Learning how to find and evaluate opportunities helps prepare for the right one and prevent entering into the wrong one.
GROWTH STRATEGY REVIEW
How to create win-win situations
By G. Edward Kalbaugh
Learning how to find and evaluate opportunities helps prepare for the right one and prevent entering into the wrong one.
Caveat emptor--Let the buyer beware--has influenced the negotiation and adjudication relationship between buyers and sellers for thousands of years. It is a common law doctrine applied throughout most English-speaking countries.
Caveat emptor tends to burden buyers with responsibility for purchases. It is a key reason why buyers undertake the extensive, and often expensive process of due diligence--the thorough review and analysis of the seller. The buyer's risk must be understood and mitigated.
This apparent one-sided view of transactions often creates an offensive-defensive relationship between buyer and seller that fosters mistrust from the beginning. It perpetuates the myth that buyers control the process--that sellers are subordinate in the transaction.
Is there a better way?
At Allegent Growth Strategies, we believe in the doctrine of inter pares--among equals. In this approach, the goals and expectations of both parties--buyer and seller--guide the process and the transaction. Both parties agree to equal status and treatment and share responsibility in assessing the risks and benefits. This approach has positive benefits from the outset.
Focusing on expectations
We start by focusing on expectations. When the expectations of both parties are understood and accepted, resolving other issues is primarily fact-based and mechanical. For example, in one small agency, the seller wanted to retire in three years but felt compelled to sell immediately because the agency was slowly losing value due to the weakness of the staff. The agency's assets included good markets and profitable, long-term commercial accounts; but the accounts were at risk due to a lack of proper servicing. The owner's retirement objective was simply to maintain his lifestyle.
The solution was to introduce a commercial producer and an account executive who would be able to bring in new business while perpetuating existing relationships with accounts and carriers. Both of the newcomers wanted to own an agency but could not afford the purchase price. A new corporation was formed, where the producer and the account executive owned all new business equally. Existing business was transferred to the producer and the account executive in exchange for servicing the accounts. The owner continued to receive consulting income from existing accounts, as well as benefits such as auto reimbursement and life and health insurance.
While the financial aspects, including tax issues, of this transaction had to make sense, the real focus was on the character of the existing owner, the producer and the account executive, and finding a way to make the transaction work for them. By treating all parties equally and focusing on expectations, the remaining elements of the transaction easily fell into place.
In this situation, the owner preserved value in his retirement and the producer and account executive gained ownership of an agency, with no down payment required to conclude the transaction, and no debt load to burden their going forward.
Encouraging innovation
As you can see from the previous example, creativity and innovation may be required to achieve transaction objectives. Sometimes assistance is needed to help clarify the expectations of buyers and sellers. This requires a thorough understanding of the business and underscores the importance that Allegent places on working closely with both the buyer and the seller throughout the transaction.
For example, another client wanted to acquire independent producers in support of a new program. This client was aggressively seeking debt- and equity-based financing as a way to fund the producers. However, lack of sales growth, negative cash flow and lack of management depth reduced both financing options. In addition, review and analysis revealed that traditional selling would not achieve results. Distribution into this client's marketplace required entrée at the top executive level that could be achieved through existing, trusted relationships.
The solution crafted for this client included the purchase of a company already involved in product distribution within the client's marketplace. The transaction was accomplished as a tax-free exchange of stock, with the owner of the purchased entity appointed president and chief executive officer of the buying entity. In addition, the structure of a new compensation plan provided cash and equity reward for upside performance in sales and earnings.
A number of valuation techniques were applied to establish a baseline measure fair to both entities. Among these techniques were the use of a price/earnings/growth ratio (P/E/G) and a price/sales ratio (P/S). The P/E/G accounts for growth by dividing the price-earnings ratio by expected long-term earnings growth. The P/S ratio--market cap divided by sales over the past 12 months--focuses on actual sales when earnings are too complex
to assess.
These valuations require agreement by all parties regarding sales and earnings forecasts. Careful attention to these forecasts by both parties early in the transaction helps uncover and resolve issues and concerns and establishes the expectations that drive the transaction to a successful close.
In this case, by being innovative in achieving a common valuation baseline that took into account mutual goals, and by creating upside compensation potential, both parties could immediately focus on growing the business, without concern over mechanical details. Now that our restructured client has additional management strength and sound prospects for immediate sales, the firm is highly attractive to potential investors.
Paying attention to process
Mergers and acquisitions such as the ones just described take place through a natural process involving six major phases. Each phase has a different scope and focus depending on the type and characteristics of the transaction.
1. Identify potential opportunities--Buyers and sellers always should be attuned to potential deals and should not avoid expending resources to evaluate opportunities, as long as this does not interfere with ongoing business. Assessing opportunities provides a broad view of the marketplace and creates internal expertise and knowledge that serves to bolster confidence and self-reliance. Learning how to find and evaluate opportunities helps prepare for the right one and prevent entering into the wrong one.
2. Concentrate on the deal--This phase comprises several mini-phases that need understanding and careful attention. As was stated earlier, both parties should first focus on expectations. Do not begin with discussions about price. We encourage both parties to gain a general understanding of why the potential merger or acquisition makes sense. We then begin coming to terms with critical business, operational, organizational and financial issues. In addition, major liability issues are uncovered and resolved in a cooperative atmosphere. In this manner, negotiations evolve naturally, as both parties learn and understand more about one another.
3. Perform due diligence--Due diligence involves both buyer and seller. While this is primarily a fact-checking exercise, it is important for principals to stay involved and informed as due diligence unfolds. In the hands of experts, due diligence need not be an onerous exercise. Rather, it is an opportunity to interact, to assess the skills and personal agendas of staff, and to learn more about the business. In many situations, portions of due diligence can take place concurrently with phases two and four.
4. Negotiate the deal--As phases two and three take place, both parties are in a position to better understand the essence of the deal and to finish negotiations. During negotiations, it is important to focus on meaningful priority issues and not get mired in trivial detail. Negotiating is a business function, not a legal or financial function, although both legal and financial considerations influence results.
We believe it is important to engage an experienced third party to lead all phases of the merger-acquisition process, but it is especially important during this negotiating and closing phase. Skilled third parties can orchestrate the process to maintain flexibility, eliminate friction, negotiate effectively, and keep the process on track to closing--thus earning their pay.
5. Complete the transaction--Closing is a mechanical process but, if not handled properly, can undo much of the goodwill established during the other phases. Completing the transaction essentially is following through on a checklist of standard items that should be in place prior to the closing date. Avoid "last-minute negotiations" during closing that can jeopardize the transaction. The closing should be enjoyable and free of stress for all parties. It is an occasion to celebrate.
6. Follow through--Once the transaction is complete, both parties must ensure a smooth implementation and transition for all concerned. Because of its depth and scope, implementation deserves special attention and will be addressed in a future article.
Summary
It is important for agency owners to remain open and to continually explore all potential merger and acquisition opportunities. At the same time, agency principals are encouraged to engage experienced third parties to lead the merger-acquisition process. By focusing on expectations early, by encouraging innovation, by negotiating as equals, buyers and sellers can create win-win situations that lead to positive results over the long term. *
The author
G. Edward Kalbaugh, is a partner in Allegent Growth Strategies, a full-service consulting firm specializing in services to the insurance industry. Allegent is located in Woodbury, New York. It can be reached by phone at (516) 364-7034;by e-mail at info@allegentgsi.com or at the company's Web site (www.allegentgsi.com).