When you are considering purchasing an agency what should you be using to determine your price for that agency, should it be a Rule of Thumb multiple? Should it be a negotiated price reached by haggling between the buyer and seller – like buying and selling a horse? Is there a process you can use to determine a reasonable price and value to you, the buyer, for the exchange of that asset in a way that will benefit you and not harm you financially?

As you know the appropriate value of any business is its future earnings expectation over a “reasonable” period of time. Typically a buyer either desires positive cash flow or at least break even on cash flow projections for the existing revenues and expenses without consideration of growth sponsored by the new owner. The period of time warranted as “reasonable” is a subjective determination of how long the buyer is willing to sponsor the cost of the property before the buyer accrues the benefit of all of the business’ future earnings.

The Value Basis is not Gross Income – it’s the Agency’s Earnings Potential

So if a business is expected to throw off $100,000 per year in after tax earnings, a buyer would spend no more than $500,000 to achieve ownership if he expected a 20% return on his investment and needed to pay off his obligation from the business’ earnings over five years. Please notice that the established value depends on “earnings” potential, not on top line income. The example agency in this scenario might generate $500,000 of gross revenue generating a 30% profit at a 33% tax rate – or it might be a $1 Million revenue business generating a 13% profit at a 20% tax rate — or it could also be a $5 Million business generating a 2.4% profit at a 15% tax rate.

But if the new owner’s projection for future cash flow after the sale is $100,000/yr and the condition under which he is willing to sponsor an acquisition is a 20% ROI (requiring full replacement of his investment in five years), the business is “worth” $500,000 to that buyer. If the seller is not willing to transfer ownership for that amount, any advance on that price is a bad deal for the buyer – he will not achieve his goals in ROI or in cash in his pocket every year.

Creating Your Pro Forma Projections

Buyers should create their pro forma projections of revenues and expenses based on known factors (like the agency’s historical performance in that line of income or expense if it will remain in place, operating as it has in the past) or on calculated economies of scale. For instance if I purchase an agency with $30,000 of annual occupancy costs and the remaining staff will fit nicely into my agency’s existing space, I can safely eliminate all or much of the historical occupancy cost of that agency in my pro forma. On the other hand I should not project growth in an agency that has been flat or in decline for the past five years based on my expectation of selling and cross selling more insurance. That form of pro forma projection is an exercise in ‘dreams and wishes’ and, even if they come true, you are paying for your own sweat equity for a property that didn’t justify that projection on its own accord. Neither should you decline projected expenses on the hunch that you can do better to control those costs. Analyze each line of revenue and expense to determine (conservatively) how those lines will act in the years after you purchase the business.

What Is A “REASONABLE” Period of Time?

If you were told initially that you wouldn’t see a return in earnings from your investment for 15 years – would you make the investment?

If your answer is no then just because the amortization period for an insurance agency is 15 years, you should not project your cash flow to breakeven over that same period.

You should be projecting your cash flow over the period of your particular tolerance for both cash flow and for asset value.

Some agents establish their ‘rule’ based on paying off the cost of an agency over X years. This sets an outside limit on the price they are willing to pay for an agency based on their need to earn profits and earnings from that investment after their desired payoff period. It also allows them to rationalize spending all available cash to pay off the debt.

Many agents are satisfied to achieve a minimum but positive cash flow while paying for the asset with the expectation of their additional income being generated by their own growth efforts using the purchased agency’s clients and presence as the base. This is fine as long as you project reasonably to achieve positive annual cash flow. But if you are seeing the acquisition as an investment, you must look at it differently.

You may certainly sell an encumbered asset. But you already know that if you have a $1 Million property and you sell it when you still owe $500,000, you are substantially reducing your profit from the acquisition and sale of that property. So, if you want to use that $1 Million for your own retirement benefit you need to plan for its payoff prior to when you intend to sell the property yourself. Regardless of the amortization period allowed by the IRS, your cash flow expectation should be expressed in the period of time you desire to fully pay off the debt to allow you time with full profits accruing to your benefit before you eventually transition the business to someone else. Most of us purchase agencies to enjoy greater earnings power before they look at it as an estate or retirement asset.

So the “reasonability” test for asset value in an acquisition should be measured by your tolerance for breakeven, minimal or growing cash flow from the asset along with your expectation of the need for that asset value to sponsor your own retirement.

As you can see your pro-forma projections of the agency’s future income and expenses become critically important to your valuation process for an agency. Long gone are the “Magic Multiples” that plagued our industry for decades and caused so many agents to be cheated through insufficient valuations and through excess valuations because of a rule of thumb that never worked. It is easy to take a valuation price and express it as a multiple of anything (revenue, commission, EBITDA, earnings, etc.) But, it is ridiculous to take someone else’s pants or dress size and assume that you can purchase your own clothes because the “average” dress size is 10 or the “average” pant size is 38.