As most readers know, we do a lot of Agency Valuations at Agency Consulting Group, Inc. The way we value agencies is to determine the agency’s likely Earnings Potential over a reasonable period of time for the circumstances of the valuation. Then we determine the agency’s Cashflow to identify the period of time during which it is most reasonable to pay for the asset if it to be transferred to different ownership (internal or external).
Far too often agents who have reached a certain “level of maturity” get invested in the old-fashioned concept of “multiples” as a simple way of estimating their agency’s value. Someone twenty years ago told the agent that average agencies were going for X times income and better agencies were going for X+Y times revenue. Ever since then the agent has an idea that his agency will sell for X to X+Y times its revenue.
Typically, buyers either LOVE or HATE the simplified concept of valuation. The love it if the real value is substantially above the owner’s estimate of his own value and they hate it if a realistic value of the agency is below the agent’s estimate.
The retiring agent tries to “negotiate” a price as if the agency is a piece of art with the value truly in the eyes of the beholder. In fact, the value is a REAL number defined by a combination of what the agency can earn for the potential new owner over the time period he’s willing to devote his earnings back to the prior owner AND the cash flow ability of the agency to pay its normal running expenses AND pay the principal and interest to the retired owner.
So the valuation process often goes like this:
ME: The value of your agency is $1.5 Million payable over five years.
Agency Owner (AO): Wait a minute! Agencies are worth Y Times Revenue for average agencies – that would be $2.2 Million and my agency is WAY ABOVE AVERAGE with low loss ratios three years out of six and my long history in the community – it should be worth at least Y+Z times its revenue!
ME: Once we calculated the savings the new owner will be able to accumulate over your costs and inserted his running costs and the continuing growth rate based on your history, he will only be able to pull $1.5 Million in after tax earnings from your agency over the next five years. And the Cash Flow of the agency (its net cash available to pay YOU principal and interest (to you or to a bank) will be break even over that five year period.
AO: The buyer should be willing to pay more than the agency net cash flow each year to get a book of business as valuable as mine.
ME: So you expect a buyer to operate the agency, pay every dollar of income generated from your agency to normal expenses related to its operation AND borrow money every year to pay you the principal and the interest on the payout for over five years? Would you buy an agency on which you won’t see any return for five to ten years?
AO: No, but he can do better than I could if he puts his efforts into it.
ME: Most agents purchase the asset that is already in place, including its future earnings based on historical performance. If he invests in new producers to generate more growth, that is an additional risk and expense that he is making, hoping to get a return, not a part of the core book of business that he has bought. We can try to find someone who will negotiate for higher than projected earnings or cash flow BUT he will have a difficult time borrowing money in excess of which a financial institution can’t see a reasonable chance of him earning. And, if he uses his own money and the excess growth doesn’t happen – it is the reason that some deals have to be litigated when an agency can’t afford the payments based on the book of business remaining in the agency after a sale.
THE MORAL OF THE STORY: Not every piece of art is worth a million dollars. Not every building is worth $50/sq. foot. Not every book of business or agency is worth Y times revenue. You would never buy or sell a building without a legitimate appraisal. Don’t buy or sell and agency without a legitimate appraisal (not one based on a multiple of anything). Be as suspicious of the person who offers you much more than the appraised value (unless the offer is in cash) as you would someone who offers you far less than the future earnings potential and cash flow of the agency.
If you have questions or would like an appraisal of your agency call us at 800-779-2430.