|
Agency Financial Management Agency Mergers—Increasing Probabilities for Success Assessing relative agency values, risk factors and, most of all, the trust factor can lead to a successful merger By Paul J. Di Stefano, CPA, CPCU
We have all heard of the horror stories related to agency mergers. In fact, we have commented on many occasions that one of the more difficult things to execute is a successful agency merger. While the benefits of a particular merger scenario may sound excellent when discussing it conceptually, when the parties attempt to agree on the financial aspects of the deal, the real issues that need to be addressed quickly arise. Relationships are quite important when considering a merger. Some of the most successful mergers that we have seen typically involve agency principals who have known each other over the years, possibly as respected competitors. One should not underestimate the value of the trust factor, which is based on a perception of the other party’s integrity. That trust factor can become a critical element in overcoming merger roadblocks. Making concessions in the negotiation process is a lot easier if you feel you can trust the other party. Often, the lack of in-depth knowledge of the other party can be a key factor in preventing a deal from moving forward. The other approach to a merger is when two organizations that are unfamiliar with each other’s history get together. In an attempt to shortcut the process of negotiating key issues, the suggestion is made to put an escape clause into the merger agreement. The escape clause basically lets the deal unwind if one party decides that the deal was a mistake. While this may seem on the surface to be a good safeguard, the reality is that it creates an illusion of protection that may cause more problems than it solves. In most cases, the due diligence process and the post-merger operational plan are never completed because both parties now have the false security of knowing they can part ways if they are not happy with the merger scenario. That concept seems quite simple until both parties actually try to unwind the combined operation. Instead of working to make the merger a success, the tendency may be to bail out before giving the deal a chance to work. Typically, a merger involves the exchange of equity in a new or existing privately held organization. Laying out an exit strategy for the new partners is a key element in a privately held agency. In defining the exit strategy for shareholders, two elements must be addressed: the valuation of the shares to be repurchased and the terms under which the purchase price is to be paid. In most cases, shares cannot be sold to third parties, but must be sold back to the agency or other shareholders. In reality, the sale of stock back to the agency is the only alternative because in most cases third parties will not entertain the purchase of a private equity interest, particularly a minority interest. Success stories We have seen many examples of successful agencies that were formed by way of a merger. As you will see, these success stories, although they may involve different structures, do have common elements. One of the more successful models we have seen is based on a fairly simple formula in which the partners agree to split the earnings of the agency on a proportional basis. One merger involved four separate agencies. Each had a successful business built around the principal, who was the key producer. To get to critical mass, a deal was arranged where each original corporation retained ownership of its existing book of business. New business was owned by the newly formed holding company. In this particular merger, in recognition of the need for a titular head for the agency, one of the partners was made president and compensated with a salary for performing the required duties. Of course, on all major issues a consensus would be required to approve these initiatives. In some instances merger discussions become quite complicated when it comes to the roles people will play and how they will be compensated for those roles. Principals sometimes confuse owner compensation with market compensation or what generally would be paid to hire an outsider to assume a role with similar responsibilities. It can be equally difficult when principals’ roles need to be sorted out because of overlapping responsibilities. The recommended starting point for any merger discussion is an assessment of relative agency values. We have seen parties to a merger handle this issue in various ways. There are what I call the formal and informal techniques. The formal technique involves bringing in an appraiser such as Harbor Capital to complete a formal valuation of both entities. By their nature, valuations involve determining sustainable revenues and profitability for merger participants. This requires a critical review of the operating results of the agencies and the application of appropriate valuation multiples, which to an extent are developed with regard to what we call “risk factors.” In general, risk factors assess the probability that the current agency business model will be able to survive in its present configuration. Risk factors are a somewhat subjective call based on the experience of the appraiser. While it may be easy for an experienced appraiser to value multiples based on risk factors, it is another challenge to communicate that concept to a merger partner who may be getting a lower valuation multiple applied to operating earnings. The less formal approach to equity distribution is routinely used in early discussions by principals who are prospective partners. Principals are expected to come up with a rough estimate of what equity distribution may look like. This involves looking at profit and revenue to calculate how the parties’ shares of equity will sort out. The danger of casually discussing equity splits is that it may be difficult to change after a more formal assessment. Of course, there is a bit of horse trading involved in negotiating the terms of a merger, and here is where many mergers may begin to unravel. The overriding question that the merger partners must answer is: What is the potential upside of completing the merger? Will it, in effect, build a better mousetrap? If the answer is yes, the perceived upside from a merger should more than offset any perceived equity imbalance in the initial construction of the deal. The view of the upside for all parties should be the motivation for some give and take in the negotiation process. In another transaction, three merging agencies placed their books of business into a newly formed holding company in exchange for stock in the holding company. The parties agreed that all operating profits were to be divided among the shareholding agencies for ultimate distribution to the individual shareholders of each agency. This model avoided a number of problems, including splits between individual shareholders of each agency’s partners and expenses being written off through the business. Rather than arguing about what expenses should be run through the business, all parties take care of discretionary expenses through their own corporate vehicles. The probability of executing a successful merger is usually inversely proportional to the number of entities involved. As with any negotiation, it is difficult enough to satisfy two parties. Having three or four merger parties at the table tends to geometrically increase the complexity of the task. That having been said, as you can see from Harbor Capital’s experience, we have seen a number of successful mergers take place with multiple entities. As we indicated earlier, the key to the success of those mergers seems to be the fact that the principals knew and respected each other and were able to review each other’s operations and agree on what seemed to be fair terms. The motivation behind most merger discussions is usually to get to a critical mass much more quickly than the individual agencies could accomplish on their own. Putting together a sound business plan is critical in exploiting the talents of the participants and capitalizing on the upside opportunities. The challenge is to structure a viable deal under which the merger partners can operate successfully. One client succinctly stated: “Shame on us if we can’t structure a deal to take advantage of the opportunity we all know is there.” * The author |
||
|
