Although developing an internal perpetuation plan seems like a relatively straightforward process, the fact is that many issues must be addressed when contemplating the ultimate buyout and retirement of the majority shareholders.
AGENCY FINANCIAL MANAGEMENT
By Paul J. Di Stefano, CPA, CPCU
Changing circumstances can necessitate
the reassessment of a perpetuation plan
Although developing an internal perpetuation plan seems like a relatively straightforward process, the fact is that many issues must be addressed when contemplating the ultimate buyout and retirement of the majority shareholders.
In the course of Harbor Capital Advisors' consulting practice, we discovered that the many agencies do not have formal perpetuation plans. A number of these agencies are family-owned agencies whose continuation plans are based on the assumption that the second generation members will "inherit the earth." Similarly, other agencies have informal understandings among key individuals within the agency that they will be the future owners.
All perpetuation plans are based upon the best information available at the time; however, everyone should be open to opportunities that arise from changing circumstances. For example, a merger opportunity may surface and should be considered on a strategic basis. Those individuals who are expecting to buy out the principals could see this as a threat to their future, when in reality it may be an opportunity. Even those agencies with ESOPs have from time to time decided to sell to third parties when that has proven to be the right decision for all the equity holders.
While it is understandable that agencies might struggle with any change to their formal perpetuation plans, we have also encountered agencies that are ambivalent about addressing the issue of altering informal plans. The problem usually centers on the fact that internal perceptions about the perpetuation issue may vary among those individuals who will in theory benefit from those plans.
A perpetuation plan is an exit strategy for agency principals. Initial decisions regarding agency perpetuation may well have to be altered over time if the plan is no longer the optimal financial and operating strategy. One of the primary reasons for altering previous decisions to perpetuate internally is that the dynamics of the insurance marketplace have changed. For example, in today's overheated merger and acquisition market, it might be decided that an original plan to perpetuate the agency internally should be scrapped for an outright sale to a third-party acquirer who has approached the agency with an outstanding financial offer.
Building a consensus to change course in midstream is usually far from easy. Although in many cases the controlling shareholders can make this decision unilaterally, the realistic approach would be to bring on board any minority shareholders and those individuals designated to perpetuate the agency. In a case like this, building that consensus requires focusing on the specific opportunity at hand and assessing its perceived and actual impact on all interested parties.
A great example of building a consensus involved a family-owned agency client of Harbor Capital Advisors. The senior principals were approached with--as the prospective well-funded buyer described it-- "an offer that they couldn't refuse." The problem was that the principals had committed themselves to turning the agency over to several members of the second generation who were active in the agency. The magnitude of the unsolicited acquisition offer forced the family as a group to revisit the original internal perpetuation commitment.
After objectively considering the facts, those involved concluded that the risk/reward ratio for all family members had shifted dramatically. When considering the net revenue to be derived from the sale with the newly enacted reduction of capital gains tax rate of 15% to the present value of the income stream taxed at ordinary income tax rates, a third-party sale scenario appeared by a wide margin to be the option to take. Another key element of the decision process was a consideration of the risks associated with sustaining the current cash flow of the agency over the next five to 10 years. The risks that the second generation would assume in purchasing the business now outweighed the potential rewards when compared to the tender offer.
Although the economic facts were clear in this case, other intangible factors had to be considered, including the emotional ties to the ownership of the agency. In addition to the purchase consideration, it was clear that it was in everyone's ongoing best interest to consummate the transaction because the acquirer had a business model that would greatly enhance the future compensation prospects for the second generation. This case is reminiscent of the decision by the Rockefeller family to sell Rockefeller Center to the Japanese at the height of the real estate boom of the 1980s.
In cases like this, other intangible factors can be at work, including ambivalence about the prospect of working for a large organization. This initial reaction is understandable, especially when the second generation has worked only in the protective environment of the family business. Unfortunately, perceptions all too often become reality. They are best dealt with through discussions with the buyer in which the culture and related philosophy of the buyer become more fully understood. In this case, the second generation members were minority shareholders. Discussion becomes less difficult when all parties will be rewarded with the security of participating in the proceeds of the sale.
Another example of changing plans is when the majority shareholder creates a perpetuation plan dependent on key individuals who may or may not be existing shareholders. In many instances, these individuals may become reluctant to "pull the trigger" and take on the risk associated with a purchase. A case in point was a small agency with a specialty book of business. The older partner was in his 70s and had planned to have his younger assistant, who was a minority partner, be the perpetuation of the agency. This individual decided, after careful consideration, that he was not willing to assume the risk with a buyout. In light of this development, both parties asked Harbor Capital to search for a compatible acquirer.
A third example of best-laid plans having to be altered involved an engagement involving two partners with a 25-year age spread. The younger, more aggressive partner had built the firm through acquisition. The senior partner had already started working an abbreviated work schedule, and the beginning of a multi-year buyout by the younger partner was about to commence. Unfortunately, the younger partner encountered serious health problems which mandated that the senior partner fill in. Although the younger partner recovered, the buyout plan had to be scrapped because the younger partner made a decision to exit the industry in favor of less stressful pursuits. The resolution of the problem was to bring in a buyer who could accommodate the senior partner's desire to slow down, as well as the desire of both partners to be bought out.
The financial ability to consummate a perpetuation plan should be of paramount concern to all parties. The following example highlights how problems can occur. A son had the opportunity to buy out his father's minority equity stake in an agency. Since the buyout would be made with after-tax dollars while the father was still active, the son would not have sufficient cash flows to take on the full buyout obligation. The solution was to have the other shareholders buy a portion of the retiring father's equity.
Although developing an internal perpetuation plan seems like a relatively straightforward process, the fact is that many issues must be addressed when contemplating the ultimate buyout and retirement of the majority shareholders. Basic issues to consider in starting the process include buyout structure, participation and timetable. Aside from the question of valuation, one of the primary concerns of exiting shareholders is the security of the buyout and whether or not the exiting management team will be capable of running the agency in a profitable manner, sufficient to satisfy the buyout terms. Concerns of those participating in the perpetuation scheme should include before- and after-tax cash flows supporting the transaction as well as possible personal guarantees which may be required.
Developing an agency perpetuation plan is more than an exercise in number crunching. We can point to the successful conclusion of a number of recent perpetuation-related assignments that came about only after the participants had expended a great amount of time and effort on the perceptions and needs of the principals, as well the key players within the agency who are typically minority shareholders, producers, or others who are instrumental to the success of the agency. *
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 and acquisition representation, strategic and management consulting. Harbor Capital Advisors, Inc., can be reached in New York at (800) 858-2732 and its Web site can be visited at www.harborcapitaladvisors.com.