An agency buyer and an agency seller may have quite different views about the issues relating to a potential deal. Depending on one's position in the negotiation, different questions arise about the deal-related issues, including the risk factors surrounding the terms of a transaction. Perception is an important part of the deal-making process. "Is the glass half full or half empty?"
When an agency is being sold, a key factor in concluding a successful transaction is to have a good understanding of some of the more complex issues concerning the agency's operations. Since no two deals are the same, a seller should assess beforehand what potential issues may arise in the negotiation process and how he or she will handle those issues.
Let's look at a few examples of deal-related issues which have arisen in transactions where Harbor Capital Advisors acted as the intermediary. The first example involves a transaction where a seller's balance sheet had a negative tangible net worth. The technical definition of tangible net worth is shareholder's equity of the agency corporation less the value of any intangible assets. Typically included in intangible assets are such items as goodwill, which was capitalized as a result of the purchase of other agencies, and covenants not to compete. Since these assets are, in this case, appropriately amortized or written off over a fixed period, we are referring to the net carry value of these intangible assets.
In addition to netting these intangible assets from shareholders equity, one also must add any outstanding obligations to the balance sheet that have not been recorded as liabilities. In this particular case, there was an unrecorded liability of approximately $500,000. This obligation related to the purchase of a book of business from a retiring producer who owned his book of business. An agreement had been executed with this producer which obligated the agency to continue to make commission payments on the producer's book of business over several years in the event of retirement. The selling agency was treating these payments as producer commission expense on the P&L. The buyer proposed treating the outstanding obligation as a liability in cash flows and prepared to analyze the transaction. The seller was concerned over the appropriateness of treating these future payments as a liability and the resultant financial impact on the transaction.
The treatment of this type of off balance sheet obligation is extremely important to both sides in the negotiations. The fact is that, in this case, it would be unfair to penalize a seller in a transaction in which obligations such as those described above will be paid off in two to three years when applying a typical deal multiple of 5 to 6 on pre-tax earnings. The appropriate way to handle this issue is to remove these obligations on a pro forma basis from annualized expenses and book them as a liability on the balance sheet on present value basis. The present value calculation discounts the liability at a risk-free rate of interest since balances paid in the future have a lower cost than current payments. Although this treatment created a pro forma balance sheet with a negative tangible net worth, the seller was actually better off than having the agency's pro forma earning stream penalized at a 5 or 6 multiple.
Sub-produced books of business can present another problematical issue. Harbor Capital has been involved in many transactions where agency-housed sub-producers own their own books of business. A buyer may look at this situation and feel that he or she should not have to pay for those books of business since he or she may have to buy those books out at a future date. The fact of the matter is that both sides are correct to a certain extent. The buyer is right that he or she will have to pay the producer under the buyout agreement at some future date. The seller is also right in that, as long as the producer stays, the profitability of the agency won't change in the near future.
The real issue here is determining the realistic expectation for the time frame in which the producer may be bought out. If there is little likelihood that the producer may leave in the short term, the potential liability may be extended many years into the future. Even at that point the agency sub-producer contracts may call for a multi-year payout. In one such case, after reviewing the sub-producer's book of business, it was determined that much of that book could be given to a CSR to service with no continuing servicing commission.
The solution was to realistically assess the present value of that obligation which again in this case should be set up on the pro forma balance sheet. This issue involved in structuring the deal is similar to the one discussed in the first example with the difference being that the time frame surrounding the liability is somewhat subjective.
Another issue with which Harbor Capital has been confronted in client negotiations is the case in which a specific program with a carrier has proved successful for the agency over the years. The continued success of this program may be viewed by a buyer as having undefined risk factors associated with it. The issue of an agency's relying heavily on a specific program is a classic example of the glass half full/half empty conundrum. Niche programs, if they are successful, are capable of generating substantial profits. We have seen buyers try to discount the value of a transaction by taking the position that the program could be lost some time in the future with the resultant loss of commission income and profits. While that eventuality should not be ignored, the buyer must keep in mind that the reason he or she was interested in the agency in the first place was the potential of that specialty book of business.
Structuring a portion of a transaction as a retention deal is a way out of this stalemate. But even with a retention component, the buyer must be willing to take a business risk, in the acquisition. One must remember that without a willingness to accept a reasonable amount of risk, a prospective buyer's chance of closing a transaction will be greatly diminished.
Another example of a deal issue which revolves around a risk factor is the situation where a seller has an extraordinarily profitable agency. In one case we worked on, the selling agency had a 40% pre-tax profit. One prospective buyer's offer was structured around the notion that the margin was not sustainable. The deal offered ended up being so conservative that the seller had little or no motivation to sell. Prior to making an offer, the potential buyer must make a realistic assessment of the real risk factors associated with the successful continuation of the agency. This exercise will greatly reduce the tendency on behalf of a number of buyers to structure an unrealistic offer to protect the perceived downside of a transaction, which eliminates any realistic possibility of closing a deal.
Tax issues also are important in the negotiating process. In many cases where agencies are "S" corporations, the buyer is forced to buy the corporate entity to protect the seller from a double taxation situation. If the seller were to sell the assets of the corporation, the corporation would first realize a tax at the corporate level, and the shareholder would realize a tax at the personal level.
There is always a reluctance to buy the corporate stock since there are many potential liabilities which may arise in the future for the corporate shareholders. Those issues include off balance sheet liabilities and potential tax assessments. In most cases, by the terms of the contract, those liabilities can remain the liability of the seller. The concern of the buyer in those circumstances is the ability to recover those liabilities from the seller once he or she has cashed out. However, a careful assessment of the potential liabilities can more clearly help the buyer make a decision with regard to reality of a potential downside in acquiring the stock of the corporation.
In the case where the assessment has been made that there may be too much risk associated with acquiring the stock of the seller, Harbor Capital has been called upon to come up with other structures to overcome this obstacle.
In summary, these examples represent a number of issues that may arise in the negotiations surrounding the purchase of an agency. In order to assure the highest possible degree of success in the negotiation process, it is best to approach the discussions in a knowledgeable manner. The use of an intermediary can, in most cases, guide agency principals through some of the more complex and thorny issues in the deal-making process. *
The author
Paul J. Di Stefano, CPA, CPCU is the managing director of Harbor Capital Advisors, Inc., a national financial and management consulting firm which offers services to the insurance industry. Services include agency appraisals, merger & acquisition representation, strategic and management consulting. Harbor Capital Advisors, Inc., can be reached in New York at (800) 858-2732.
| Overcoming the obstacles to a sale | |
| Representative deal issues | Suggested steps to resolution |
| Risk-related | Realistic assessment of what risk is being assumed |
| Comprehensive presentation of facts | |
| Perceptions of value | Appraisal/valuation |
| Balance sheet issues | Understanding off balance sheet obligations and treating them appropriately |
| Book of business ownership issues | Time frame surrounding producer buyout obligation |
| Understanding of producer motivations | |
| Structure of transaction | Compromise of deductibility of purchase price vs. capital gains/ordinary income tax treatment |
| Understanding constraints of corporate culture | |
©COPYRIGHT: The Rough Notes Magazine, 1998