BEYOND THE NUMBERS GAME:  Do financials tell the whole story?

Leader's Edge Magazine - April 2005
Author:  Robert J. Lieblein  

Many agencies today rely too heavily on historical and even projected financial information in determining the value of their firms. Too often, they try to back into industry multiple norms, such as “seven times EBITDA” (earnings before interest, taxes, depreciation and amortization) or “1.5 times revenue.” But the numbers that industry insiders use as a rule of thumb are not necessarily appropriate valuation techniques. An experienced professional will consider a lot more than just those numbers, and if you’re evaluating your own agency, you should consider them, too.

I can make a sound argument that only half the value of an agency should be based on an objective financial analysis and the other half should be a subjective non-financial analysis. Revenues and earnings simply do not tell the full story of your firm. Do you have two “key” producers who account for a large chunk of your revenue? What is the risk that they might leave to go to a competitor or start their own agency? What is the quality of your earnings? Are you a “one-man band,” or have you created a strong management team? These are just a few many factors that must be evaluated, and the leader of the firm is the only person in the position to really know what’s nestled in leather in his back pocket.

Don’t Fear the Matrix

While it’s tempting to simply blue-sky the non-financial evaluation of your firm, you’re best served by a thorough, honest assessment. The assessment should start with a list of the top 10 criteria that both you and an independent third-party would consider important in analyzing your agency. While some people provide equal weight to all criteria, it makes more sense to assign each factor a rank and a score. Then you can add up the score to see where you stand.

The following list of “top 10 criteria” is a good starting point for most agency assessments. The example below includes one objective factor—historical financial performance—but even that is really driven by non-financial matters. The list ranks criteria in the order of importance to your success, with 10 being the highest and 1 being the lowest. While this might seem counter-intuitive in our “we’re No. 1!” society, the reason will soon become clear.

Next, assess your current status with regard to each of the criteria, giving score of 1 to 10, with 10 again being the highest. Let’s evaluate the top three.

10—Management: You have a strong management team at all levels that are actively involved in making operational and strategic decisions. Score: 9 points.

9—Growth potential: The firm enjoys historical high growth rates that can be increased through additional service and product capabilities and more effective cross-selling. Score: 8 points.

8—Book of business: Although you have a good mix of large- and small-business customers, you’re focused on selling to the construction market and, therefore, are not well diversified. Score: 6 points.

Multiply the rank by the score for each, then review the totals and percentages:

So, what does a 78% mean? How does this translate into how a buyer might value your firm? Here are some rules of thumb for how a composite score translates into value.

Composite Score

90% to 100%: You were way too kind to your agency in your assessment. Try again! In all seriousness, most firms would not really rank this high if a candid assessment were done properly.

80% to 89%: Your firm is very well managed and would be considered a high-performing agency. Translated into a multiple of EBITDA, this would be at the high end of the range, assuming a “normal” valuation range of 6 times to 7 times EBITDA. Deserves a market premium.

70% to 79%: Good, solid firm that has areas for improvement but no major weaknesses. Would almost definitely be valued in the normal range and possibly deserve a slight premium.

60% to 69%: A typical mid-sized firm with one or two areas that definitely need improvement. More than likely, significant “power” with one or two key employees (e.g., the owners), a weak second-tier management, too much concentration in the book of business and lack of depth in staff. This is the “typical” agency. Valuation would be average or slightly below average.

50% to 59%: Same as last ranking, but probably with financial performance that is below the average of your peer group. Your valuation would probably be 6 times EBITDA or below.

Below 50%: Several areas need significant improvement. Depending upon exactly what those areas were, they could significantly impact not only valuation but also how attractive you are to a third party. Definitely a multiple below 6 times EBITDA.

This approach allows you to see how you are doing overall and how this affects the value of your business. Perhaps more importantly, you can use the individual evaluation scores to see which elements of your competitive strategy would pay the highest dividends if their scores were improved. In this example, you’d be much better off diversifying your mix of business products than focusing on changing your management structure.

SWOT, That’s What

The evaluation of non-financial criteria sets the stage for true strategic planning. Your strategic plan cannot be developed without performing an analysis of your strengths, weaknesses, opportunities and threats (SWOT). The SWOT analysis is a vital self-assessment because it forces the introspection necessary to fully assess your competitive and market position. By completing a SWOT analysis, you can further apply a formal process to improve non-financial matters that can increase shareholder value.

This is what the SWOT analysis would look like for the previous example:

Now you’re getting warmed up. To fully complete this evaluation, consider all aspects of your operation by going down that list of your top 10 criteria, and penciling any conclusions into your S, W, O or T columns. Your assessment might include the following areas:

• Are earnings highly dependent on contingents? A history of solid performance (steadily increasing revenues and profits, without dependency on contingents) would tell a third party that your agency is well-managed.

• The profile of your book of business may also reveal your client base stability and potential for future growth. Do you have high retention rates? What is the average account size? What are the loss ratios? Just the fact that you can track and manage client profiles and have it listed on your top 10 criteria may indicate that you are a forward-thinking manager.

• Does your staff productivity track with industry averages? If not, is this a weakness that can be corrected? Do you have non-compete and/or non-solicitation agreements in place? What is the age of your work force?

• Consider how your management is structured. Is your second-tier management strong? Can you go away for two weeks and not worry about how the business operates?

• How strong are your firm’s relationships with the carriers it represents? You hope they are an important partner, which will translate into better contracts, additional staff training and other benefits. What is the financial strength of your carriers, or do you have carrier concentration?

• Analyze your public image. Are you perceived to be a market leader or are you just another name in the Yellow Pages?

 
Gamble Your Future? No Dice

Now that you’re on a roll, look beyond your top 10 criteria to other non-financial aspects of your business that may prove to drive—or detract from—value.

Intangibles that may add value to your firm are things like:

• specialty or niche products;

• unique skill sets of staff members;

• technology advantages over the competition;

• unique carrier relationships; and

• competitive advantages in your market.

By taking the time to explore and explain these potential value drivers, you will get a better understanding of how these items can increase shareholder value.

What about those factors that detract from your firm’s value? Perhaps you’ve been meaning to create a mentoring program after you lost a promising producer who wasn’t being given the tools needed to succeed. Or maybe your client retention rates are below industry averages, and client service needs special attention. These are things that need to be addressed in your strategic-planning process. Do you need to develop a formal training process, or hire a human resource manager? The answers become very clear.

You can’t fix a problem if you don’t see it. In strategic planning, you can’t address issues that affect your shareholder value if you don’t identify those issues. They need to be clearly understood, which sometimes requires brutal honesty from the firm’s leadership.

When identifying non-financial factors that will affect the value of your firm, a complete and thorough operations analysis is the starting point. Your firm’s future may lie well outside the contents of the company wallet. Don’t let someone tell you that your brokerage’s value can be calculated simply by an equation related to your revenues or earnings. As a well-known consultant once said, “You can never know too much about a business, but you can certainly know too little.”

 
Lieblein is a contributing writer and managing principal of WFG Capital Advisors.  rlieblein@wfgca.com