An Economic Case for Internal Perpetuation
If you just sold your agency to one of the many private equity backed brokerage firms, congratulations, but you may want to flip this page.
Now that the former agency principal has moved on to the next article, I would like to tell you why I believe there is a good reason for you to strongly consider perpetuation for your agency. Our agency seller colleague, who is now reading the next article, may regret having sold the agency his or her family built over the last three generations.
There is a sound and understandable economic justification that suggests that there is as much value to be realized over time by retaining and investing in your agency. After doing the math, you may find that a perpetuation is potentially more attractive than an outright sale, even given the recent frothy deal valuations.
Consider what happens when you completely sell your agency to a third party. In exchange, for likely a very tidy sum, you give up all of the future cash flows of the agency, and all of the clients you and your family have amassed. Chances are that the guaranteed portion of the sale is all that may be realized because there is risk of achieving the full earn-out beyond your control. Also, since you no longer own the shares, you cannot enjoy any future appreciation in the value of the stock.
When you take the sale proceeds, besides purchasing a sailboat, you will need to make investments in other assets, such as securities, which will probably not produce a yield as great as the return from running and owning a good performing agency. You will certainly not be able to duplicate the return you would receive from owning the agency with any alternative investment approaching a similar risk profile. If you perpetuate your agency, even if you sell a small share to employees, chances are that you will have a more valuable agency in the coming years such that your (smaller) ownership share is worth more down the road than the full share would be worth today.
Here is a brief description of the math exercise you may wish to attempt. The impact of taxes will not be considered.
If one assumes an agency with commission revenue of $5.0 million with relatively good performance delivering a 22.5 percent EBITDA (earnings before interest, taxes, depreciation and amortization) margin, the value on an outright sale may be $9.5 million. Conversely, the value for an internal sale, of less than a full interest, would be $5.6 million. The EBITDA valuation multiples used are conservative — 8.5 and 5.0 times, respectively.
Now assume that you sell 30 percent of the shares of your agency to your best producers. Because you were able to retain your best people with an equity stake, they are even more productive and your agency revenue records organic growth of 5 percent per year and grows to $6.4 million revenue in five years. At the 22.5 percent EBITDA margin and same 5.0 multiple, the agency is now worth $7.2 million and your 70 percent interest is worth $5.0 million. But, over the same period, you received annual cash flows from your 70 percent stake totaling $4.5 million. Add the cash flows received to the projected value and your “total investment” is worth approximately $9.5 million.
While the numbers are simplified and ignore taxes and the time value of money, a case can be made that perpetuation can be very attractive since modest growth and retention of cash flows yields a similar value after five years. The best part is that you can continue to do this serially for as long as you care to bring on additional owners or allow the widened group of owners to increase their shares.
In addition, you always have the ability to sell out in total, should you want to. This is the equivalent of having the best of both worlds. Naturally, you would need sound legal advice to craft the share purchase and redemption agreements.
Here is another thought worth considering but I can’t model it out for you. Why are agencies so attractive?
Besides the fact that there is a lot of capital in search of a return hoping to tap into your reliable and recurring cash flow stream, agencies own something that lends great value to the cash flow. Agencies are in the enviable position of “owning the customer.” The ability to own the customer is exactly what is driving entrants such as Google into your industry. They desperately want a piece of the insurance distribution space. Google is not setting out to be an insurance carrier since that risk is too great. Don’t be afraid of Google entering your industry but ask yourself why they are entering and you will realize that you have something very special. That is why they want a part of it.
Think next for a moment of the Amazon model. Amazon is doing all it can do to become the distributor of choice to the consumer for all types of goods. The ultimate value of, and success of, Amazon will be realized when one no longer thinks of driving to Walgreens to purchase deodorant, but simply orders it online from Amazon over their tablet and it is delivered to their door, with free shipping. Being the distributor is the preferred, and far less risky, place to be than being the manufacturer or producer of the product. Clients are satisfied when given wide choices, with excellent guidance and support, preferring to repeatedly purchase through a single point of sale. Does this sound familiar to your business?
There are a variety of perpetuation scenarios that are available. I will focus on the simplest and easiest to implement.
Consider approaching perpetuation candidates at an earlier age by offering equity ownership in your business. It has been said that talent flows to equity. I would advise you that the opportunity to purchase equity in your business only be extended to those individuals that have demonstrated that they are high performers. Those who are able to produce business, manage relationships and exhibit the same passion you have for your business and want to be part of its future. Those who are willing to devote some of their financial resources to buy into your business. Equity ownership is a proven way to attract and retain the best talent.
Those potential owners are encouraged to obtain a loan from a specialty lender such as InsurBanc secured by the stock purchased. As a seller, you want the purchasers to actually “buy” the equity. This places the exercise of financial discipline on the part of the buyers and readies them for greater financial responsibilities in the future.
To facilitate the financing, as a seller, you would agree to the bank that you would repurchase the shares to regain control of the stock, likely at a discount, in the event that one of the minority principals defaulted on their loan. The downside risk to you as a seller is therefore greatly diminished.
Now, you may ask, “What is the best way to start the process of planning for and implementing a perpetuation based on a sale of stock to your future leaders?” The agency principal who is considering what I have discussed will need to have a very good assessment of the current value of their agency and a projection of the value of the agency several years from now after the implementation of the perpetuation plan and making appropriate investments in the business. We would be very pleased to provide some advice to you and provide referrals for qualified valuation consultants. Always seek accounting and legal advice from the best qualified professionals.
We have all been reminded repeatedly of the challenges facing the industry. Crafting and implementing a perpetuation strategy cements your chance for a solid financial future by widening ownership in your agency and diversifying the ages of the owners, while giving you the best options to maximize your investment.
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