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Agency Financial Management Agency appraisals and deal structures What is fair market value? By Paul J. Di Stefano, CPA, CPCU During a recent meeting with a new prospective client, we discussed having Harbor Capital complete an appraisal of the agency. The subject came up because the agency had been approached on two recent occasions about selling or merging. The idea did make some sense, but the principals were wrestling over how to move the process along. One of the partners was looking to retire in a few years while the younger partner was eager to move the agency to the next level. What began between Harbor Capital and our client as a discussion of the appraisal process evolved into a request to have us represent the agency principals in any potential sale or merger. The question raised in our discussion with the client made it clear that an appraisal would just be the starting point in the complexities of the merger and acquisition process. Our client’s philosophy was simple: “Why take the risks of going through the merger and acquisition process without a high probability of a positive outcome?” As we discussed the appraisal process, the question arose as to what exactly was fair market value. The classic definition is found in IRS Revenue Ruling 59-60, which defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell; both parties having reasonable knowledge of relevant facts.” A common point of confusion regarding appraisals is whether or not the fair market value arrived at is based on some specific anticipated deal structure. Fair market value established in an appraisal is typically based on the equivalent of a cash transaction. The competitive nature of the merger and acquisition business ultimately dictates what the final deal will look like. Remember, deals consist of two elements: price and terms. Price is the total amount that a buyer is willing to pay and that can be guaranteed and/or contingent, and terms are over what period the buyer will pay the purchase price. Both elements must be considered in comparing competing offers. A buyer who is aware of all the facts surrounding a deal will construct a proposal with a guaranteed purchase price. The buyer will effectively discount the purchase price to reflect the risks normally encountered in a structured transaction involving future performance. For example, agencies often have ambiguities in the ownership of producer-controlled books of business. While the appraisal may take this fact into consideration, the appraisal will not show how to structure the deal to address this issue. In the case of a producer without a formal contract, the ultimate structuring of a deal typically would be based on negotiations among the acquirer, the seller and the producer. A formal appraisal would identify this situation as a risk factor and discount the agency value appropriately. While a qualified appraiser can usually establish a range of value, the real test of how much an agency is worth comes with an actual negotiated transaction. In that environment the dynamics of the marketplace can come into play through negotiation. The marketplace sets the value of an agency because all buyers are evaluating the same set of conditions and circumstances. We are and have been in a period of substantial demand for agency acquisitions from a number of well-qualified, motivated entities. A major challenge, however, is to actually qualify those buyers. Many agency principals are under the impression that banks will pay the highest purchase price in an acquisition. History has shown that banks, at least in the recent past, have been motivated buyers and willing to pay up to the high end of a fair range of value, but they are far from cavalier with their money. While the deal process can be simplistically viewed as an auction, the reality is far more complex when one introduces the personal and cultural factors. Given the pressure of competition, prospective buyers must determine how far they are willing to go with their acquisition proposals. One should be realistic and keep in mind that buyers will pay only what they have to in order to secure a deal. Some buyers balk at the notion of “getting involved in a bidding process.” Sellers should be wary because this may be code for the fact that the prospective buyer is looking for a one-sided deal and has no intention of being competitive. Some buyers actually have the nerve to bristle at the notion that the sellers are hiring an intermediary to advise them. We have found that the majority of agency owners are not aware of many of the elements involved in the process of selling an agency. Structuring a transaction that both protects the seller and maximizes value is more complex than it might seem at first blush. Although having an agency appraisal is an important first step, before embarking on a negotiation, principals should be armed with the knowledge required to address any and all issues that may arise out of those negotiations. Acquirers that have completed other deals have the advantage over the agency owner who has not gone through the process previously. Prospective sellers can level the playing field by hiring a merger and acquisition intermediary to guide them through the process. * The author |
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