The following article was published in Insurance Journal magazine on Dec. 6, 2004
Many owners have at one time or another thought about selling their insurance agency or brokerage. Many were tempted but never quite took the plunge. Those who didn’t sell most likely were making too much money at the time or decided to sell later but didn’t know when.
Currently there are three major considerations that could or should be major drivers in reaching this decision: Capital Gains Taxes, Timing in Relation to Earnings and Desired Exit Planning.
Capital gains taxes
Few things are forever and the current 15 percent tax on capital gains could be nearing the end of its generous life. With the federal budget deficit growing exponentially by the minute capital gains could quite easily be one of the first changes in the tax code.
In fact, President Bush has already set as a major priority in his second term to begin the process that will cut the deficit in half within five years. To accomplish this it is very likely the President will have no choice but to press Congress to raise taxes. Increases will happen. It is just a matter of when. It is also a good bet that when they get targeted, capital gains will be hit with a minimum increase to the range of 20 to 25 percent and may be even higher.
A company or agency with a taxable selling value of $10 million could see their capital gains tax liability jump from the current $1.5 million to $2.5 million (assuming a zero tax basis in the company). That’s a 66 percent increase or, in this example, $1 million. The increase, whatever amount, will be a reduction in proceeds to the seller. Or even better put: An armored truck filled with money will to be diverted from the seller’s pocket to the IRS while waiting for a “better time to sell.”
Timing in relation to earnings
This is the most painful decision of all. It may be agonizing to think about selling the “Golden Goose” now, but waiting until later will likely be very costly to the seller.
It is a well proven and many times documented fact that the best time to sell an agency or brokerage is during the time of peak earnings. It takes a shrewd and savvy business person to embrace this idea, to accept it as the sound strategy it is and to have the courage to act on it.
Buyers are not interested in nice buildings or beautiful offices. Purely and simply, they are buying earnings, cash flow, growth potential and to a certain degree, management. It is historically true that a buyer’s purchase price will also increase because of the ability to fulfill a specific need or niche. However, nothing consistently drives purchase price multiples up like high revenues and earnings (EBITDA).
The hard truth remains. When a business is at an earnings peak, assuming there is no significant debt, there is no better time to sell.
Is there still time to act?
Both of these critical issues have not yet reached a point in the current economic and political climates to declare the “Golden Goose” as terminally ill.
It will take some time for the Administration and Congress to agree to actually pass a Capital Gains Tax increase. Once done, it will not take much time to get it in force. Additionally, in the aftermath of this year’s hurricane season, most insurance lines still have promising outlooks for firm rates to continue.
Even so, strong rates are other things that also do not last forever and assuming it takes 6-12 months to conclude the sale of an agency or brokerage, hopefully, value has not been sacrificed because of waiting too late to make the decision to sell. There should still be ample time for an owner to begin the process of selling.
What happens to after the sale income?
The ongoing investment income from the proceeds of the sale can be substantial, but most likely there is even more money to be made.
A typical sale is designed to include holding back a substantial part of the selling price for an “earn out” period. This “earn out” period usually lasts between two and five years. In these cases, the buyer desires the seller (and the seller desires) to stay on and continue to run the business under an employment agreement for most or all of the “earn out” period. This typical deal structure is meant to insure that revenues and EBITDA continue at or above the pre-sale levels and to “bridge the gap” between the buyer’s and seller’s valuation expectations.
There are even various possibilities where, armed with a well structured management contract for the duration of the “earn out,” it is not unusual for the seller’s salary to actually increase after the sale!
After putting a significant chunk of cash in their pockets and experiencing the total personal income increases after the sale, it is no wonder that many former agency/brokerage owners have been more than happy to continue working during the “earn out” period.
Desired exit planning
This is the easiest decision to make. If the commitment has been made to fully exit the business within the next five years and the owner expects to achieve that goal, the decision to sell has already been made.
Considering the requirements of a typical “earn out,” if the choice is made to sell today, it will still take typically three to five years to fully exit the business. If the selling process has not already started, the owner is looking at adding the six to 12 month average window to conclude a sale plus the “earn out” period. In this case, the painful question of “when to sell” has been made for the owner. There is no better time to start the selling process than right now because the owner is already behind in schedule.
What about the contingent commissions issue?
The highly volatile issue of contingent commissions is not going to go away for quite some time. Many brokers have already stopped or plan to stop the practice of accepting them. Therefore, buyers will most likely discount any contingent commissions being received by a potential acquisition target before deciding on an offer price. Of course, this will mean lower selling prices for owners.
No matter the outcome in the courts, it will be what it will be. Until it is fully resolved, this should be considered as a constant. It would not be a prudent strategy to wait for this issue to end in the favor of the brokers.
If an agency owner accepts the negative implications of the contingent commission situation as a constant, he should consider the situations regarding Capital Gains Taxes, Timing in Relation to Earnings and Desired Exit Planning as dangerous variables. Waiting to make a decision will only serve to increase the downside risk in each of these areas.
Attorney General Spitzer’s actions could be, or even should be, all the more reason to act now if there is any doubt about what to do. By doing so, the owner will at least accept the constant and implement a sort of hedge against the potentially negative variables.
Taking the first step
It is only human nature to fear the unknown. Therefore, if an owner has never been there, he or she can take comfort in the fact that it does not take an extraordinary amount of courage to take the first step.
That first step is easy: the most important decision an owner will ever make with regard to selling is the choice of investment banker. Without fail, in the investment banking business, “people get what they pay for.” Therefore, they should consult an investment banking advisor who specializes in mergers & acquisitions for the insurance industry.
Selling an agency is probably not something an owner has a great deal of experience doing. A good merger & acquisition investment banker lives, sleeps and eats the process every day. An insurance specific M&A firm will lead him smoothly through the complex preparation and selling process with the knowledge and experience required to avoid most of the potholes along the way.
If an owner has not completely decided to make the full commitment to sell, it is well worth the time to talk with an insurance investment banking advisor. Maybe the owner only wants to “check the water temperature before making the plunge.” Getting a valuation done for his or her business is the equivalent of sticking a toe in the water. With accurate information supplier by the owner, a qualified advisor can value a business properly.
Once the valuation is completed and the owner has a good idea of the general market value of the agency, if he/she wishes, the process can move forward.
They should meet with their advisor to discuss whether or not it makes sense to take the next logical step. A good insurance M & A firm will have full knowledge of the current market. They already know or can find the answers to questions such as:
• How many potential buyers are there?
• Who are they?
• Who has an appetite for specifically what this agency has to offer?
• Does the agency offer any unique selling points?
• Can the owner achieve maximum market value for the agency?
• What selling price can the owner reasonably expect?
Once these questions and maybe a few more have been answered to the owner’s satisfaction, he or she will decide whether or not to proceed with actually offering the agency/brokerage for sale.
For many owners, it is important to know the actual offering for sale can be done on a highly confidential basis. It is perfectly normal to contact potential buyers with a disguised description of an agency along with the actual financials to determine their level of interest. The name of the seller is not revealed until confidentiality agreements are signed by the interested buyer. Carriers, agents, competitors and employees do not need to know of the owner’s considerations until the appropriate time.
Test the water or swim?
With a properly structured agreement between an owner and the investment banker, it is not necessary to go straight from “testing the water” to “swimming for a gold medal”. Everything can be done in very carefully controlled stages. The owner should be able to abandon the process any time things do not look favorable for continuing.
If the owner is concerned that capital gains taxes will be significantly increased in the foreseeable future, or earnings are at a pinnacle, or there is a desire to exit the business within five years, the time to explore selling the agency is now.
Walter B. Sherman is managing director of LMC Capital LLC, a national investment banking firm devoted exclusively to the insurance and financial services industries. The firm is located in Charlotte, N.C.
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