Pro Forma Development for Budgeting & Agency Value

Whether an agency owner is looking to streamline their operation to do their annual budget, make more profit, or ascertain agency value for an internal valuation or potential sale, creation of a pro forma income statement is important.

Many agencies do not have budgets—but they should. It does not work to just show certain percentage increases for most expenses and compensation. Each line item should be evaluated with managerial and financial staff to determine what is really needed.

Accounting can take a first crack at this process and should remove non-recurring or discretionary items and leave in the expenses that are necessary and ongoing for the department heads and owners to then take a look at. It is best to do a budget by department, which could include personal versus commercial lines, employee benefits, and individual health versus life insurance. Any niche programs can also have their own budget, such as programs. If an agency has created a separate small commercial department, those expenses should be segregated to see if any profit is being made. Making profit on small accounts is hard, especially if producers are also being paid for writing these accounts.

As described above, if possible, segregate the revenues by department and the related expenses. If there are expenses for the whole agency, such as owner management salaries, postage, repairs, and maintenance, then often using the revenues to the total percentage to separate these expenses can be used. Or if the expense is related to the number of people, like rent, then the number of people and producers in that department to the total personnel percentage can be used to assign these expenses.

Once the pro forma income statement is created and management has signed off on the necessary expenses for the agency, the true agency profit can then be used for valuation purposes.

For internal valuation purposes, we use the profit and then do two or three valuation methods. First, we use the Capitalization of Earnings method that establishes the price a buyer could pay in order to yield a specific required rate of return on investment. This method of determining value is widely used in the financial industry. It is also widely utilized by knowledgeable buyers and sellers of independent insurance agencies.

The methodology first determines a risk-free rate, ordinarily U.S. Treasury bonds of 20 to 30 years maturity. A separate risk premium rate, based on the inherent risk of the agency, is then added to the risk-free rate to determine the total rate of return a buyer would require if he/she invested in the agency. The additional return required is usually in the range of 5% to 15%. The greater the perceived risk in an investment, the higher its return should be.

Then we use the Price Earnings method, which is most often used by major public corporations when acquiring or merging with another firm. Publicly traded insurance brokers have historically utilized this method in acquiring other agencies.

As a multiple of pretax earnings, the P/E multiple has averaged 7.0 to 10.0. The P/E multiple, however, is usually discounted before applying it to a prospective seller’s earnings because the buyer does not want to dilute their own earnings and the potential seller typically carries a higher level of risk. Most insurance agencies are valued somewhere between 6.0 and 9.0 times their pretax earnings by other independent agency buyers.

The method determines the value of the firm by multiplying sustainable pretax income by an adjusted price/earnings ratio of publicly held insurance brokers. This price/earnings ratio has been adjusted to reflect the comparative attractiveness and risk of the firm being valued. Regional and national brokers, especially those backed by PE firms, use a 9 to 12 times pretax earnings multiple depending on the firm’s profit margin and risk of earnings continuing in the future.

The Discounted Future Earnings method is too complicated to be able to write about here, so use the two above and average them. Often working capital is also removed for 30 to 45 days of pro forma expenses.

The multiple of revenue approach for valuing a business is outmoded and is not recommended by most professional consultants. This method survives by word of mouth and misunderstanding. Multiples published in trade journals or consultants’ newsletters after a sale is a reference used to communicate the purchase price but does not detail the actual approach to the establishment of that price.

Even though some transactions still occur today using the multiple of revenue approach, it is being done out of ignorance of more accurate methods. Paying 1.5 times to 2.75 times revenue will save you time but will cost you money.

When a valuation uses a multiple of revenue it ignores variation in profitability and risk. Two firms with the same revenue may vary significantly in both the risk that profit will be sustained as well as in the actual profit margin. An astute buyer would not pay the same revenue multiple for both firms.

Multiples used for the valuation methods described above are much higher than for internal valuation. There would also be other expenses a third party would remove that may not be needed or allowed under third-party ownership. Assume a higher profit and multiples for the Capitalization Method and Price Earnings multiples in the 9 to 12 range. Most of the time, 80-90% of the value is paid up front, with some stock in the 10-15% range and a growth bonus. This is why so many agencies have sold to brokers with private equity backing in the past five years. Internal buyers—often family or key employees—could not compete with these prices.

The typical sale price today is 1.75 to 2.75 times revenue if paid for in cash and the firm is making at least a 25-30% profit. If terms other than cash are used, it will affect the value of the firm. Many owners ignore this when discussing value received, thereby adding to the myth of owners receiving prices of 1.5 times to 3.0 times revenue. Present value needs to be calculated on future payments received. Astute buyers often base terms on retention of revenues and may pay a slightly higher value for lowering their risk.

The goal should be to pay the seller using the profit created by the agency or book being purchased. If the acquisition generates a 20% profit margin, a buyer will need five years before realizing any profit, assuming the buyer only pays 1 times the revenue. If 2 times revenue is paid, it would take 10 years before a buyer realizes a profit. This assumes the firm can generate a 20% profit margin before excess compensation to owners. Today, many agencies or books generate profit margins of only 10-18%. Many buyers do not want to buy a firm that can’t generate a 25% to 30%, or more, pro forma pretax profit.

This process of first creating a meaningful pro forma income statement and budget with the management team, and removing expenses the agency will no longer have or really need, is a good exercise to perform each year. The result can then be used to do an estimate of agency value with appropriate compensation for the owners.