Agency Financial Management
Seller beware—Have you done your due diligence?
Make sure buyer has the financial resources and a realistic plan to fund buyout of your firm
By Lorna L. Gunnersen, CPA, CVA, CPCU, CIC
Mergers and acquisitions within the insurance industry have been at a peak during the past few years. The market is flooded with multiple types of buyers including private equity groups, top brokers, banks, and regional and local agencies.
These buyers are usually eager to add revenue to their top line, and many are willing to put forth offers at a premium. Upon receipt of a Letter of Intent (LOI), a seller may be hypnotized by the fact that years of hard work are about to be turned into cold, hard cash in the form of a down payment and most likely subsequent earn-out.
The buyer will likely send the seller a request form for a number of documents to be reviewed during due diligence, including corporate records, regulatory, financial, book of business and operations, taxes, insurance, and human resources, to name a few.
In many scenarios, the seller provides the requested information for the buyer to sift through and awaits the close of the transaction. Is that a prudent role for the seller to play?
This is likely the seller’s largest investment. A home is also a large investment; however, would a seller go under contract to sell a home without first requesting documentation that the buyer was qualified for financing? A premium offer from a “smooth talking buyer” doesn’t necessarily mean that the buyer has the ability to pay now, or in the future.
What are sellers able to do to protect themselves when divesting their business? The due diligence phase of a transaction is the time for both the buyer and the seller to get a peek at the inner workings of their future partner. Many sellers overlook this opportunity and hang their hat on the LOI and warranties and representations provided in the impending purchase agreement.
With years of transactions experience under our belt, we hear the good, the bad and the ugly from individuals in the industry who have experienced the transaction process first-hand. The following are a few examples of instances where the seller did not perform proper due diligence procedures on the buyer.
Scenario #1: Does the buyer have the money?
Periodically, we will hear a story from a seller who was “left at the altar.” Typically, the seller signs a Letter of Intent with a party that represents itself as being reputable and having the “financial backing” to consummate the transaction. The seller opens itself and its office up to the buyer’s due diligence team to review all of its operations. Meanwhile, attorneys from both sides are drafting and reviewing purchase agreements, and both parties are racking up hefty bills from advisors. However, at the last minute, the buyer walks away.
Typically, this is a classic case where the buyer is unable to come through with the financing. This may occur with private equity groups that are dependent upon investors to approve and fund the transaction as well as insurance agencies that intend to retain bank financing for a transaction.
To prevent such a scenario from occurring, we recommend that sellers inquire about the financial backing of the buyer and make sure that the buyer is “qualified” to do the deal and has the funding to close the transaction.
Scenario #2: Where is my earn-out payment?
A typical transaction to purchase an insurance agency involves some amount of a down payment with the remaining portion of the purchase price tied to retained revenues or earnings before interest, taxes, depreciation and amortization (EBITDA) over a specified future period.
Even if a buyer has the financial backing to fund the down payment on a transaction, it is critical to ensure that the buyer will be able to fund the earn-out as well. An upfront payment varies for each transaction; however, it is not unusual to have at least 50% of the value connected to an earn-out scenario.
The legal documents need to be specific about how the earn-out is to be calculated and over what time period payments will be made. Perhaps what is most important is that the seller should make sure that it has control over the components of the earn-out in the post-transaction environment.
In addition to the above, not only should the seller request that the buyer disclose its financial condition up front during the due diligence phase to determine the financial ability to fund the down payment, but the seller also should review historical financial information of the buyer to ensure that sound financial practices are in place.
The seller should be comfortable with the integrity of the buyer’s financial managers and gain a conceptual understanding about its financial practices. Does the buyer have an annual audit or review performed? Is there an active board of directors that reviews the quarterly or annual financial statements and approves transactions?
A buyer that is taking on large amounts of debt to fund multiple acquisitions should be looked at with a higher degree of skepticism. What will happen when all of the earn-out payments are triggered? Will the buyer’s debt service be too much to handle?
Scenario #3: Is the buyer financially responsible?
Unfortunately, there are many buyers out there who have all of the appearances of financial well-being; however, a good examination of their financial statement indicates otherwise. As a first indicator, the seller should calculate the trust position of the buyer. Do cash and trade receivables sufficiently cover carrier payables? If not, this should be considered a red flag.
An agency that is out of trust is likely to have poor financial management. An out of trust position may mean that it has too many overhead costs and is using policyholder premiums to fund the day-to-day operations of the company. It may indicate that management or employee compensation is too high, that debt service is unmanageable or that the company is just living outside its means.
The potential result of an out of trust position varies by state because some states do not have laws on the books to set such standards; however, in general, carriers require an in-trust position in their contracts, and employment and non-compete agreements typically refer, in general, to the fiduciary responsibilities of the employer. Thus, if an agency is not in trust, it may result in carriers canceling contracts and producers walking out the door with their books of business in tow, leaving the company with no legal recourse in either case.
Another simple exercise is to compare the buyer’s financial statements to benchmarks set by industry peers. Compare the percentage of personnel, selling and administrative costs to those incurred by peers. Is the company in line with such costs? If not, why not?
Scenario #4: How will EBITDA be impacted by hiring new producers?
A seller that agrees to an earn-out scenario will likely go to great lengths to increase its top-line revenues. Initially, one might think that the seller should hire new producers to increase revenue, which, in turn, would increase the earn-out payment.
New producers often take at least two years to validate. Thus, during the earn-out years, new producers may provide a source of new revenue; however, they will likely be compensated via a fixed salary, rather than commission, until the producer validates. Thus, it is extremely likely that during the first few years the producer will make a minimal impact on top-line revenues while drawing a comfortable salary and absorbing dollars that would have resulted in a higher earn-out payment under an EBITDA calculation.
We suggest that a seller discuss the buyer’s plan for growth during the due diligence phase and make sure that everyone is on the same page. It is okay to hire new producers, but if this is the case, make sure that they are not included in an EBITDA calculation if the seller is being paid based upon the net return of the agency rather than top-line growth. *
The author
Lorna L. Gunnersen, CPA, CVA, CPCU, CIC, is a director of Mystic Capital Advisors Group, LLC, a national mergers and acquisitions consulting firm, which focuses exclusively on the insurance industry.