by Tom Doran, February 2008

National Underwriter

As we have pointed out in numerous National Underwriter articles over the years, internally-perpetuated agency valuations typically lag those of third-party buyers by a wide margin.  In other words, your agency's value to an external, third-party buyer is generally considerably higher than the value of the agency for internal stock transactions.

In 2007, the average agency in our Reagan Value Index (an index of thirty independent agencies we value for internal perpetuation purposes on an annual basis) was valued at 1.34 times revenue.  A review of several recent agency transactions for which we represented the seller reveals an average sale price of 2.05 times revenue, a difference of 53% over our average internal valuation.  For several recent transactions, the third-party buyer value was almost 100% higher than the seller's most recent internal appraisal of value.

This gap between internal and external agency valuations continues to frustrate many agency owners who would like to perpetuate internally, without significantly discounting the value of their agencies in the process.

Although it is unlikely you'll ever bridge the internal vs. external valuation gap entirely, there are a number of steps you can take today to increase your agency's value on an internal basis.  Many of these steps are the very same steps that third-party buyers take to justify their higher valuations.

Projected profitability weights heavily in the third-party valuation equation.  Generally, when an agency prepares to sell, a historical pro forma income statement is prepared to give the buyer an indication of the profits the agency could have/would have generated under third-party ownership.  This pro forma profit is most commonly expressed as EBITDA, or earnings before interest, taxes, depreciation and amortization.  As you might imagine, the profit numbers look very different than the actual numbers in this analysis.

For internal agency valuations, pro forma EBITDA is generally calculated on a going concern basis, after adjusting for certain discretionary owner compensation issues.  In other words, pro forma profitability is largely measured in light of the agency's actual existing expense structure.  Properly done, an internal valuation does not generally value an agency on the basis of how profitable it could be, but rather how profitability it likely will be before discretionary adjustments are made.

In an external valuation, pro forma EBITDA is generally calculated on a will be basis.  The numbers are adjusted to show how they would have looked under third-party ownership.

Therein lies much of the differential in internal and external valuations - assumptions made regarding future profitability.  Under third-party ownership, agencies are generally considerably more profitable than they were as an independent.  To be sure, a number of factors allow for this, including consolidation economies and other expense eliminations.  However, the single issue that typically most influences the internal vs. external profitability picture remains compensation.  There are generally a few specific practices a third-party buyer will address in order to arrive at a higher level of profitability:

• Producer compensation - Many of the national brokers and large bank buyers seem to be settling on a 40% new / 25% renewal commission arrangement for commercial P&C and benefit producers.  This one change to an agency's expense structure can materially increase an agency's profitability and, thus, its value in an external agency sale.

• In the following example, the EBITDA profitability of a hypothetical $5.5M agency increases by almost 23% simply by decreasing the producer commission arrangement by 5.0 percentage points, from 35% new / renewal to 30% new / renewal.  This reduction in producer compensation improves the agency's EBITDA margin by almost 23%.  Assuming a 6.5 times EBITDA valuation, this one change results in a 23% increase in agency value.

  

• External EBITDA calculations also contemplate go-forward compensation assumptions for agency owners that often look materially different than they do at a privately-held agency.  These changes, in the form of payroll compensation and other owner perks, also tend to improve the profitability picture, further enhancing the agency's value to an external buyer.

• Other go-forward compensation adjustments leading t a higher level of profitability may include underperforming employee terminations, the elimination of compensation to non-active family members and deferred compensation payments made to former employees.

The intent of this article is not to imply you should overhaul your compensation plan, but rather to remind you that a compensation overhaul often times accompanies an insurance agency sale and, to a large degree, helps to generate the strong values paid by third-party buyers today.  For those planning to perpetuate internally, the application of a third-party-like valuation without implementing third-party-like compensation practices is highly problematic.

In the real world, many agency owners will say these compensation practices, especially with respect to producer compensation, are unrealistic and would hinder their agency's ability to attract talent.  This may be true in certain cases, but it also raises an interesting question - do you really need to pay higher-than-market compensation to attract talent?  If so, what other non-compensation benefits (private ownership opportunities, selling & service resources, quality of life, etc.) might you stress to make sure you get your fair share of available talent, while at the same time, ensuring your agency's internal valuation is maximized?  Does it make sense to trade compensation for a higher agency valuation?  In certain cases, it may.  Quid pro quo - this for that - why wait to sell your agency to consider this question more fully?