Acquisitions and Agency Value

Growth by merger or acquisition is still a popular and valuable tool. One of the main reasons why this is staying popular among agencies is because it is a way for them to show growth when they are struggling with it organically.

Though this may seem like an easy way for an agency to grow their book of business, if this is the owner’s last resort for growth there are usually other issues going on as well! The only way an acquisition is going to work as a growth tool for an agency is if that agency is already seeing internal growth.

If the agency is not seeing internal growth, there are usually other factors as to why growth is not happening. Some examples of why an agency may not be growing internally are producers not performing, CSR workloads are not appropriately managed, or the agency may not have a sales and marketing plan. Owners need to make sure the agency is showing internal growth before a decision to acquire is made.

Once the agency is ready to consider an acquisition or merger, this is when agency value and the fundamentals around it will be most important. If an agency is already in the middle of a deal, it is probably is too late to worry about agency value. The best time to look into an agency valuation is right when you start the process of being at either end of a merger or acquisition.

Paying Too High a Price

Since mergers and acquisitions have become so popular, too many deals are being made with the buyer paying too high a price in too short a period because there is competition, especially with all the private equity (PE) money available to the larger national firms today. Often the agency or book of business has not been properly valued. Also, agency owners get excited and may make a quick decision, and can end up with a purchase of an agency that is not good for them.

Regardless of the size of the purchase, a professional valuation is always going to be worth looking into.

First, let’s go over the wrong ways many agencies value themselves. The biggest mistake that is made when it comes to agency value is usually done when there is a “self-made” deal going on. The purchase price is usually set through a multiple of revenues and/or commission, ignoring the actual potential profit/cashflow to the buyer that the book or agency can generate.

The “multiple” approach to valuing a business is outmoded and is not recommended by most professional appraisers.

This approach is tempting to use if the acquisition is a small book of business and other assets are not included. The ease of calculating value at 1 times to 2.5 times revenues can cost thousands of dollars, not only in lost profit from possible overpayment but also lost income from using available capital for the purchase, rather than putting that money into other investments, like good people or new producers.

When a valuation uses a multiple of revenue or commission, it ignores variation in profitability and risk. Two firms with the same revenue may vary significantly in the risk that profit will be sustained, as well as in the actual profit margin generated. An astute buyer would not pay the same “multiple” for these two firms if the risk and profit margins vary greatly.

The other key is whether the acquisition is growing or just wasting over time, from lack of attention from the owners.

Valuation Methods to Use

So, what valuation methods should agencies be using? There are several different acceptable approaches to valuing a book of business or an agency. Income approach methods are commonly used by professional appraisers and are often the most appropriate methods. The two basic methodologies using the income approach are the Capitalization of Earnings method and the Discounted Future Earnings method.

The Capitalization of Earnings method uses a single period earning stream (pro forma profit) and divides it by an appropriate capitalization rate (rate of return) to arrive at a value for the operation of the business.

The Discounted Future Earnings method uses the same concept but bases it on a multiple year forecast and takes into account the present value of the forecasted future earnings.

The typical property/casualty firm today is able to generate between a 15% to 25% pro forma profit margin. The value of an agency or book of business is then determined using a multiplier to this pro forma profit. The higher the risk for continued earnings, the lower the multiplier. Astute buyers today are typically paying between six to nine times the pre-tax pro forma profit to value the deal. Some very aggressive firms with PE backing have been known to pay 10-12X EBITDA (earnings before interest, taxes, depreciation and amortization).

Capital Gains Tax Rates

If one finds themself on the side of selling their agency, there are also capital gains taxes to deal with. Capital gains federal tax went up from 15% to 20% on Jan. 1, 2013, with the new fiscal cliff taxes. In addition, in California there is a Health Care Act tax of 3.8%, so that leaves capital gains federal tax at 23.8% plus the state income tax on a sale. Prior to that, it was only 15% plus state.

The taxes are at a high but there are talks about capital gains federal tax possibly even getting to 35% and recently President Biden suggested 60%! So, selling now is not a bad idea.

Also, if a seller takes his/her payments over a couple of years, the tax burden is not all at once. If a seller accepts an earn-out, which is a percentage of renewing commission over a few years, the value of the agency’s book of business can increase because the seller benefits from the improving economy and the hardening of commercial line rates at each renewal, especially for workers’ compensation.

The opposite is true for the books that decline, as the buyers do not have to pay for commissions that go away over the time period set by the terms. Buyers like to have an earn-out so they know that the book of business is properly transitioned before all payments are made and there is no fallout.

Summary

In conclusion, astute buyers should take the time to properly analyze any acquisition both financially- and compatibility-wise. By following the advice in this article, sellers will also position themselves today to sell at an above average fair price tomorrow. Remember that everyone must sell someday, either internally or externally. Planning this strategy well, especially with a good consultant, can be very worthwhile for both sellers and buyers.