Three main elements that affect the perception of value for an insurance company: 1)) pro nominal earnings,) the risk that comes with future earnings, and three) the market’s conditions. Additionally it is the same elements that determine the worth of any investment. The purpose for this post is to dive into these aspects in order to provide the agency’s owner more knowledge of the best method to plan for the eventual sale of their Church Insurance Agency.
“Pro Forma Earnings” and the Return on Investment of the Buyer
The pro forma income is what buyers look at in order to calculate their projected returns on investments (ROI) and coverage for debt service on any loan. Pro earned earnings are calculated using the calculated EBITDA formula (“Earnings before interest, taxes, depreciation and Amortization) and is a measurement of the actual cash flow that one can anticipate to receive from an agency. Mathematically, this is:
Adjusted EBITDA = Agency net profit plus interest on debt plus income taxes charged (typically for a C-corp) + amortization and depreciation (non-cash costs) + the owner’s salary and benefits other business expenses that are not recurring or essential to the business +/- projected adjustments to employees’ compensation, rent and management costs such as keeping or replacing an owner (some of the adjustments will be made by the particular buyer).
A pro forma forecasted EBITDA is calculated by adjusting to the financial statements of the past. Pro fora forecasted EBITDA is dependent on a future projection which is created by the buyer, and includes their internal adjustments.
The success for an organization is largely dependent on the operational model and the market segment it serves. A company with a solid sales force, like numerous commercial lines P&C and benefits brokerages generally has an EBITDA of 30-40 percent of revenue. Agents that have more marketing-driven sales such as private lines P&C and some specialist agencies, usually operate with more favorable EBITDA margins, which range from 35 to 45 percent. There aren’t many sectors that the profits of similar companies can be as different like in the insurance sector. A company could be operating at a loss every year while another one of the same size that is operating in 50% or more profit. Controlling costs is crucial and can lead to selling the agency.
The return on investment of the buyer from the purchase is the reverse of the multiplier of EBITDA to be paid to an agency (e.g. 5x EBITDA = 20 percent ROI). Every buyer has certain expectations about the potential return on their investment in acquisitions and this will be determined by the capabilities of the buyer’s finances as well as the synergies and expectations of the agency regarding risk.
Strategic buyers with large amounts of capital, like national brokerages and banks can afford a lower return (e.g. 12-18%, or 6-8 x EBITDA) and consequently pay the most. Many of them can benefit from synergies that are not available small buyers for example, more commissions and greater chances to grow by leveraging existing relationships. A lot of them also have substantial reserves of cash and are constantly looking for opportunities to acquire companies to increase their investment returns and growth. Large strategic buyers typically seek agencies that have an EBITDA of more than $500k, but will consider smaller companies when they are able to be incorporated into an existing company. They are generally seeking more professional, well-run agencies with more risk-free investment options.
Strategic buyers in smaller regional markets usually need at least a 20% return on their investment. They are typically owners of agencies who are looking to acquire more market share or even enter an entirely new market. Buyers who are not owned by agencies typically want at least a 30% ROI since the agency must generate a profit that they can live off. Individual buyers, as the ones mentioned earlier, generally require third party financing for an acquisition and, therefore, the costs of debt and capital will be a factor in their valuation. The majority of buyers are not equipped with the financial resources required to acquire an agency that is valued at more than $2-3M since obtaining third financing for a sale that large is more challenging.
Perceived risk, price, and Sale Conditions
The risk that is perceived for future earnings could affect the sale price and terms that buyers make available. The due diligence process for buyers will comprise a list of inquiries about the book of business as well as agency operations. Concerns about the composition of the business , such as contract with carriers, the kinds of policies, sizes of accounts, and the class of business raise questions about the inherent risks of writing the business book. Also, inquiries regarding the agency’s operation, its reputation and longevity as well as structures for management and strategies for marketing selling force, underwriting processes and retention strategies are concerns 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 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 inherently is more risky like one that is specialized in a particular market that has little retention or renewal fees then the perceived value of the total will be diminished.
A final point to be discussed prior to moving to the next one: We often encounter stories of buyers who offer offers without a down payment, and also payments made upon renewals. These are referred to as predatory buyers. A company owner shouldn’t sell without a buyer with an enviable stake. A sale that pays 60 to 80 percent of the purchase amount at closing, and the remaining balance to be paid through a fixed 4-8 year note or an earn-out of 2-4 years is the norm. If less than the amount is paid upfront the seller must bargain for a guaranteed minimum amount and then have it personally guaranteed to the purchaser.
The impact of market conditions
As with any investment sale market conditions, timing and market conditions the sale will affect the profit from the sale. Market conditions like the economic outlook, the condition of lending markets, the performance on the market for stocks, the position of the cycle of soft markets and the tax rate for capital gains all play a role. Most of these issues are categorized under risk and earnings however, since these elements are not under the management of the agency’s owners, they must be considered in a separate manner.
It’s difficult to find statistics on these changes, however the information is usually available through consulting firms that work in the insurance sector. The years 2011 and 2012 will provide favorable conditions to sell because long-term capital gains and rates of interest are currently at 50-year low, and the premiums in a variety of markets are rising and the value of stocks of many brokerages that are publicly traded are recovering from 2009’s lows.
Making a Sales Strategy
Each agency’s owner must develop an exit strategy at least two years prior to the sale. The initial stage of the process is to evaluate the current value of the company and determine any outstanding issues, as mentioned in the previous paragraph. Since that the system of insurance distribution encompasses an array of agencies operating in different markets there isn’t any magic formula that can swiftly and easily appraise an agency. The owner of the agency must engage an advisory firm that is well-versed in their field and the regional market to aid in the process of valuing the organization. The process will eliminate any problems and a discussion must be conducted on how to fix the issues, and the impact the resolutions impact the value.