Agency Financial Management What is your agency worth? It’s all in the eye of the … By Paul J. Di Stefano, CPA, CPCU Over the years, we have seen agency principals struggle with the challenge of how to assess agency value. In some cases, the principals initially use some of the more informal approaches to valuation, such as using revenue multiples or trying to find out the terms that a friendly competitor recently accepted for his agency. If those approaches do not bear fruit, the next step many principals take is to have an agency appraisal done. Appropriately conducted appraisals are a useful tool, and by their nature they are conservative in their approach to assessing value. The reason is that appraisals are prepared on the basis of a “willing buyer” and a “willing seller” and, therefore, are not necessarily reflective of the optimal deal situation. Establishing realistic agency value is more complex than it may seem at first glance because the value ultimately resides “in the eye of the beholder.” For example, a key concern of buyers in constructing an offer is the sustainability of the target agency’s earnings stream. Earnings sustainability, of course, is ultimately a function of many factors, including competitive markets, growth rate, ability to produce new business, quality of service and client relationships. After evaluating these factors, the acquirer must make a judgment call with regard to their effect on earnings sustainability. As I have indicated, an agency’s growth rate is a key component of value. Typically, the faster an agency is growing, the higher the multiple that would be assigned to the cash flow being purchased. There are, however, some cases where that methodology alone will not capture the real value of the agency. An example is when the seller has put in motion initiatives that are likely to result in additional material future growth that is not yet reflected in earnings. In this situation, a seller would logically expect that a deal would be structured to address that additional potential value. An offsetting argument that an acquirer could make is that after the acquisition, the agency’s organic growth may benefit from the buyer’s business model, making it difficult to distinguish between the two forces. Alternatively, in agencies where profit margins are extremely high, buyers frequently perceive a risk that current margins may be inflated and therefore not sustainable. We have had several cases where the buyer arbitrarily adjusted its pro forma P&L for the agency on the basis that, from the buyer’s perspective, profit margins were unsustainable. In that case, our client was so confident that the margins were sustainable that he was willing to agree to a partial earn-out as part of the purchase price. In the simplest terms, from a seller’s point of view, value revolves around the question: How does what I am giving up financially compare with what I am getting? Some sellers look at the process simplistically and conclude that they are effectively being “bought with their own money.” They weigh a buyer’s offer against financial scenarios where they hold on to their agency ownership and accompanying cash flow as long as possible and then sell. That reasoning may have some validity but, in many cases, a willing seller may be missing from the valuation mix. Although many agency owners may not feel immediate pressure to sell, forecasting that the future holds little downside risk may also lead these principals to the wrong conclusion. A recent example of assuming the best and ignoring the worst involved a client who had turned down offers to sell over the past several years. The agency suddenly lost a key market for a specialty program that represented a substantial part of the agency’s book of business. Unfortunately, the agency had no perpetuation plan, and replacement markets would agree to take over the program only if there was a viable perpetuation plan, which included the acquisition of the agency by a larger firm. In retrospect, those previous offers started looking pretty attractive. In another assignment where perception was a key factor, we worked with a client who had a very successful agency. It was a cash cow that for the most part “ran itself.” Believe it or not, the principal was actually becoming somewhat bored by that state of affairs and was looking for ways to get reinvigorated. From his perspective, since he took substantial cash out of the agency each year, his vision of a viable deal was one in which he could secure his future by taking a substantial amount cash off the table and still have the opportunity to participate financially in building a better mousetrap with a strategic partner. Complicating the challenge of establishing agency value in a deal setting is the flawed assumption that an acquirer will usually offer its best deal right out of the box. Unfortunately, this is rarely true. One must remember that in many organizations, financial and operational responsibilities are often divided. The operational person from the acquiring organization who falls in love with what he hears about your agency is usually not the one constructing the offer. The financial person is typically more focused on the numbers and on protecting his organization from a bad deal than on the positives of future growth and operational synergies. The initial offers that are put on the table often reflect this dynamic. Another dynamic is the fact that some acquirers are more motivated than others to close a deal. Some acquirers will not complete any acquisition unless the terms are extremely favorable to them. Unfortunately, the seller may not realize until later in the game that this is the case. Establishing a realistic valuation for an agency requires a full understanding not only of the marketplace but also of the perspectives that both the buyer and seller bring to the table. Understanding these biases is key to making good strategic decisions. * The author |
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