AGENCY FINANCIAL MANAGEMENT

AGENCY PURCHASE & SALE AGREEMENTS

Understanding critical parts of these
potentially overwhelming contracts

By Paul J. Di Stefano, CPA, CPCU, and Thomas Pepe

The phrase “the devil is in the detail” is an apt description of many agency sellers’ reactions when they get their chance to review the purchase and sale documents prepared by the buyer. It can certainly be overwhelming for agency principals to receive 50- to 100-page documents related to the sale of their agency. While the complexity of the documents can vary based on whether the purchase is structured as an asset or stock transaction, one can be sure that in any case, they will not be an easy read.

One saving grace is the fact that the seller’s legal counsel will be reviewing the documents and will be able to interpret and explain, where necessary, the actual meaning and import of the more complex sections of the document, including pertinent cross references. In the end, however, the reality is that the seller is the one who will be signing the documents and must fully understand them. Unfortunately, we have seen many transactions where the seller has not focused on the documents until right before the closing, having relied up till that point on counsel to do the initial review and mark up the documents for recommended changes. What happens in these cases is that the seller is suddenly confronted with a great deal of information and recommendations to understand and digest and, understandably, can easily feel overwhelmed with the process.

In light of the above, Harbor Capital Advisors believes that it is quite beneficial for potential sellers to understand the nature of the documents that they will be required to sign, well in advance of the formal closing. Our intent in this article is to address some of the more critical parts of the purchase and sale documents, which we believe are the Representation and Warranty sections as well as the Escrow sections.

The Representation and Warranty sections of the purchase agreement routinely cause many sellers to knit their brows. One of the reasons for this consternation may be the fact that representations and warranties typically survive the closing for three years with the exception of tax-related representations which for obvious reasons survive for the statute of limitations. Some of the important representations and warranties that sellers make include the following:

• Account expirations are delivered with good title
• Required insurance licenses are in place
• Appropriate E&O insurance is in place
• Commission revenues reflected in financials are correct
• Receivables are fully collectable
• Carrier payables balances are correct
• Key employees’ noncompete agreements are in place
• No adverse changes in agency’s operations have occurred

From time to time, Harbor Capital has seen clients overreact to some of the language contained in the Purchase and Sale agreement. The concept of having the total purchase price which the seller has just received being available to offset the warranty and representation claims can understandably be quite a daunting prospect to agency principals selling their agency. This perception fortunately is much worse than the reality since potential claims, under this section of the purchase and sale agreement, do not typically include a warrantee of the continuing revenue stream of the agency. What sellers should understand is that claims that would typically be made under the representation and warranty section of the purchase agreement would have been made against the agency even without a sale, and the buyer is in effect requesting protection against claims that, in fact, arose on the seller’s watch.

What the layperson might consider an adjunct to the representation and warranties are the disclosure schedules which are referenced in the representation and warranty clauses. The disclosure schedules are typically prepared by the seller listing assets and liabilities of the seller, which are being transferred or assumed by the buyer.

Financial statements and account expiration listings that the buyer relied upon in structuring the deal are also a key part of the disclosure schedules. The disclosure schedules routinely include the following information:

• Account expiration listing
• Financial statements
• Receivable and payable balances
• Office and equipment leases
• Insurance licenses
• Agency contractual agreements including sub-brokerage
• Outstanding & potential litigation
• Employment agreements
• Intermediary fees

It is quite important that the seller take care in preparing the disclosure schedules accurately since the buyer is, in effect, assuming the risks associated with the items disclosed, having been made aware of their existence. In some cases, the buyer may be willing to close without all the necessary agreements in place such as noncompetes with key employees. The seller, however, should be cognizant of the fact that he or she is representing and warranting that these agreements are in fact in place. Harbor Capital has seen cases where a producer without a noncompete agreement has left subsequent to the sale and where the buyer was able to adjust the purchase price based on the fact the representation was made that the producer was covered by an agreement.

Closely related to the representa-tions and warranties is the escrow balance that most buyers will require to be held back which is part of the purchase price. The escrow balance required by a buyer in an agency deal is typically 10% to 20% of the purchase price and is held for around 12 to 18 months. This time period gives the buyer the opportunity to clean up the balance sheet and be assured of the fact that there are no issues related to the transaction which need to be offset against the purchase price. As further protection, the seller will purchase a tail policy which will protect it against E&O claims made for incidents that occurred prior to the closing of the deal.

Part of the contract negotiations includes establishing a minimum aggregate of claims before an escrow deduction takes place. The rationale for this practice is that rather than offsetting a number of small claims against escrow, a so-called “basket” is typically established which allows the buyer to offset claims only over a certain minimum amount or basket. The actual minimum amount is typically negotiated by the parties’ attorneys on behalf of their respective clients. An escrow account is usually not required in a transaction where an earn-out is a substantial part of the deal. In those cases the buyer, instead, has the ability to offset representation and warranty claims against future purchase payments.

In summary, closing a deal can be stressful enough without additional confusion rearing its ugly head in the form of closing documents which are difficult to comprehend. Hopefully, the points covered in this article will give potential sellers some insight into the complexities of the agreements involved in the purchase and sale of an agency. We at Harbor Capital realize that early guidance in the document preparation phase of a deal can help agency principals eliminate some of the hurdles of completing a deal. *

The authors
Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a national consulting firm which offers services to the insurance industry. Services include agency appraisals, merger & acquisition representation, strategic and management consulting. Thomas Pepe is an associate director for Harbor Capital and was previously president of A.J. Gallagher of New Jersey. Tom spent six years with A.J. Gallagher. 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.