Agency Financial Management
DEBT AS A STRATEGIC TOOL FOR GROWTH
Use leverage or equity financing to grow your agency
“Neither a borrower nor a lender be,” cautioned Polonius in Hamlet, and William Shakespeare’s advice has gone on to form an attitude about debt that has stood the test of time.
If you would like to expand or transform your insurance business with an acquisition, by hiring an experienced team, or by implementing a succession plan, you likely will need to invest some additional capital—debt and/or equity. This could mean borrowing—which means taking on debt. Most insurance professionals, however, are conservative by nature, and their attitudes toward borrowing often spill over into their business lives. If you avoid debt in your personal life and do your best to steer clear of it in your business dealings, you may be debt averse. Aversion to debt can result in not taking out a loan—even when it is economically advantageous. Are you comfortable with risk, or do you make an effort to avoid risks as much as possible? Your degree of risk aversion can play into the decision as to whether or not to take on debt to grow.
There unquestionably is some wisdom in avoiding debt, particularly for individuals. One of the first financial lessons most people learn is to live within their means. Taking on more debt than we can afford can create a financial situation that spirals out of control. When it comes to business borrowing, however, “debt” is not the most accurate term. A better choice is “leverage,” because it describes the role that borrowing can play in your insurance business. Essentially, when your business borrows, you are leveraging other people’s money to achieve a purpose that will increase the value of your business.
When leverage is optimized, current ownership structure and control of operations remain in place, thus eliminating the risk of your business getting pushed in a direction you don’t want it to go.
When the idea of borrowing is unappealing, insurance businesses may look to another option for extra capital: equity financing. Equity financing consists of giving up part of your ownership in the business by assuming new partners or selling shares to new investors. Are you prepared for new decision makers setting strategy at the table for your company?
As with most things in life, there are pros and cons to both leverage and equity financing.
Leverage versus equity
When you decide to secure financing for your business, you need to ascertain whether equity or leverage is the better fit. The biggest differences between equity and leverage are ownership and control. With equity financing, the business exchanges a portion of the existing equity or issues new shares for capital. Exchanging existing ownership will dilute your position, and you will have new partners and/or new investors. When leverage is optimized, current ownership structure and control of operations remain in place, thus eliminating the risk of your business getting pushed in a direction you don’t want it to go.
The chart on page 92 provides a snapshot of the pros and cons of using leverage versus equity to transform your business.
Leverage as a strategic tool
Once you have decided to optimize leverage to expand or transform your business by executing your growth strategies, it is important to use that leverage strategically. Before borrowing, create a strategic business plan that outlines the growth initiatives, reasons they are attainable, and plans for reaching them to ascertain whether the return on investment warrants borrowing. Your plan also should include a budget to ensure adequate cash flow to cover all expenses, including loan repayment. Sample business plans can be found online and will guide you through the process.
Next, how will your business fare if your profits do not meet your expectations? The time you invest in the planning process will help you ascertain whether borrowing is the right choice and, if so, whether a loan is the better avenue or if taking out a line of credit to help with shorter-term needs, like managing cash flow, is a better option. Finally, for best results, find a lender that understands your business and the industry.
In addition to being strategic in planning for growth, it is important to be deliberate when considering financing options. For those who have little or no experience in commercial lending, local community banks are often the first lender insurance professionals consider. Such banks, however, are often hesitant to lend to insurance businesses because future commissions are the primary asset and they normally base lending on balance sheet financials and tangible collateral such as equipment, inventory, and real estate. As a result, insurance businesses frequently find it difficult to obtain such bank financing without providing personal assets as collateral.
Another option is to apply for a loan guaranteed by the Small Business Administration. Historically, SBA loans take longer to process, involve an excessive amount of paperwork, have relatively low lending limits, and can require a second lien on your home and a guarantee from your spouse.
An alternative is to explore cash flow-based lending through a specialty lender that understands your business and is accustomed to working within the confines of the insurance industry. A specialty lender will allow historical and projected cash flow from commissions to serve as collateral for financing and will take into account carrier ratings, contract rights, retention rates, and loss ratios.
For the best results, insurance professionals should partner with a specialty lender to responsibly fund business growth. At Oak Street Funding®, we are able to lend based on an insurance business’s intangible assets because we consider the future cash flow that is embedded in your in-force insurance policies or future commissions as the primary collateral for loans up to $30 million. To date we have completed almost 3,000 leverage transactions. In addition, we don’t sell our loans after origination, instead partnering with the borrower for the long term.
While taking on debt can be daunting, planning strategically, setting realistic expectations, and carefully researching your funding options will put you on the path to successfully leveraging capital to grow or transform your insurance business.
Rick Dennen is president and CEO of Oak Street Funding, which provides commission-based lending for insurance businesses that need capital to buy, build or sell. Dennen is a licensed agent in the state of Indiana for life, accident and health products and a licensed Certified Public Accountant in the state of Indiana. In addition, he holds an MBA in finance and is an instructor of venture capital and entrepreneurial finance at the Indiana University Kelley School of Business. He can be reached at firstname.lastname@example.org.