AGENCY FINANCIAL MANAGEMENT
A producer's equity interest can create obstacles--
but not insurmountable ones--when an agency is sold
By Paul J. Di Stefano, CPA, CPCU
Many agency owners give equity interests in their agency to key individuals within the firm. These interests can be in different forms. The most obvious example is equity interests given to producers in their books of business. These equity interests usually remain dormant until the agency is put up for sale and the principals realize that these interests have an impact on their valuation.
Typically, the conversation between the buyer and seller goes something like this: The buyer indicates that the seller does not own the entire book of business. The seller acknowledges that some producers have equity in their respective books of business--but the buyouts for these books are a long way off--and resists the fact that the seller wants to exclude a portion of these books of business from what he is buying.
When assessing the impact on the agency of a producer-owned book of business, one of the points to resolve is what the rights of the agency are and what the rights of the producer are. In a case where a producer has the right to buy the book from the agency, one must assess the likelihood of the producer's buying that business. If the producer is being paid a reasonable percentage of the gross commission and is happy with the current situation, the argument can be made that the producer will in all likelihood be with the agency for the long term. In this case, the agency probably would buy the producer's equity interest sometime in the future. A buyer would then appropriately calculate the expected date that a buyout would take place and calculate a discounted present value of the payment to be made in the future to the producer. If the payout were to be on a contingent basis, the buyer would further discount the net present value for attrition.
The execution of non-compete/non-solicitation agreements is another area where agency value might be impacted. While most agencies require producers to sign non-compete and/or non-solicitation agreements, we at Harbor Capital Advisors routinely run into situations where these agreements have not been signed. Here we should distinguish between non-compete agreements and non-solicitation agreements. Non-compete agreements prevent a producer from soliciting any prospects from a geographical area within a certain time frame. Non-solicitation agreements, which are much more limited, prevent a producer from soliciting existing clients of the agency.
In the case where a producer has not signed either agreement, a buyer in all probability will insist that the producer sign, at a minimum, a non-solicitation agreement to protect the buyer from being raided after he has purchased an agency. The reality is that in order to secure a non-solicitation agreement from the producer after the fact and in the middle of sale negotiations, financial consideration will most probably have to be paid because the producer's status has a potential impact on value. The buyer will see a risk that if the producer were to leave and join another agency, the portion of the book that the producer controls and services might leave the agency. Figuring out the actual risk is the most difficult assessment. The financial deal to be made with the producer must take into consideration his or her value to the agency as an active part of the agency team, as well as the potential damages to a transaction if he or she were to leave.
There are occasions where producers risk overplaying their hand in these negotiations. We have seen many cases where the producer's vision of his or her control over accounts is substantially overstated. In one specific case in which Harbor Capital was involved, and which may be representative, a producer had suggested that he be given an equity position in the agency based upon the book of business that he serviced. The producer had never signed a non-compete or non-solicitation agreement and was seeking to use that subtle leverage in negotiating with the agency owner. The agency owner realized that the producer was being extremely well compensated through renewal commissions while benefiting from agency-generated leads. After conducting a careful cost benefit analysis, the owner decided to reject the producer's demands. It had become apparent that the potential financial consequences of the producer's leaving could in all likelihood become a "positive" for the agency because the potential amount of lost business would be dwarfed by the producer compensation savings that the agency would experience.
In this case, the agency principal used this opportunity to creatively renegotiate the producer's deal, making new business goals a key component of the producer's package going forward while enabling the producer to keep his total compensation at current levels in the short term.
In another agency sale situation, Harbor Capital Advisors employed a creative way of dealing with excessive producer compensation. The agency principal initially had sought to make the issue the buyer's problem, approaching the problem by assuming that any buyer would continue the producer's deal in its current form. Potential acquirers were reluctant to do this because it would throw their own producer compensation program into chaos.
The seller had failed to consider a simple solution--a buy down of the producer's current commission schedule to a lower level offered by the acquirer. While the computation of the actual buy down amount was not simple, the producer agreed to the concept, much to the surprise of the agency principal. The difficulty was in determining the attrition rate on the producer's book of business in the future, as well as the positive impact of the buyer's potential cross-selling opportunities for the producer. The producer would receive a lump-sum payment out of the purchase price in exchange for his signing an employment contract with a lower commission schedule.
One of the biggest problems that we encounter is the concept of giving the producer the right to purchase his book of business. In certain circumstances this makes sense, such as when the producer's technical skills make the book extremely vulnerable without the producer. The producer usually wants to secure a portion of the value of the book that he or she produces. It is not necessary to grant the producer a purchase option as this is not required to satisfy the producer's expectations.
Giving producers the right to buy their book under certain circumstances creates a complicated scenario when an agency is put up for sale. A producer who has a right to buy his or her book of course must be allowed to put the resources together to consummate a transaction. Herein lies the rub. When the owner is selling the agency, the last scenario that the owner wants to face is being forced to sell off part of the book of business. It becomes difficult to present the agency in a positive light when a producer has the option to leave by buying the book of business he or she controls.
We found that the normal complications with a producer purchase scenario were even more complicated in a transaction involving the untimely death of an agency principal during sale negotiations. The estate had decided that a timely sale of the agency was the best course. A key producer's right to buy his book of business led to an unexpected set of events. The producer looked at his right to buy his book--which at the time accounted for approximately 10% of the agency's gross commissions--as leverage to buy the entire agency. While the estate would have entertained a potential offer from this producer, the reality was that even with his potential partnering with another agency, the producer did not have the financial strength to buy the agency on a fair market valuation basis.
What ensued was a several-month delay in selling the agency. Negotiations were pursued with the producer to give up his quest, accept a financial offer for his equity interest, and join the acquirer's operation. These negotiations proved costly from both a time and money perspective. Several buyers lost interest believing that they were competing with a key insider. Even though the transaction concluded positively, the reality was that the producer's equity interest set in motion a potentially dangerous course of negotiations.
In summary, agency principals should give a great deal of thought to the equity participation deals which they make with producers, particularly the impact which these agreements will have on a future agency sale if there is no non-competition/non-piracy agreement in place. Spending time thinking out these issues in advance will make it much easier to execute an exit strategy in the future. *
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 or via its Web site (www.harborcapitaladvisors.com).