How to Value Small Books of Business & Terms

By | October 21, 2013

Oak & Associates receives many calls about valuing small books of business, and is asked if it is worth doing a valuation when the buyer knows what they want and the buyer does not want to spend a lot of money.

Usually on a small deal — those under $500,000 in commissions — a fair market valuation does not need to be done. Instead, an Opinion of Value basically covers the creation of the pro forma income statement on the book of business, a basic description and the value calculations using three methods of valuation. Cost is usually in the $2,500 to $4,000 range versus a Fair Market Valuation for $4,000 to $6,000.

Hypothetical Example

For example, look at a hypothetical book of business that is $250,000 in commissions in both personal and commercial lines. Assume a strong 95 percent retention rate.

Personnel Expenses. A producer is needed to service accounts totaling only $150,000 of the book. The producer is paid at 30 percent of commission or $50,000. For the servicing expenses, there would probably be half of a commercial lines CSR and half of a personal lines service CSR, probably $30,000 for commercial lines, $15,000 for personal lines and $5,000 for accounting and administrative help. The purchaser will have a little management time, so $10,000 is allocated for that effort. Total compensation expenses is $110,000.

Add in benefits of 15 percent or $16,500 for all these payroll costs, which covers payroll taxes at 8 percent, health insurance, dental and some other employee cost, like a 401(k) plan. Thus, total personnel expenses are $126,500, or 50.6 percent of revenue.

Business Development and Operating Expenses. Business development costs, such as telephone, postage, advertising expenses of about 4 percent or about $10,450, will be assigned in this example. Operating expenses, such as rent, insurance, automation expenses will be assigned at about 9 percent or $22,400. This costs a total of $32,850 or 13.2 percent of commissions.

So, now we have $84,900 in profit or 34 percent on a $250,000 book of business. With this profit do some valuation calculations.

Valuation Methods

First, there is the Capitalization Method, which looks at the rate of return on the buyer’s money in something risk-free and then adds a risk factor for putting one’s money into the purchase of a book of business. The range is usually in the 10 percent to 15 percent range. Then, add an additional 13 percent to a risk-free rate of 4 percent. This becomes 17 percent, and divided by the profit is about $500,000 about 2 times commissions.

Next, there is the Price/Earnings Method of valuation, which uses a multiple of profits to determine value. A typical range for the multiplier is 5 times to 6.5 times pro forma pre-tax profit.

For this example risk has been measured and the potential of sustaining a 34 percent pre-tax pro forma profit is set at 5.5, so the value becomes $467,000 using 5.5 times $84,900, which is 1.87 times commissions of a $250,000 book of business.

Lastly is the Present Value of Future Earnings approach, which is looking ahead at what this book could earn if it is growing and profitability is maintained. It is difficult to explain all of the factors in this method, but the calculations were done, and a 5 percent growth rate was maintained and the same 34 percent profit resulted, and the value became about $500,000.

In all three examples, subtract some working capital for the buyer, which is usually 30 to 45 days, or about $13,000 to $20,000.

These three valuation methods are weighted appropriately, and the value would be about $500,000. This is two times commissions, which may seem high, but based on a profitability of 34 percent in a growing book of business, this is probably right.

Not all books or agencies have this kind of profit. Usually profitability is in the 15 percent to 25 percent range today. If an agency rolls a book of business into an existing agency versus leaving it as a standalone firm, there is usually a much better chance of having this type of profitability. Most buyers would not allow a book to stand alone as a separate office unless there was $1 million in commissions.

Please note that if the pre-tax profit is only 20 percent for this book of business, for example, then the value would probably be closer to one times to 1.25 times commissions, or $300,000 to $375,000, with the three methods weighted again on appropriate valuation for the situation.

Typical Book Terms

If a buyer gives the seller 30 percent down, that is $150,000. Typical down payments are 20 percent to 50 percent for a book of business. Then the buyer still owes $350,000. The balance is usually on an earn-out. That amount that is still owed, which is 70 percent of the money at 2 times or 150 percent is turned into a percentage for the next three years.

The payout rate is 150 percent divided by three years, 50 percent renewed commissions. With an earn-out, interest is usually not paid. That way the buyer can tell the seller no matter what comes in, the seller will receive about 50 percent of renewal commissions. With commercial lines rates increasing, that is great. If an account is lost, the buyer is protected.

The down payment is paid the first year and buyers usually don’t start paying until the beginning of the second year, then can be paid monthly, quarterly or annually.

Letter of Intent (LOI)

It is best to draft a LOI that each party signs before a purchase agreement is drafted by an attorney. Having a well-drafted LOI saves a lot of the attorney’s time and is in layman’s language.

Topics Profit Loss

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Insurance Journal West October 21, 2013
October 21, 2013
Insurance Journal West Magazine

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