The Financial Side of Acquisitions

By | October 3, 2011

The merger and acquisition trend of agencies continues, despite the turndown in the economy. One reason for this trend is that publicly traded firms and those run by investment companies need to show growth despite today’s flat or soft market. These self imposed goals can only be achieved through buying a book of business.

Growth by acquisition can be a very valuable tool but only when part of an effective strategic marketing plan, including a compatible book. The transaction should be well planned out and structured efficiently. Understanding all the risks and the true financial picture is imperative to a successful transaction.

How Not to Value a Book

The frenzy to buy or merge leads to many deals in which the buyer is paying too high a price in a short period, and where the deal is not properly analyzed.

The mistake some buyers make is to underestimate expenses and risk.

Buyers may feel that the purchase is too small to warrant a professional valuation without even getting a quote from a professional appraiser. Regardless, this should not 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 or commission and ignoring the actual profit potential, if any, to the buyer.

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 1.2 times minus 2 times revenues 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 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 to Use

There are several different 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 methods. The two basic methodologies using the income approach are the Capitalization of Earnings method and the Discounted Future Earnings method.

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 operation of the business. 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 other common method used by appraisers and successful buyers is the Market Approach concept or the Price/Earnings Multiple method. As in the other methods, pro forma financial statements are created which state the anticipated revenues and allocate all expenses that are required to maintain the book of business.

The typical P/C 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 used. Buyers today are typically paying between four to seven times the pre-tax pro forma profit to purchase a book of business.

Can You Make a Profit?

It is important to make sure that the pro forma financials and projections take everything into consideration and are reasonable. Being too optimistic with the pro forma and risk assessment may not only mean an over-inflated value, but could spell a financial disaster in running long term losses.

Retaining the business and maximizing profits are the fundamentals to a good acquisition. Buyers are sometimes lulled into believing a purchase based on retention will prevent any potential of running a loss on the deal. If the price is too high, it does not matter whether or not it is based on retention. Also, paying too much too quickly can mean a long-term loss on the deal.

The hypothetical example below will show the dynamics of this problem. The profit margin of the book, the terms of the pay-out and retention level are directly related to the ability of the buyer to make a profit on the acquisition and must all be analyzed together. The following is a case study to illustrate the analysis that needs to be performed.

Case Study: An agency has an chance to purchase a $500,000 commission book from a retiring agent and will divide the handling of the acquired book between two existing producers. The retiring producer’s staff and office will remain. The terms of the deal are 50 percent of the commission paid per year for three years, based on retention. The payments begin at the end of the first year.

The Retention Purchase Model chart illustrates the cash flow of this case study. The chart shows the payments for the book, the annual gross profit from the book and net profit to the buyer for two different book profit margins, 20 percent and 15 percent. The analysis is performed for a 15-year period and uses a 90 percent retention. The expenses include the commission to pay a producer to service the book, salaries to staff and overhead so the profit margin shown is a net profit to the buying agency.

The hypothetical purchase of this book will require a buyer to use their own money in order to be able to make the payments. The three payments are $225,000, $202,500 and $182,250 for a total of $609,750. However, the profit earned at a 15 percent profit margin is only $67,500, $60,750 and $54,675 for those same years.

Therefore, a buyer will spend $182,925 of their own money during the first three years to purchase a $500,000 book. The danger is that each year the book gets smaller and smaller due to attrition, the profit dollars get less and less on the declining book.

Today’s high performing agencies may be able to maintain a 90 percent retention rate and a 20 percent profit, but many agencies fall short of these results. The chart demonstrates that even a high performing agency will not be able to make a profit in this hypothetical situation until the 11th year! Using a retention rate of 85 percent and a profit margin of 15 percent (both very common today) an agency will never make a profit.

Keep in mind that this hypothetical purchase is a stand-alone operation and includes paying a producer (either the seller or one of the buyer’s producers) to service the book. If a buyer were able to fold the book into an existing operation, a much higher profit margin could be obtained.

The mistake some buyers make is to underestimate expenses and risk. Even if the acquisition is folded into an existing operation, expenses such as management and staff salaries as well as rent needs to be included in the pro forma income statement.

A Final Thought

Take the time and effort to properly analyze any acquisition both financially and compatibility-wise. The key is for buyers not to pay for their own risk in an acquisition. Instead, use the firm’s profit to buy the book of business. Any amount paid to the seller above the profit generated from their book comes out of the buyer’s pocket. Structuring the purchase price based on the profit earned from the book will assist the buyer in achieving a positive cash flow much sooner.

Topics Mergers Profit Loss

About Catherine Oak and Bill Schoeffler

Oak is the founder of the consulting firm, Oak & Associates, based in Northern California and Central Oregon. Schoeffler is an associate of the firm. Oak & Associates. Phone: 707-935-6565. Email: catoak@gmail.com. More from Catherine Oak and Bill Schoeffler

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Insurance Journal West October 3, 2011
October 3, 2011
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Surplus Lines: State of the Market / NAPSLO Issue, Lloyd’s Syndicate Spotlight, Agency Financial Products Directory (Banks, Funding, Capital for Acqui