Minding Your Business
The Fundamentals of Agency Valuation
By Bill Schoeffler and Catherine Oak
Growth by acquisition can be a very valuable tool-when it is part of an effective strategic
marketing plan. However, an agency must first be able to grow internally. An owner that feels the
need to acquire a book of business in order to grow usually has much more serious problems on
his hands.
Lack of internal growth usually means producers are not producing, CSR workloads are
not appropriate or a sales and marketing plan doesn't exist. An agency that cannot grow internally is not as valuable to an outside buyer. Since many agencies today are using mergers or
acquisition as a major growth strategy, you need to understand business valuation for those
transactions.
When your agency is involved in a merger or acquisition transaction-whether you're on
the buying or selling end-the issue of agency value is a poignant one. If you are already in the
middle of the deal, it's probably too late to worry about agency value. The time to take action is
well before any move toward a merger, acquisition or implementation of an internal buy-out.
Today, too many deals occur in which the buyer pays too high a price over too short a
period and has not properly analyzed whether the purchase is good for the agency. Buyers often
feel that the purchase is too small to warrant a professional, and perhaps costly, valuation.
Regardless, this shouldn't preclude them from performing their own valuation.
Perhaps the most common error made during these "self-made" deals is to set the
purchase price as a multiple of revenue, without any regard for bottom-line profit. A multiple of
revenue valuation method involves multiplying an agency's revenue by a set factor (often in the
range of 1.5 or 2) to achieve the purchase price.
Multiple of revenue
This approach for valuing a business is outmoded and is not recommended by most
professional consultants. It survives by word-of-mouth and misunderstanding.
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 to 2 times the revenue will
save you time in the short-run but cost you money down the road.
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 profits will be
sustained, as well as in the actual profit margin. An astute buyer would not pay the same revenue multiple for both firms.
Fair market value
A professional consultant appraises an agency based on its fair market value. Fair market
value is defined in IRS Revenue Ruling 59-60 as "the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."
Fair market valuation is dependent on three major factors:
• Sustainable earnings capacity: the value of the firm's earning capacity, the profit the
firm should be able to generate for a third party.
& Inherent risk: the value of the firm's earning stream must be tempered by the risk that
the earning capacity will not be maintained over time.
& Tangible net worth: the value of the firm's balance sheet after assets have been turned
into cash and all liabilities have been satisfied. Reported pre-tax profit is not the firm's sustainable earning capacity. To properly calculate, the appraiser will make pro forma adjustments to the most current actual financial statements. Pro forma (Latin for "as a matter of fact") refers to a presentation of data, such as a balance sheet or income statement, where certain amounts are hypothetical. Pro forma adjustments for a valuation are made by the appraiser in order to show the true earning potential of an agency that a third party could expect to generate. Line item adjustments are made to remove the affects on the profit of an agency due to ownership, write-offs, one time expenses, etc. Pro forma adjustments include:
• Discretionary income and perks to owners;
• Removal of non-recurring income and expense items;
• Non-operational business expenses; and
• Items that have not been reflected.
The valuation methods are then based on this pro forma pre-tax profit which currently
tends to be in the 10 to 25 percent range. A professional appraiser will use more than one method
when performing a valuation at the discretion of the consultant. By using a variety of methods the consultant is able to "box in" the value with a high degree of confidence. The most common
methods used include:
1.Capitalization of earnings method
Capitalization of earnings 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, which are ordinarily U.S. Treasury bonds of 10 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 or she invested in the agency. The additional return required is usually in the range of 5 to 15 percent. The greater the perceived risk in an investment, the higher its return should be.
2.Price/earnings multiple method
This method is most often used by major public corporations when making an acquisition or merging with another firm. Publicly traded insurance brokers have historically utilized this method in acquiring other agencies.
The method determines the value of the firm by multiplying sustainable pre-tax income by an adjusted price/earnings ratio of publicly held insurance brokers. This PE ratio has been adjusted to reflect the comparative attractiveness and risk of the firm being valued. Most privately held insurance agencies are valued somewhere between four and seven times their pre-tax earnings.
3.Discounted future earnings method
This method determines the value of the firm by calculating the present, discounted value of the firm's future earnings stream. The earnings stream for the next five years is projected based on estimates of future revenue growth and increases or decreases in expenses for personnel, business development and operating expenses. The resulting earnings are discounted to present value using an appropriate discount rate. This method can be difficult to use because it's hard to project the future. There are a myriad of variables that can affect a firm's revenues, expenses and resulting profitability or sustainable earnings. Although this method has the potential to overstate value, it allows for growth and is especially effective for determining value in cases where the current level of sustainable income is not entirely reflective of the potential profitability of the firm.
In each of the valuation methods, value is adjusted to take into account the amount of working capital necessary to produce the income stream. An investor buying only a book of business typically contributes working capital of 30 to 60 days (45 is average) of cash to generate the income stream. The amount varies based on the collection practices of the agency.
Final value
The appraiser calculates the firm's value using these valuation methods and factors in the evaluation of risk in the firm by adjusting the multiple or rate of return. The appraiser will determine the risk by reviewing the book of business and the producers, assessing the overall business climate and investigating several other factors, including size of account, retention, markets, compatibility of the parties or the books, etc. Despite the seemingly endless supply of buyers and the relative dearth of sellers, agency values are lower today than in the past. The typical sale price (paid in cash) today translates to .75 to 1.4 times revenue. There are several reasons for this, with today's low profit margins being the most significant. Market uncertainty has also added to the risk. It is important to note that if terms other than cash are used it will affect the value of the agency. Many owners ignore this when discussing value received, thereby adding to the myth of owners receiving prices in the 1.5 to 2 times revenue range. Present value needs to be calculate on future payments received. Perceptive 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 by using the profit created by the agency or book being purchased. If the acquisition generates a 20 percent profit margin, the buyer will need five
years before he will realize any profit, assuming the purchase price was only a single multiple of the revenue. If the buyer pays 2 times the revenue, it would take 10 years before he realizes a profit. This assumes the firm can generate a 20 percent profit margin before excess compensation to owners. To put this in perspective, many agencies or books generate profit margins of only 10
to 18 percent.
The fundamentals
To evaluate another agency for purchase or for internal use in increasing one's own agency's value, an owner needs to be aware of several fundamental valuation factors:
&# The efficiency of systems, procedures and staff,
&# Retention rate of key employees and key accounts;
&# Fair and equitable compensation plans for owners and producers;
&# Performance standards and ratios in line with industry standards;
&# Good loss ratios and market relations; and
&# Desirability of medium-to-large commercial accounts versus other lines.
The most important action to take for improving your agency's value is to commit to
predicate all decisions based on their affect on the agency's value. The successful agency
operates as if it needs to justify business decisions to a third party. Following this advice today will position an owner today to sell at an above-average fair price tomorrow. Remember, everyone must sell someday-either internally or externally.
