The perceived value of an insurance agency is affected by three things: 1) earnings, 2) future earnings, and 3) market conditions. These are the same factors that affect the value of any investment. This article will explore each aspect of insurance agency selling in order to help agency owners understand the best ways to prepare.
“Pro Forma Earnings” and the Buyer’s Return On Investment
Pro forma earnings are the basis for determining the buyer’s projected return on investment (ROI), and their debt service coverage on any financing. The adjusted EBITDA formula (Earnings Before Interest, Taxes and Amortization) is used to calculate the pro forma earnings. This formula gives an indication of the expected cash flow from the agency. This is mathematically:
Adjusted EBITDA = Agency net profits + Interest on debt + Income taxes (typically for C corps) + Depreciation, amortization (noncash expenses) + Owner’s salary and benefits + Other non-recurring or essential business expenses +/– Projected adjustments to rent, employee compensation and management expense such as retaining/replacing an owner. Some of these adjustments will depend on the buyer.
An pro forma EBITDA is calculated from historical financial statements and adjustments. Pro forma EBITDA forecast is calculated using adjustments to historical financial statements.
A strong determinant of the profitability of an agency’s operation model and the market segment it serves is its operating model. EBITDA is typically 30-40% of the revenue for agencies with a strong sales team, such as benefits brokerages and commercial lines P&C. Higher EBITDA margins are typically enjoyed by agencies that have more marketing-driven sales such as personal lines P&C or specialized agencies. In the insurance industry, the profitability of similar-sized businesses is not as variable as it is in other industries. An agency might be losing money annually, while another agency of the same size could have 50% or more profitability. It is crucial to control costs, especially when the agency is sold.
The buyer’s return-on-investment from the acquisition is equal to the multiple of EBITDA that was paid for the agency. A value of 5x EBITDA equals a 20% ROI. Buyers have expectations about the return on their investment in acquisitions. These expectations will be determined by the buyer’s financial capabilities, the agency’s synergies, and the agency’s risk perception.
Large strategic buyers such as national brokerages and banks can afford lower initial returns (e.g. The highest price is often paid by large strategic buyers, such as banks and national brokerages. Many buyers can benefit from synergies that are not available to smaller buyers. This includes higher commission rates and greater growth opportunities by leveraging existing relationships. Many have large cash reserves and are actively looking for opportunities to grow and increase investment returns. Large strategic buyers are looking for agencies with an EBITDA of more than $500k. However, they will also consider smaller agencies that can be merged into an existing operation. They are generally looking for professional, larger agencies that can be incorporated into existing operations.
Regional strategic buyers often want a return on their investment of 20% or more. These buyers are often agency owners who want to expand their market share or open new markets. Because the agency must generate an income to support their lifestyle, buyers who are not agency owners often want a 30% ROI or higher. As mentioned, individual buyers will often need third-party financing in order to purchase an agency. The cost of capital as well as debt service will also be a factor in determining their value. Because it is more difficult to find third party financing for an agency worth over $2-3M, most individual buyers don’t have the financial resources.
Perceived risk, price and sale terms
A buyer’s willingness to accept a price and terms of sale will be influenced by the perceived risk associated with future earnings. Buyers will need to ask a lot of questions about agency operations and the book of business during their due diligence. Questions about the structure of the business, including the types of policies, account sizes, and carrier contracts are all questions that concern the inherent risk in the book of businesses. The agency operation, including its longevity, reputation, management structure and marketing strategies, as well as retention plans and underwriting procedures, is also a concern.
Some commonly encountered high risk factors include: declining revenue/earnings trends, revenue concentration with carriers/producers/accounts, revenue concentration with non-rated carriers or sub-standard markets, low account retention or renewal commission base, employee issues, high loss ratios, and poor record keeping.
If only certain parts of the agency are perceived as high risk, such as having a few large accounts or a few high performing producers, then the buyer may want the seller to share in a portion of risk in the form of an earn-out based on the agency maintaining certain revenue/profitability metrics or retaining specific accounts. The perceived value of the entire agency will decrease if it carries greater risk than others, for example, if it specializes in a low-retention or renewal rate market.
Before we move on, let’s talk about one last thing. We hear often of buyers who make offers without a down payment and then renew. These are known as predatory buyers. A buyer should have substantial financial backing before an agency owner sells. It is not uncommon for a sale to bring 60-80% of its price at closing, with the balance being paid on either a fixed note (4-8 years) or earn-out (2-4 years). If the buyer is willing to pay less upfront, the seller should negotiate a minimum amount that can be guaranteed and then have it personally guaranteed by him.
Market Conditions and Their Impact
Market conditions and the timing of the sale will have an impact on your net gain. Market conditions include the economic outlook, the state of the lending markets, performance of stock markets, position of soft market cycles, capital gains tax rates, and the economic outlook. While many of these factors fall under the umbrella of earnings and risk, they are not within the agency’s control.
Although it is hard to find data about these trends, information can often be found from insurance consulting firms. Because long-term capital gains rates and interest rate are at a 50-year low, premiums are rising in many markets and stock values are recovering from 2009’s lows, 2011, and 2012 should offer good market conditions.
Creating a Sales Strategy
A sale strategy should be developed by every agency owner at least two years before the sale. First, determine the agency’s current value and address any outstanding issues. There is no one formula to quickly and easily value an insurance agency because there are so many agencies operating in different market segments. To help with the valuation of an agency, the owner should consult a merger-and-acquisition advisory firm that is familiar with their market and industry. This will help to identify any problems and then a discussion about the best way to fix them and how they will affect the agency’s value.
M&A firms can help with the preparation and assist the owner in choosing the timing. The M&A advisor will create a selling memo that gives an overview of the agency to potential buyers. It will also organize all records of the agency that will be required for the due diligence stage. They will be responsible for identifying the best buyers and maintaining confidentiality. An accountant who is familiar with insurance agency operations will be needed as well as a business attorney who can deal in buy/sell agreements.
The insurance agency is the most valuable asset of most owners. The owner will see a significant increase in the return on their agency asset if they understand the market conditions and the value drivers.