Every car enthusiast has heard the term “barn find.” Sadly, for folks hoping to become classic car hobbyists, these finds are becoming few and far between. Ready access to collector car sales and auction data has made even the least savvy car owner aware that the dusty old sports car in the garage is worth too much to sell cheaply.
So why aren’t insurance agency principals as aware of the potential of their agency as Nana is of the value of Grandpa’s antique car?
Agency merger & acquisition activity continues to drive up agency sales prices. The record-setting pace of transactions continues unabated, and deal values are climbing. New buyers—mostly private equity-backed players—are entering the market flush with capital, aggressively looking to buy agencies.
As an agency owner, you may think there are “so many of you” and only 20 or so of these big buyers. For an agency principal seeking to harvest value, this creates a perception that if you’re lucky enough to be approached by a suitor, you’ll miss the boat if you don’t sell.
But you’re not missing the boat if you really didn’t need to take the boat after all.
The Issue
Three years after selling his agency to a private equity-backed buyer, a client reached out to me hoping to discuss options for getting back into the business, perhaps by acquiring or starting an agency. “I didn’t realize how bad it would be for my kids,” he said.
He sold the agency believing that he was receiving enough value to live well, that he could take care of himself and his wife as he approached his older years and still “leave something for the grandkids.”
Now consulting for the agency he had sold, he was working as hard as ever and still energized by the prospects for the business. But he was no longer in a position to fully direct the agency’s activities, nor fearlessly lead the people he loved who had invested their careers in him.
He saw that the agency was doing quite well, but its continued success was not going to benefit him or his people. “It’s kind of a hollow feeling,” he said, “knowing that I didn’t really need to let it go.”
Our client came to realize that his agency was likely worth considerably more than the acquirer paid. Why?
For starters, the cash flow of his agency no longer accrued to his benefit but to the buyer. His agency, when merged into the buyer with greater scale, created better income potential. The buyer’s ability to slash expenses, particularly with respect to producer compensation, extracted even more cash flow than he would have been willing to extract from his people.
Furthermore, those who remained saw their quality of life decline. Some of those impacted included the former owner’s family. Knowing they would not have an opportunity to be as successful financially as he was because an ownership opportunity was no longer available to them was particularly distressing.
But the realization that his agency was a “barn find” for the buyer came too late. The former owner underestimated the length of his runway.
The Solution
This real-life scenario is a great example of why there’s still a compelling case for internal agency perpetuation, despite rising deal multiples. If you approach perpetuation sensibly and in a staged manner, it can generate as much, or perhaps even more, than an outright sale.
Simply stated, if you sell your agency, you are giving up the cash flows from it in exchange for a lump payment. Over time, these cash flows can accumulate and be reinvested in your agency and producers aspiring to ownership, who can then acquire additional books of business or even other agencies.
The goal of a perpetuation is to ensure that the perpetual cash flows of an agency flow to the recipient(s) of your choosing. That may mean you, internal parties, family members, a combination of both or something reimagined.
Our client who sold his agency to a private buyer regrets not going through this exercise or asking our opinion. He was blinded by an offer that seemed “too good to pass up,” as well as the acquirer adviser’s glowing endorsement of how good life would be post-acquisition and overenthusiasm regarding the earn-out potential over time.
Unfortunately, by the time we hear of these events, the ink on the contracts is already dry and money has already changed hands. Had our client asked, the answer for him might have been a “strategic recapitalization”—my euphemism for a staged dilution of ownership.
In essence, you can take some cash off the table from your agency, but you still own it. This partial equity redemption can be accomplished by obtaining a commercial loan or through the sale of a partial interest to an internal party, or a combination of the two.
Assuming a shuffling of a partial interest, a principal could start out modestly, redeeming a 30% interest in the business. They could obtain a loan that would provide a cash payment to accomplish this goal, or they could sell 30% to their three primary producers. This could be financed by an insurance agency specialty lender. In either scenario, the principal gets a head start accumulating funds for their elder years as well as the grandkids.
While the principal would now only receive 70% of the agency’s residual cash flow, the business would be on its way to enhanced value—and the three primary producers, as owners, would be motivated to grow the business because they, too, have upside.
The Math
Let’s consider a simplified illustration of what our client could have accomplished. Assume his $5-million commission agency produced a cash flow of $1 million. He sold the agency for a base purchase price of $7.5 million, or approximately 7.5 times cash flow. He had some upside potential built into the deal, provided the agency was able to realize thresholds for growth in both revenue and margin.
In retrospect, these proved challenging to achieve because of a weak economy in his area and overly lofty targets. Had he been able to grow both, perhaps as much as 10 times cash flow could be realized. The larger potential multiple is the figure agency principals toss about with colleagues after a round of golf.
So let’s assume, instead, that he sells 30% of the agency to his two sons and a third top producer. He extends a discount to the value of the shares equating to a five-times multiple to account for the fact that he’s selling a partial interest to internal parties. In exchange for the shares, he receives $1.5 million cash from the sale to tuck away for the grandkids.
Because our principal’s business is in a state experiencing lower growth, the agency grows modestly, only about 2% per year. He doesn’t have the heart to slash expenses, and his cash flow margin is about the same, but he can still look at himself in the mirror when he shaves.
In five years, modest growth has resulted in top-line revenue of about $5.5 million. At the same margin and a five-times multiple, his agency is now projected to be worth $5.5 million, and his 70% interest is worth $3.8 million. But over the same period, he receives cash flows from the agency that total $3.7 million. He also receives $1.5 million from the partial interest to his two sons and the third producer.
When he adds the cash flows received to the projected value, his total investment is worth approximately $9 million, compared to the original price of $7.5 million. And the best part? He still owns a significant share of a valuable agency.
He could also have made other share redemptions along the way. In doing so, he could have reduced his investment and taken more cash off the table. There’s nothing wrong with owning a smaller share of a larger enterprise, as long as you give up control more gradually than the ownership stake.
And don’t forget that sound legal and accounting advice is necessary to get all this structured appropriately.
The Takeaways
Agency principals make a common mistake underestimating the length of their runway. Our client was not particularly old and had more than enough “good years” left. Note, too, that he is now seeking to reengage into agency ownership and start over again in order to make up for selling and not perpetuating a legacy.
The perceived difference in value between an outright sale and a staged sale to related or internal parties is just that—perceived. Simple math is a good place to start—while it ignores taxes and the time value of money, it also does not factor in the ability to reinvest cash flows received. Simply put, if you sell, you are giving up the right to perpetually receive cash flow.
Everybody’s financial situation is unique, and selling your agency to a private equity-backed broker is an alternative. But it’s not the only alternative. You need to carefully consider all the facets of selling, good and bad, including the amount and timing of consideration received and the impact on quality of life for you and your people.
A well-thought-out strategy for creating value by widening ownership and receiving perpetual cash flows gives you options. It fulfills your wishes and those of your descendants to create a lasting legacy.
And the cherry on the sundae might just be the continued satisfaction of serving your clients, whose runways could be as long as yours.
Robert Pettinicchi is the executive vice president and chief lending officer for InsurBanc. A division of Connecticut Community Bank, N.A., InsurBanc is a community-focused commercial bank specializing in products and services for independent insurance agencies.
