View this article online: https://www.insurancejournal.com/magazines/mag-mindyourbiz/2013/08/19/301668.htm
Growth by merger or acquisition is still a popular and valuable tool, despite the economy being on hard times. One of the main reasons it remains popular among agencies is because it is a way to show growth even with today’s market. Although 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 will work as a growth tool is if the agency is already seeing internal growth. If the agency is not seeing internal growth, there may be other factors at play.
Some examples of why an agency may not be growing internally include:
So before choosing to grow through acquisition, make sure the agency is showing internal growth.
Agency Value
Once the agency is ready to look into an acquisition or merger, agency value and the fundamentals around it become most important. If an agency is already in the middle of a deal, it is probably too late to worry about agency value. The best time to look into an agency valuation is when you start the process of being at either end of a merger or acquisition.
Because merger and acquisitions have become popular, too many deals are being made with the buyer paying too high of a price in too short a period, because there is competition and the agency has not been properly valued. Also, agency owners get excited and may make a quick decision and can end up purchasing an agency that is not good for them. Regardless of the size of the purchase, a professional valuation is recommended.
The biggest mistake agencies make in valuation occurs during a “self-made” deal. The purchase price is often set through a multiple of revenues and/or commission, and ignores the actual potential profit/cash flow 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 one to two times revenue 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 in other investments.
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 both 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.
Valuation Methods
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. The two basic methodologies using the income approach are the Capitalization of Earnings and the Discounted Future Earnings.
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 business operation.
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 percent to 25 percent 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 five to seven times the pre-tax pro forma profit to value the deal.
For agency sellers, there are also new capital gains taxes to deal with. Capital gains federal tax went up from 15 percent to 20 percent on Jan. 1, 2013. In addition, there is a Health Care Act tax of 3.8 percent, so that leaves capital gains federal tax at 23.8 percent, plus the state income tax on a sale. Previously it was only 15 percent, plus state tax. The taxes are high, but there are talks about capital gains federal tax increasing to 35 percent! So selling now is not a bad idea, if capital gains tax does go up again.
Also, a seller can take payments over a couple years, so 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. Buyers like to have an earn-out so they know that the book of business is properly transitioned before all payments are made.
In conclusion, astute buyers should take the time to properly analyze any acquisition both financially and compatibility-wise. By following the recommended advice, sellers will position themselves to sell at an above average fair price. Remember that everyone must sell someday, either internally or externally. Planning a strategy well – especially with a good consultant – can be very worthwhile for both sellers and buyers.