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BUILDING EQUITY VALUE PERPETUATION ARCHITECTURE Use a combination of financial alternatives to transfer the agency to the next generation By Wayne A. Walkotten, CPA If you want to retire within the next 10 years and have not started planning for the perpetuation of your agency, you are not alone. Nevertheless, you should be planning. The process of transferring books of business, agency leadership and stock in an effort to realize the value of your firm must begin immediately, or you may not reap the rewards of your years as an agency owner. The goal of this article is to help you understand that perpetuation is a long-term process and also to educate you on what it takes to properly guide you through this agency transition. The foundation for perpetuation begins with communication—communication with your partners and your perpetuation candidates is critical to the successful transition of the agency. Partners must first understand the personal goals of one another, each individual’s retirement plans, how this affects the agency plan, and how to transition each person away from the agency. Agency owners too often are surprised when a partner states that he or she wants to retire in one year and expects the agency or partners to buy 100% of that person’s respective stock. Outline the agency’s future and ownership opportunities with prospective hires. Such information is an effective carrot once you’ve identified a quality candidate. Agency owners today often speak about the shortage of young people who want to get into insurance and the shortage of perpetuation candidates available in the market. While these concerns are valid, how well have current agency owners educated the next generation regarding ownership potential, expectations, and the financial discipline necessary to assume ownership? How well have current owners proactively communicated the skills and goals necessary to become an owner? The problem of finding and hiring viable perpetuation candidates is greatly compounded by a lack of internal communication by agency owners. Open communication (among all stakeholders) during both the planning and transition stages of books, management, and stock will ensure the effective hand-off to the next generation. Any lack of communication may cause excellent candidates to leave the agency, unsure of the future and the opportunity that ownership can bring. Once the communication foundation is established, an agency can begin to build the pillars of perpetuation: Books of Business, Leadership, and Stock Ownership. Pillars of perpetuation Books of business. Not only must the agency have a sales culture that supports growth, but the books of retiring owners must also be transferred to capable producers and account managers over a period of time. You already know that owner books of business are rooted in relationships. As such, why take them for granted? You need to plan for the smooth transition of these relationships just as you need to plan for transitioning stock and leadership. Additionally, high retention obviously facilitates net revenue growth. All the new production in the world is great, but as your attrition rates begin to approach your new business production rates, the agency’s overall revenue growth flattens. One potential transition scenario involves the following two steps. First, retiring owners can set a minimum commission threshold equivalent to the bottom 80% of their accounts and transfer anything below this floor to the house, account executives or CSRs, if possible. The top 20% of an owner’s accounts is likely to represent close to 80% of the owner’s revenue and therefore production compensation. This allows the retiring owner to maintain the majority of his or her payroll, provides more time for new business production, and allows the retiring owner the chance to groom the next generation. Because these accounts are being assigned to producers, the agency can ultimately pay smaller renewal commissions to the new producer or assignee. This will drop additional dollars to the agency’s bottom line and thus help fund the perpetuation process. (See the example below.) We encourage a multiple year process as this still affords the agency time to find the right relationship fit should any differences arise between the insured and the producer. This example assumes that the agency is currently paying the retiring owner 30% renewal commissions.
Many agencies make the mistake of handing only the smallest and most labor-intensive accounts to new producers. This process only breeds a culture of writing small accounts, as the producers become comfortable with accounts that should be handled by a small commercial department. In addition, accounts that don’t need the higher level involvement of a producer or do not require a significant amount of time out of the office should be transferred to account managers. The support of more experienced producers can help new producers write larger accounts. Through a process of trading down smaller accounts, producers will build the agency’s book of business, which is the first pillar on which to perpetuate the agency. It also should be noted that references to the books of business are to those of the agency. It is imperative that the agency own the books of business. Otherwise the ownership rights of producers will significantly impair the overall value of the agency. Leadership. Leadership is the second pillar upon which an agency bases its perpetuation plan. This pillar relies on the sales and management leadership of the agency’s key employees. Without leadership, the agency will not have a direction—sales and management effectiveness will suffer. Strong leadership in both sales and management can be rewarded with the opportunity for stock ownership. But not all producers are great leaders, just as not all leaders are great producers. When attracting prospective employees to the agency, look for attributes that will have a positive impact on the culture of the agency. When there are gaps in the leadership or management roles, it is important to document the need and its role in the organization, and then recruit for the specific position. Owners can take two steps to help fill these roles. First, establish an organizational chart and indicate the roles and responsibilities for each position. Make sure everyone within the agency knows where he or she stands, what everyone does, and the reporting structure. Second, define both the subjective and objective criteria that an employee must satisfy in order to qualify for ownership (or advancement in general). These two steps will foster communication across the agency and help manage the expectations associated with continued development of each individual. Owners must also allow perpetua-tion candidates the opportunity to manage various functions within the organization. This will expose each candidate to the intricacies of running the business, dealing with employees, working with carriers, reviewing the financials, etc. When done over the course of multiple years, this also allows the owner to help educate and groom future leaders across all facets of the organization. Stock. Stock ownership is the third pillar of perpetuation. When one considers buying a stock on Wall Street, the potential investor weighs the risk and reward of the potential ownership. In much the same way, an agency investment has risk, and these risks influence the transfer of ownership. The rewards of ownership come through the cash returns available to owners and the increase in value over time. Current owners already know the value of ownership. Do your perpetuation candidates? Not only should the perpetuation candidate consider the risk and reward of buying agency stock, but when such a person is identified for potential equity, the current partners should be asking themselves, “Can I trust this person to buy me out?” What is the candidate’s tolerance for risk and will this person leverage his or her personal financial assets to help buy you out? The harsh reality is that the stock transfer process will need to be funded in large part by the agency. This could take 7 to 10 years. As an owner, are you willing to walk away from your agency in the hopes that someone can run the operation as well as you did and make payments to you over 10 years? Probably not. You do not want, nor deserve, to assume that much risk. This is another reason why you need to view perpetuation as a continual process. Most owners need to begin divesting stock 10 years before they plan on retiring. This serves many purposes—among them: 1. The owner can continue to manage and oversee the success of the agency. 2. The selling owner reduces the need to take large value discounts. 3. The agency still has time to reinvest in the work force in an effort to find, groom and qualify ownership candidates. 4. From a cash flow perspective, it is much easier for a perpetuation candidate and/or the agency to purchase stock over multiple years. Without an effective perpetuation plan, the ability to liquidate owner investment through an internal or external sale is in jeopardy. Agency owners should embrace qualified candidates who want to “take it away” from them. Candidates who strive to own the agency and provide strong leadership in management or sales are hard to find; so when you have one, it is important to establish a plan, communicate that plan, and follow through in a timely and proactive manner. You will most likely need to invest in several new hires before finding the right people, with the proper risk appetite, who also prove themselves worthy of becoming owners. Another relevant financial issue is the strength of the balance sheet. As previously discussed, many agency owners have been liquidating the balance sheet on an annual basis. The failure to grow the retained earnings of the business impairs its ability to weather hard times and make continued investments in producers, staff and technology. An agency should strive to build its tangible net worth to 20%-25% of its annual revenue in order to prepare itself for perpetuation. At this point it is also appropriate to counter a misconception. Many agency owners do not grow the tangible net worth of the agency because they view the value of the agency as only the book of business. However, upon a valuation of the firm, the balance sheet, whether positive or negative, is combined with the value of the book of business. Agency owners should reflect the balance sheet value in the structure of the transaction, receiving their share of the value, while at the same time not leaving the agency under-capitalized or weak in the area of working capital. Summary With the Books of Business, Leadership, and Stock Ownership pillars in place, the perpetuation of the agency can now become a reality. Through a combination of financial alternatives, the owners of an agency can effectively transfer the organization, at a fair value, to younger candidates. When it comes to the perpetua-tion transfer process, there is no “one size fits all.” The valuation of the firm, the transition of production and management, along with the compensation thereon, and the timetable have an impact on the structure of the perpetuation plan. Agency owners, regardless of age, need to start planning for the continuous perpetuation of the agency. Agency executives must then lay the foundation by communicating personal and corporate goals to stakeholders and then start building the three equally important pillars facilitating the proper transfer of books, leadership, and stock. * The author |
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