“I bought this book of business 25 years ago for two times—I was just going to do the same when I'm ready to retire." This is one of the most common quips IA Valuations hears from the generation of agency owners getting ready to retire. However, it's potentially harmful to their retirement funds and their agency. What do they mean? Two times what? Commissions and fees? Gross revenue? Net income?

Owners must understand the details of the agency price. Far too often, the owner cannot answer that question confidently.

In the market right now, prospective buyers are not determining the price they will pay for an agency based on revenue alone, but instead on EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. It is expressed as a percentage of gross revenue.

You may hear someone use the term “profitability margin" when referring to EBITDA, and while that is commonly accepted, they are not quite synonymous. Technically speaking, EBITDA is just one of many ways to measure profitability.

In essence, EBITDA eliminates the “noise" associated with expenses that aren't directly related to operating the business. Interest expense, taxes, depreciation and amortization are all expenses that can vary between businesses in the same industry, based on levels of debt, tax circumstances and non-cash deductions from income.

EBITDA is often used by lenders or buyers because it removes any variables to provide a clearer picture of the cash related to operating the insurance agency. From a buyer's perspective, the “ITDA" of EBITDA—the interest, taxes, depreciation and amortization—will change under new ownership anyway, so it shouldn't be a factor in the valuation.

Having a high EBITDA is not always best. Instead, your agency's EBITDA should match the goals of the agency. Is your agency applying for a loan or are you selling the agency? If either of those things are true, then maximizing EBITDA is wise.

However, there are many other phases in the lifecycle of a business where it makes sense to have a low EBITDA. For example, when a business needs to grow and doesn't have the luxury of acquiring a book of business, the agency will likely have to invest in a new producer or increase other selling expenses, which will reduce the EBITDA. This lower EBITDA reflects growth goals and should not be of concern.

The only time to be concerned about a decreasing EBITDA year after year is if it is unexpected. If it's part of the agency's business plan, then it's a positive because it means you're taking action to achieve your goals.

While lower EBITDA isn't always a bad thing, there are ways to drive up EBITDA to maximize the value of your agency. Here are three ways to increase your agency's EBITDA:

1) Purchasing books of business. Upon purchasing a book of business, the agency is increasing its revenue. If debt was involved to do so, the interest wouldn't reduce the agency's EBITDA. The only reductions come from any increase in operating expenses that it takes to run that acquired book of business.

2) Decrease operating expenses. This is no secret to business owners trying to drive up profits. Some agency owners operate their agencies with minimal margins so they can run lifestyle expenses through the agency, including cars and social clubs. If this sounds similar to your situation and you plan to exit the agency in the near future, begin to think about ways you can start to decrease any unnecessary costs from your income statement.

3) Increase policies in force (PIF). Increasing PIFs does not just mean increasing revenue. While increasing revenue is great, increasing your PIF is the best way. Smart buyers and lenders are wise to the industry's hard market. Nowadays, growth is not the goal—quality growth is. Is your agency's top line increasing just because of rate hikes? Or is it increasing because the sales culture within your agency is driving new policies despite the rate environment?

No matter where your agency is in its lifecycle, understanding EBITDA is important. Knowing how to talk about EBITDA will make you more comfortable when negotiating your agency's value, enable you to see your agency from the eyes of a lender or buyer, and help you measure if your agency's actions match its goals.

Jarod Steed is business planning and valuation analyst at IA Valuations.

The information provided in these documents is general in nature and shall not be construed as personal legal, tax or financial advice for your situation. Please contact@iavaluations.com to discuss your personal situation. 

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