Changing Seasons for Agency Values

Independent Agent Magazine
By Susan L. Hodges
October 2004

You’ve heard it more than once: The time to conduct an agency valuation is when you’re anticipating a financial event, such as the sale or perpetuation of an agency, or the distribution of stock in an Employee Stock Ownership Plan (ESOP). In the absence of such events, experts traditionally advise a new valuation only once every three to five years.

But if you haven’t valued your agency in the past 18 months, the time to do it is now. Why? Market conditions and the U.S. economy came together to produce the highest agency values in history in 2003. And if you’re not acting to preserve those values, your agency will begin to depreciate by the end of 2004. That’s right: One year of maximum value will be followed by several years of decline.

Spectacular 2003: The Perfect Storm

First, the hard market’s soaring premiums earned agencies as much as 30% more than usual on renewals in 2003. At the same time, expenses grew at a much smaller rate. As a result, some agencies projected annual growth rates of as much as 25% last year, which greatly enhanced their value.

Second, carriers and agencies have increased their use of technology, spawning an unprecedented opportunity to boost agency profits through new efficiencies.

Third, interest rates continued at historic lows in 2003 and are still extremely reasonable, even though the Federal Reserve has raised them twice recently. Low interest rates, of course, make it cheap to borrow money.

Normalizing the Agency Financial Statement Even after a detailed discussion of valuation, it’s still fair to say that some agency owners put them off because they dread the thought of all the pro forma adjustments. But normalizing revenues and expenses shows how an agency would look under new ownership – and it’s a discipline that every agency should undergo. Here, then, from Wayne Walkotten of Marsh, Berry & Company, Inc., is a list of the more common adjustments made to income statements to show the return available to a new owner. Revenue Adjustments Commission Income – Remove the commission of extraordinary lost accounts or extraordinary commissions, such as a large, first-year life policy. Contingent Income – Examine the pattern of the last three to four years and the trend in loss ratios. Depending on this analysis, a three-year average may be appropriate. Special Production Bonuses – Remove non-recurring bonuses on production from the revenue stream. Investment Income – Allow credit for the investment income earned on the float on agency bill/ insurance company payables. Extraordinary Income Items – Remove non-recurring revenue, such as gain on sales of investments or assets. Expense Adjustments Selling Expenses – Eliminate excess travel and entertainment expenses, including those in excess of normal business expenses or those that are not benefits offered to employees functioning in a similar capacity. Automobile expenses must be legitimate, ordinary, and necessary for the position. Owner or Executive Compensation – This is compensation, whether salary, bonus or commission, paid by a third-party owner to hire the services of producers and managers. Compensation above and beyond that which is received for production and executive duties is considered owner return, and should be removed. Service and Support Payroll – Must be adjusted to reflect the annualized cost of new hires, and the elimination of terminated employees.  --S.H.

Fourth, capital gains taxes fell to 15% (from 20%) in 2003, and will remain there until 2009 unless revised earlier. Together, these four factors have created a happy paradox: Agency values are high, taxes are low, and inexpensive interest rates make it attractive to buy, sell or perpetuate.

Moderate 2004: Look Out Below

But here’s the catch: A hard market “covers a multitude of sins,” says Tom Doran, senior vice president of Reagan Consulting, Inc. in Atlanta. Agencies that haven’t reinvested their profits have grown alongside better-managed agencies, thus creating a false sense of security. And now the hard market has begun to soften. “We’re now in a market dictated by 8 to 10% increases in premiums,” Doran says. Already agency growth projections are down from 20-25% to 7-12% going forward, he notes. The upshot: Weaker premium growth will result in lower agency incomes and values as early as this year—unless owners find other ways to grow.

So even if you’re not planning a financial move for another five years, now is the time to conduct a valuation. A new valuation will reveal your agency’s true location on the road to its future. And if those coordinates aren’t as well placed as you thought, you’ll have time to make corrections that will put your agency back on track.

Ken Felten hired a consulting firm to value his agency earlier this year because he is considering a merger. Felten & Associates is a Vero Beach, Fla. agency with $2.5 million in annual revenues. Although the agency was considered good-sized not many years ago, “We’re becoming small now in the scale of things, and I’m concerned about our ability to compete,” Felten says. Merging with a larger agency will allow Felten to continue getting paid and possibly maintain a certain amount of autonomy while doing so.

“This is a unique time in the history of independent agencies,” Felten says. “The synergies coming together now justify agency owners’ need to know what their businesses are worth.” Not only does valuation clean up your financial statement and help you create a more profitable environment; it also tells you if you’ve created enough equity to execute a successful perpetuation.

How did Felten & Associates’ valuation turn out? “I was pleasantly surprised and pleased,” Felten says. “I’m fortunate to own a vibrant and profitable agency.”

Magic of the Five Year Mark

If your own valuation doesn’t produce such sparkling results, give yourself as much time as possible before making a major move. Within five years, for example, an agency can bolster its value substantially by implementing new sales activities, entering new markets, trimming expenses and writing a better grade of business. And by paying closer attention to carrier contracts, agencies can often produce more volume and with it, more clout—another factor that increases agency value.

“So many owners of very small agencies mistakenly believe that their businesses are worth one-and-a-half to two-times revenue,” observes Wayne Walkotten, a senior vice president at Marsh, Berry & Co., Inc. in Grandville, Mich. But an agency with less than $1 million in annual revenues “is often just an extension of the owner’s pocketbook,” he says. In other words, owners of small agencies tend to take most of the profit out of the business, instead of reinvesting in the agency. Examples: Children who don’t really work for the agency are listed on the payroll. Automobile expenses of the stay-at-home spouse are claimed as deductions. “Owners need to recognize that when they do these things, they’re taking out a percentage return on the business,” Walkotten says.

The same thing happens when agency principals fail to hire new producers, acquire new technology or enter new markets. “Owners make a choice not to reinvest the value of their agencies,” says Walkotten. They may save money in the short term, but over the long term, they end up cheating themselves.

Mike Herlihy, president and CEO of Farmington, Conn.-based InsurBanc, an IIABA-affiliated bank serving independent agents, agrees that now is “an extremely good time” to think about perpetuation and seek advice on putting a successful plan in place. A successful plan, Herlihy says, is “one that allows the selling generation to accomplish its retirement goals while enabling the succeeding generation to purchase a growing agency with a strong financial future.”

An agency valuation tells everyone involved not only the value of the business, but its strengths, weaknesses and potential areas for improvement. “You’ve got to start the perpetuation process sometime,” Herlihy says. Independent agencies are financial services companies that sell advice and manage risk for their clients. But “they spend so much time taking care of clients, they’re slow to take care of themselves,” he says. “You know, it’s the barber’s child who always needs a haircut.”

Put a Number on It

The agency owner who can put a value on his own agency is rare. “Agents aren’t accountants, and they’re not objective, either,” says Herlihy. While there are ways to apply certain accounting principles to cash flow to arrive at a ballpark figure, Herlihy says the figure may be considerably inaccurate.

Tom Doran agrees. “Doing your own valuation would be like trying to do your own audit,” he says. “Unless you’ve done it repeatedly, there will be aspects that will escape you.” And if you make a mistake, you expose yourself to liability that could result in a costly lawsuit. “Think of it like a checkup at the doctor’s,” Doran suggests. “You’re going in to make sure things are as you intend them. And if they aren’t, there are treatments you can apply.”

An agency’s value consists of its growth rate and profitability, and the risks of maintaining those factors. More than 20 variables must be considered and calculated to arrive at an accurate value. Among them:

• Ages of key employees
• Dependency on large accounts
• Receivables management
• Quality of carriers
• Historical underwriting profitability
• Agency location
• Employee quality and productivity
• Technology proficiency
• Sales management
• Cash/asset management
• Quality of facilities
• Historical growth rate.