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Agency Financial Management Perpetuation planning Two sides of the same coin By Paul J. Di Stefano, CPA, CPCU In order to answer the question of “what exactly is involved in perpetuating an agency,” one needs to consider the perspective of each of the parties involved in that process. Those two parties are usually—under the most accepted definition of perpetuation—the current equity owners and those key employees who aspire to become shareholders. From the existing shareholder perspective, the concept of perpetuation means many things including: providing for future personal financial liquidity, finding a way to reward employees for their contributions and loyalty in the form of equity or job security, satisfying the concerns of the agency’s markets that an orderly plan is in place, and providing for the future of the agency and its clients. From a key employee perspective, perpetuation primarily revolves around the desire to become an agency owner with the related financial rewards and security and, in many cases, the fulfillment of previous commitments made by agency principals. It is not uncommon to think of family-run agencies when referring to perpetuation planning. We commonly hear of instances where the second generation is taking over an agency by agreeing to buy out parents. The motivation to keep the agency in the family is quite understandable, since the children are likely to inherit the agency. Lack of formality in these cases is much easier to deal with in light of the commonality of interests. Formal equity transfer plans are more likely to be consummated in situations where there is a clear rationale for such a transfer, as in the case of a key producer who controls business and has clearly contributed to the success of the agency. To avoid possible disappointments when no formal plan is in place, both sides should be realistic about the development of a perpetuation plan and how, ultimately, it may actually be implemented. Because many plans tend to be informal, with incumbent shareholders making verbal commitments to future shareholders regarding future equity ownership, little thought is given as to how a purchase will be structured—until a transaction becomes imminent. One of the greatest obstacles encountered by aspiring shareholders when they purchase an equity position is that they are buying it on an after-tax basis. This places employees at a distinct disadvantage in their ability to structure competitive deals that are attractive to exiting shareholders. Although exiting shareholders have many intangible reasons for seriously considering selling to one or more employees, the financial considerations are still paramount in most cases. Selling shareholders, unless it involves a family situation, will typically anticipate that an internal sale will be at least as attractive as a sale to a third party. Part of that consideration is the financial structure of the transaction, including how much of the purchase price is paid upfront and what, if any, security is available. In a third-party transaction, the security behind any notes that are taken as part of the purchase price is, in effect, both the strength of the acquiring agency as well as the assets of the selling agency. In addition, the business risk is moderated by the fact that the acquiring agency typically lends some diversity to the combination in the form of complementary markets as well as experienced staff. ESOPs One of the ways to address some of the issues involved in a traditional perpetuation plan is the creation of an ESOP (Employee Stock Owner-ship Plan). ESOPs are actually qualified plans that offer substantial tax benefits. The ability to deduct contributions to the plan is quite attractive to the agency because it is being done on a pre-tax basis rather than after-tax. All employees are eligible to participate in an ESOP, which may make it more attractive if the agency has a handful of rainmakers trying to keep equity in only a few hands. Having focused narrowly on situations where perpetuation is basically an internal process within the agency, the question might be raised as to how broadly perpetuation can be defined. Can it be considered perpetuation in cases where the agency is sold to a larger entity but where few changes occur to operations or management? This raises the question of how permanent a perpetuation plan actually has to be. Even in cases where an agency creates ESOPs, which are quite formal, long-term plans, many of these agencies are ultimately sold to third parties in order to buy out the ESOP shareholders. Even in agencies where formal plans are in place, opportunities arise which cry out to be taken advantage of. Take the case of an agency where various stages of perpetuation planning had already been implemented. The first part of the plan was the buyout of passive partners; the second part was a merger with an agency where the principal was to be bought out in the near future; the third part was the conversion of producers’ ownership of books of business into agency equity; and the last part was to have been the buyout of the largest shareholder. Along came a strategic acquirer whose business model would enable all parties to realize their future goals on an accelerated timetable. As they say: point, set and match. The desire to be a future partner and the desire of existing principals to have future security becomes somewhat of a balancing act for all parties. Expectations need to be realistic. In many cases, compromise is the best option for all interested parties. Because initial plans may have to be modified over time, the real objective should be to create plans that meet the needs of all parties for the foreseeable future and that are flexible enough to accommodate changes in circumstances. * The author |
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