Balancing Key Employee Retention With Internal Vs. External Valuation

Understanding the differences between an independent insurance agency’s internal value and external value is important for agency owners to retain key employees while preserving the opportunity for a profitable exit value in the future.

An external valuation is used when selling an agency to outside buyers, such as private equity investors or strategic outside buyers, such as large brokers or competitors. Outside buyers focus on carrier synergies, niche specialties, geography and upside potential, which often yield higher pricing due to competition from multiple potential buyers and higher EBITDA (earnings before interest, taxes, depreciation and amortization) multiples.

Determining the external value of an agency includes preparing a pro forma income statement that includes adjustments to normalize EBITDA to show an agency’s true cash flow by eliminating non-recurring and extraordinary expenses. These adjustments can include the normalization of an owner’s total compensation, profit sharing and employee salary adjustments to maximize an immediate financial return.

Often, business owners may include a variety of “perks” that need to be eliminated, as they are items that a third party would not continue paying for in arriving at the external value. These items include mortgage payments for a building personally owned, company cars (especially for family members not directly involved in the business), personal expenses such as flights, memberships, non-business cell phones, artwork and other non-business items.

In contrast, an internal value refers to the valuation used for such internal transactions as perpetuation to producers or family members, ESOPs or buy-sells. The internal value of an agency often results in a lower price based on fair market value, which is typically focused on an agency’s historical performance, steady growth and continued stability.

Internal transactions generally involve one buyer, or a small group, often resulting in a lower valuation due to lack of market competition; however, they prioritize employee retention, stability, legacy and an agency’s current ability to generate sustainable cash flow.

A valuation gap occurs when agency owners attempt to bridge the gap between an agency’s internal value and external value. If the price is too high, internal perpetuation becomes unaffordable for key employees. Conversely, if agency ownership is sold internally at a low price, the owner may sacrifice value that could be realized by selling to an outside buyer.

Employee incentive plans

By separating internal value and external value models, agency owners can structure incentive plans that reward key employees today while preserving the ability to maximize market value if the time comes for a sale to an outside buyer. This allows agency owners to recognize that the employees responsible for maintaining client and carrier relationships, growing revenue and supporting growth are the same people whose retention is essential to supporting the agency’s future valuation. Incentive plan examples include granting agency employees Phantom Stock or Stock Appreciation Rights and issuing shares of non-voting stock.

Phantom Stock mirrors the full value of actual shares and provides financial upside of an agency’s growth without granting actual ownership in the business. Employees receive bonus payouts tied to the total value of the shares or only the growth, depending on the way the plan is set up. It allows them to benefit financially without reducing the agency principal’s ownership or requiring upfront investment from the employee. Stock Appreciation Rights grant employees a bonus payment tied to only the increase in value from the day the rights are granted, without having to purchase the underlying stock.

Think of Phantom Stock and Stock Appreciation Rights not as actual ownership but rather as bonus plans tied to an agency’s performance. Both plans let employees profit from the agency’s success without granting actual shares or voting rights. This is good for owners, because it keeps control of the agency in their hands while still rewarding their team for their performance.

Obviously, size matters, given the costs involved in setting up a plan. Usually this means that agencies with at least $1 million in commission income will decide the utility of this type of approach. Because of the nuances involved, it requires hiring an industry-specific consultant, HR firm or CPA firm that knows the applicable tax rules to help prepare an incentive structure that aligns with the owner’s long-term goals and employee recognition or incentive rewards.

Agency owners can also utilize non-voting stock, which grants actual ownership shares that vest over time and are subject to specific vesting conditions tied to tenure or performance. This allows employees to gradually build ownership while the owner retains control of the agency. Think of a producer growing their book of business to a specific revenue amount, which then triggers the vesting of non-voting stock shares in the agency that can be fully owned and redeemed by the agency using an independent appraisal of the stock, as long as they continue working at the agency. To ensure long term retention, if the employee leaves before the shares vest, they lose them.

More agency owners are considering these types of plans to reward initiative to help retain key employees. Yet, implementation of these programs is the exception, not the rule. Agency owners should not wait for the employee to raise the issue because the lack of communication could result in a key employee departure that could have been avoided.

Pay for performance compensation

Beyond long-term equity incentive tools, agency owners can also consider pay-for-performance compensation models tied to long-term agency valuation growth. A well-designed compensation model typically includes a competitive base salary, short-term incentives such as production bonuses, and long-term incentives like long-term equity participation. This model incentivizes key drivers of enterprise value, such as EBITDA growth, client retention rates and profitability targets.

Employee retention strategies also can help protect the agency’s potential sale value to an outside buyer who places significant importance on an agency’s management, operations and revenue stability. Agencies with strong leadership teams, stable client and carrier relationships, and consistent organic growth complemented by new business typically command the highest valuation multiples. Retaining and incentivizing key employees helps owners preserve the agency’s attractiveness to potential outside buyers.

Agencies with strong leadership teams, stable client and carrier relationships, and consistent organic growth complemented by new business typically command the highest valuation multiples.

Written plan is key

A clear and well-written plan that includes easy-to-understand methods for valuing the agency can help agencies retain top talent. It also involves engaging the services of an industry consultant that can prepare an annual valuation to help ensure a level playing field and allow employees to track an agency’s value annually based on consistent metrics.

Planning an agency’s eventual sale to key employees or an outside buyer involves a choice between maximizing financial return or prioritizing employee retention, stability and legacy. While selling to an outside buyer often yields higher upfront valuations, faster liquidity and performance-based earn-outs, it may come at the cost of an agency’s culture. An internal perpetuation to a key employee or family member ensures continuity, stability and preservation of that agency’s culture, although it typically represents a lower purchase price.

Ultimately, the most effective strategies come from long-term, proactive planning rather than heading straight towards a final event. By creating a positive workplace environment that promotes opportunities for agency ownership and rewards staff for increasing agency value over time, owners can bridge the valuation gap, retain staff and achieve a profitable, stable, and lasting transition.

The author

Keith J. Mangini is vice president, commercial team leader, at InsurBanc (insurbanc.com). He can be reached at kmangini@insurbanc.com.