Today’s
acquisitive marketplace has put the option of a
merger or sale in front of many agency owners, but
if you’re making a good salary and annual growth has
been in the double digits, you might think that
selling now would be killing the cash cow.
Not necessarily.
When you perform a detailed financial analysis, you
might find that the cash cow is producing skim milk.
Indeed, to assess the true value of a potential
sale, you must compare projected growth and tax
ramifications against an investment portfolio
created from sale proceeds after taxes.
Factors that could
tip the scale toward selling include:
-
The tax
differential on capital gains versus ordinary
income.
-
The present
value of invested funds.
-
The
uncertainty of future market conditions.
Also consider the
possibility that your agency’s rate of growth could
flatten. Essentially, you would then be working
harder while earning less.
Many agency owners
closely track their growth rate and resolve to sell
at the time that rate is cresting. Ask anyone on
Wall Street how risky a game it is to attempt such
timing in the markets.
When you delay the
decision to explore consolidation or disposition of
the business, you are betting the future on
uncontrollable factors.
Tax
Considerations
Perhaps the
biggest factor in the sell-vs.-continue
equation is in taxes.
In 2003, the
federal government presented agency owners
considering a sale with a 25 percent reduction in
tax liability—by significantly reducing the capital
gains tax rate. The tax rate of 15 percent on
long-term capital gains can have a significant
impact when compared to the effective ordinary tax
rate for a high-earning individual, which could be
39 percent.
Many times, too,
the acquiring company will desire—or insist—that the
selling principals continue working for the
business. Far from being a drawback, this offers
great benefits. You can continue to earn income and
stipends, and the sale has substantially reduced
your personal financial risk.
If agency owners
have most of their personal worth tied to their
businesses, the timing of a sale may be even more
crucial.
In today’s
competitive landscape, consolidation may be the only
way to remain viable—especially in the middle and
larger markets, where competition is fierce.
Also, alignment
with a larger organization provides professional
opportunities for a leadership role within a larger
organization. The greatest benefit is minimization
or removal of personal risk to the owner by
obtaining liquidity for ownership in the agency.
Right now, the low
cost of capital is making acquisitions quite
attractive, but that equation will change. As banks
and second-tier brokers build their networks, the
acquisition pace will inevitably level off as supply
will be greater than demand.
When it does,
market stabilization of product rates will result in
very modest, incremental revenue growth—or even
declines. Rate declines (market softening) will
result in elevated direct expenses and earnings
deterioration.
Because the
valuation of a business is based upon revenue and
earnings trends, such leveling or a decline will
certainly mean lower valuations for agencies on the
market. This would be further exacerbated by the
shrinkage in demand for agency acquisitions among
the leading acquirers.
Finally, there is
no guarantee that today’s low capital gains rate
will continue into the future. In fact, there
already is speculation that the tax cut would be
quickly abolished if a Democrat should be elected to
succeed President George W. Bush in the next
presidential election.
To fully weigh the
options, agency owners must understand the concept
of monetizing their agency versus a “steady state”
course. The playing field must be equalized to be
able to compare the two scenarios.
The net difference
can be seen by looking at long-term cumulative
results, and by comparing these results on a
tax-effected, discounted, present value basis.
Monetizing Vs.
Steady State
To be, or not to
be on the market?—that is the question. Whether it
is wiser to seek a sale can be objectively compared
by creating a numerical pro forma of continuing
operations at a presumed growth rate. Assumptions
can be made about many predictable elements of the
equation.
Comparisons must
include these key input variables:
-
Current agency
market value.
-
Current owner
compensation.
-
Length of
employment time for the owner after acquisition.
-
Any debt or
leverage carried by the agency.
-
Presence and
stability of any minority shareholders.
-
Reinvestment
requirements.
Using these
variables, the firm’s expected growth rate and a
market-based approach to agency valuation,
projections can be created to compare selling versus
remaining as-is.
Do The Math
The following
scenario outlines an evaluation using a formula
developed to assess sale versus continued
operations:
-
Begin with the
projected net tax-effected cash flow under
normal operations for future periods.
-
Add the market
value of the agency at the end of those future
periods (tax-effected and discounted to present
value).
-
Subtract from
this number the current market value of
disposition (factoring in any earn-out or
deferred purchase), yields earned on invested
sale proceeds and post-transaction compensation
earned by the principal (all tax-effected and
discounted to present value).
-
The resulting
number will show the value of immediate sale or
disposition versus continued operations.
If the result is a
negative number, there is deterioration in
shareholder value and a merger should be considered.
On the other hand,
a positive number supports a premise that the
business shareholders would be better served by
continuing operations.
To effectively
evaluate the assumptions, several scenarios should
be modeled.
For instance,
assume earnings growth rates (using EBITDA—earnings
before interest, taxes, depreciation and
amortization) of 5-, 10- and 15 percent. Although
some firms show double-digit growth rates going back
a number of years, it is not wise to assume those
healthy rates will continue forever.
Also, it is best
to model several possible sale dispositions, such as
the agency selling for 7.5, eight or 9.5 multiples
of present annual earnings. These variables will
balance the overall impact of a severe, moderate or
favorable environment, and thus provide parity in
the overall comparison.
Add It Up
Take, for example,
an agency with current cash flow of $6.6 million.
Assume growth rates and market multiples as
mentioned above.
In a baseline
scenario (see the accompanying table), we would
assume an expected growth rate of 10 percent and a
current market multiple of eight-times earnings.
Other factors are
reinvestment in growth at 20 percent of earnings and
a discount of 18 percent to arrive at present values
for cash flows and for the agency.
The bottom line
result is a present value of $44.6 million, if the
business remains as-is.
For an acquisition
model, we would assume a total purchase price of
$52.8 million (current cash flow of $6.6 million
with a market multiple of eight), paid out by the
buyers over three years.
We assumed two
more key elements:
-
That the
principal stays with the business for five years
after the sale (at an initial compensation of
$400,000, that grows by 15 percent annually).
-
That the
investment rate for the proceeds from the
agency’s sale is 8 percent (pre-tax).
The result of this
model shows present value to the principal—through
the investment portfolio and net compensation—to be
$60.4 million.
Thus, in this
case, the net benefit of selling versus continuing
is $15.8 million. In fact, in this case it would
take a sustained 25 percent annual growth rate for
the numbers to tip in favor of continuing operations
rather than selling.
While this
analysis (the numbers are from an actual recent
case) showed the wisdom of selling the agency, the
next case might show the opposite.
Indeed, every case
analysis provides different results. Many times, the
shareholders are better served by continuing
operations. Before embarking on either pathway, it
is prudent to obtain this type of analysis.
Any evaluation
must include realistic assumptions and must take
into account both tax rates and the value of an
investment portfolio.
Once a financial
analysis is in hand, intangible factors such as
succession planning, risk reduction and
uncertainties in the acquisitions market may be
considered.
Only then can a
sound decision be reached—whether to milk that cash
cow, or put it out to pasture.
Steven S. Wevodau ,
managing partner of WFG Capital Advisors in
Harrisburg , Pa. , is co-author of the “2006
Insurance Mergers & Acquisitions Insights
Sourcebook,” published by The National Underwriter
Company. He may be reached at 717-780-7800.
