Preparing an Insurance Agency for Sale

There are essentially three factors that impact the perceived value of an insurance agency: 1) pro forma earnings, 2) the risk associated with future earnings and 3) market conditions. Not so incidentally, these are also the same factors that influence the value of any investment. The intent of this article is to delve into each of these facets in order to give an agency owner a better understanding of the best way to prepare for the sale of an insurance agency.

“Pro Forma Earnings” and the Buyer’s Return on Investment

The pro forma earnings are what the buyer looks at to determine their projected return on investment (ROI) and debt service coverage on any financing. The pro forma earnings are calculated from an adjusted EBITDA formula (“Earnings before Interest, Taxes, Depreciation and Amortization), which is a measure of the real cash flow a buyer should expect from the agency. Mathematically this is:

Adjusted EBITDA = Agency net profit + Interest on debt + Income taxes expensed (typically for a C corp) + Depreciation and amortization (non-cash expenses) + Owner’s salary and benefits + Non-recurring or non-essential business expenses +/- Projected adjustments for rent, employee compensation and management expenses such as retaining/replacing the owner (some of these adjustments will be determined by the specific buyer).

A pro forma recasted EBITDA is determined from adjustments to historical financial statements. A pro forma forecasted EBITDA is based on a future projection that will be created by the buyer and include their own internal adjustments.

The profitability of an agency is strongly dependent on the operating model and market segment served. An agency with a strong sales force, such as many commercial lines P&C and benefits brokerages, will typically have an EBITDA of 30-40% of revenue. Agencies with more marketing-driven sales, such as personal lines P&C and certain specialized agencies, typically operate on higher EBITDA margins of 35-45%. There are very few industries where the profitability of like-sized businesses can vary so significantly as in the insurance industry. One agency could be running at an annual loss, and another of similar size running at 50% or better profitability. Cost control is critically important, especially leading up to a sale of the agency.

The buyer’s return on investment from the acquisition is the inverse of the multiple of EBITDA to be paid for the agency (e.g. a value of 5 x EBITDA = a 20% ROI). All buyers have certain expectations on the return of their investment in an acquisition, which will be driven by the buyer’s financial capabilities, synergies and risk perception of the agency

Large strategic buyers, such as banks and national brokerages, can afford a lower initial return (e.g. 12-18% or 6-8 x EBITDA) and hence often pay the highest price. Many can gain synergies unavailable to smaller buyers, such as higher commission rates and better opportunities for growth through leveraging existing relationships. Many also have large cash reserves and actively search for acquisition opportunities for growth and investment returns. Most large strategic buyers seek agencies yielding an EBITDA greater than $500k but will consider smaller agencies if they can be folded into an existing operation. In general, they are looking for larger, professionally run agencies that are lower risk investments.

Smaller regional strategic buyers typically want a 20% or better return on investment. These are usually agency owners that either want to gain a greater market share or enter a new market. Non-agency owner buyers usually want a 30% or better ROI because the agency also needs to produce an income for them to live on. Individual buyers, such as mentioned above, also typically need third party financing to make an acquisition, so the cost of capital and debt service will factor into their value determination. Most individual buyers lack the resources to acquire an agency valued over $2-3M because locating third party financing for a sale of this size is much more complicated.

Perceived Risk, Price and Sale Terms

The perceived risk of the future earnings will influence the price and sale terms that a buyer will offer. The buyer’s due diligence process will include a laundry list of questions about the book of business and agency operation. Inquiries about the make-up of the business including carrier contracts, types of policies, size of accounts and class of business are questions about the inherent risk of the book of business. Likewise, inquiries about the agency operation including its longevity and reputation, management structure, marketing strategies, sales force, underwriting procedures and retention plans are also questions about the risk.

Some commonly encountered high risk factors include: declining revenue/earnings trends, revenue concentration with carriers/producers/accounts, revenue concentration with non-rated carriers or sub-standard markets, low account retention or renewal commission base, employee issues, high loss ratios, and poor record keeping.

If only certain parts of the agency are perceived as high risk, such as Non Profit Growth having a few large accounts or a few high performing producers, then the buyer may want the seller to share in a portion of risk in the form of an earn-out based on the agency maintaining certain revenue/profitability metrics or retaining specific accounts. If the agency itself inherently carries more risk, such as an agency specializing in a market with low retention or renewal commissions, then the perceived value as a whole will be reduced.

One last item to discuss before moving on: We often hear stories of buyers that make offers with no down payment and payments made on renewals. We refer to these as predatory buyers. An agency owner should never sell without the buyer having substantial skin in the game. A sale delivering 60-80% of the price at closing and the balance paid either on a 4-8 year fixed note or 2-4 year earn-out is common. When less money is paid up front, the seller should negotiate a guaranteed minimum amount and have it personally guaranteed by the buyer.

The Impact of Market Conditions

Like selling any investment, market conditions and timing the sale properly impact your net gain from the sale. Market conditions such as the economic outlook, state of the lending market, performance of the stock market, position of the soft market cycle and capital gains tax rates all factor in. Many of these considerations really fall under earnings and risk, but since these factors are outside the control of the agency owner they should be considered separately.

It is difficult to locate data on these trends but information can often be obtained from consulting firms functioning in the insurance industry. The years 2011 and 2012 should be good market conditions for selling because long term capital gains rates and interest rates are at a 50 year low, premiums in many markets are on the rise and the stock values on many public brokerages are rebounding from the lows of 2009.

Developing a Sale Strategy

Every agency owner should develop a sale strategy at least 2-3 years in advance of the sale. The first stage of the process should be to determine the current value of the agency and identify outstanding issues as highlighted above. Because the insurance distribution system includes such a wide array of agencies functioning in various market segments, there is no magic formula that will quickly and easily value an agency. The agency owner should engage a merger and acquisition advisory firm that that is intimately familiar with their industry and regional market to assist in performing a valuation of the agency. The process will flush out any issues, and a discussion should follow about how to resolve the issues and what impact such resolutions will have on the value.

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