acquisition, local independent buyers have been known to stretch on the purchase price and pay a seller over two times revenue over a period of five to eight years. This is based on cash flow and limited access to funds. If there is a 30% profit margin, the independents may pay six to seven times EBITDA (earnings before interest, taxes, depreciation, and amortization), which equates to 1.80 to 2.10 times revenues or more.

Many independent agency buyers will need to go to the bank/lender for a down-payment, usually 25% to 40% of the purchase price. Often, the seller is required to finance some of the purchase price. Typical terms include earn-out payments in order to cash-flow the deal. For these types of deals to be successful, the seller needs to have an EBITDA of no less than 25% and hopefully even 30% or more.

Terms of Private Equity Deals

Well-funded buyers look at acquisitions based on the immediate return of investments first, and then look at the long-term rate of return because of their access to cash/investment money. These buyers offer large cash payments at closing and future performance bonuses based on growth (revenue, EBITDA, or both). To make these deals work, sellers need to have a minimum 30% EBITDA margin. This allows a good return on the cash paid to the seller at closing and an increase in the profit margin of the buyer’s overall entity. Buyers usually offer about 20% of the initial price in the form of stock in the buyer’s entity. Buyers need less cash, which improves the rate of return, and sellers are incentivized to perform to improve the bonuses and stock equity.

Well-funded buyers are currently paying between seven to 10 or more times EBITDA. This translates to revenue multiples in the 2.5 to 3.5 times range.

As M&A consultants, we try to negotiate a revenue-based earn-out for our clients. This is because often sellers are afraid to add people to grow the firm and can’t control the expenses assigned to them after the deal is closed. With a revenue-based transaction, the sellers don’t have to worry as much about making their earn-out.

Know the Terms

Back in the 1980s, buying a stereo system could be overwhelming because there were so many options and variations. One had to focus on a few choices and then just compare them before a final choice is made. The same applies to buying and selling a business.

‘The terms in a purchase price that a local independent agent buyer can offer a seller are generally quite different from what the well-funded national and regional brokers can offer.’

There is often a not negotiable fee charged by large buyers. It can be in the 4% to 10% of revenue range depending on the support provided. This creates a lower EBITDA when calculating future bonuses. There is at least one buyer we know of that does not credit the seller with contingents in its pro forma, which can often be five to 15 points of an agency’s profit or EBITDA.

On the other hand, a large buyer might have higher commission rates and better contingents that improve EBITDA when calculating bonuses. Beware that in some cases it is only for new business, not the whole book, which can be a big difference and can be negotiated.

Keep in mind that buyers typically assume the best-case scenario in their offers. Buyers attempt to lock in the sellers with a signed letter of intent (LOI) to woo sellers before due diligence has begun. After due diligence, the numbers in the original offer in the signed LOI can often be very different from the final numbers in the purchase agreement. This is often the result of adjustments made to revenue after due diligence.

Often, there is a big difference in value if stock is also offered. Some buyers determine their stock prices without much clarity given to the seller as to where those values came from.

For publicly traded buyers, sellers can get the stock price from the stock exchange. However, privately owned firms, such as PE-backed agencies, do internal stock valuations or hire a firm to value the stock on a periodic basis. The purchase agreement needs to be examined carefully on the timing method of the valuation of the buyer’s stock.

If stock is offered (and it almost always is), it is best if it is optional as to the amount the seller takes in stock for the down payment or earn-out. It is also important if the stock can be sold back in a reasonable timeframe, such as at retirement or at the end of the seller’s earn-out. Sometimes sellers have to hold the stock for a period of time.

Tie in Key People

Some sellers want to tie in those perpetuation candidates they had hoped could buy them out.

But these perpetuation candidates can’t compete with these prices, so the owner might need to give some of the stock or down payment to those candidates to help tie them in for the future earn-out accomplishment and perpetuation of the book of business. If they have any vesting producer agreements, those always need to be paid off before a sale with the sale proceeds. Any 1099 employees (usually producers) should be made W-2 employees before the transaction can close, which means discussing this before the sale.

Without the worry of how the key people can afford to buy them out, handle the management of the firm and the owners’ books, the sellers can more easily move into retirement.

Some owners we know have gotten energized with a new buyer, and being a producer again, and stay longer. A nice producer compensation plan should be in place for owners that write new business, which also is created during negotiations.

Post Transaction

It is important for the seller to know what will happen after the check has been cashed. Each buyer will have their own approach, philosophy and goals for the acquisition. The alignment of post-transaction expectations between a buyer and seller is critical for a successful deal. This applies whether the buyer is a local competitor or a national broker.

Compatibility and integration questions include:

• Does the seller operate independently, or will they be fully integrated into the buyer?
• What will be the seller’s role after the sale?
• Does the agency name change?
• Will the buyer provide management support?
• Does the buyer have access to needed markets and value-added services?
• What is the impact from any changes to compensation plans (usually for producers) that was needed to close the deal?
• Will the employee benefits plan change?
• Are management fees charged (which lowers EBITDA)?

Every buyer is unique, and the sellers really need to know the buyers. Integration after the sale is handled very differently from buyer to buyer.

Capital Gains Changes Looming

One of the reasons for the haste of getting deals done before the end of the year is that President Biden has recommended eliminating capital gains tax treatment for sales of any asset over $1 million in gain. This means that ordinary income tax rates would come into play for that excess, and his proposal is 39.6%. This literally more than doubles the federal taxes paid by a seller, and on top of that is state taxes, and some of those are increasing. There was also a proposal to make this elimination retroactive to April 28, 2021.

Seek Advice

Sellers are insurance salespersons, and they don’t know how to negotiate to a higher EBITDA or a better deal. Sellers are often approached that don’t yet have a consultant representative. Often they are pressured not to use advisors because the buyer does not want to compete against other buyers and need to make a second or third offer. We believe that sellers should get at least two offers.

Owners who would rather internally perpetuate the ownership of the business should still get assistance on the available options and the best approach. A business valuation is always needed with family members on internal sales.

Summary

Now is a great time to sell a business. Aggressive buyers are paying top-dollar.

But please take this advice, don’t try to close a sale without an advisor’s help. If an owner decides to sell, it is only done once, and most do not know what they are doing and do not have the time to manage the whole process.