Agents often misunderstand the VALUE of their agencies. They believe that a “value” is a single point and that they should be able to yield that value in the perpetuation of their agencies under any circumstance. However, the truth is that every agency buyer, internal or external, will likely identify a different VALUE to an agency depending on its earnings potential to them specifically.
An Example to Prove the Point:
Agency A has $1,000,000 of revenue and $870,000 of true expenses. It may choose to reflect the $100,000 profit at the bottom line, bonus the money to owners and staff or have a thousand other uses for the profit, but the fact remains that, after paying reasonable expenses for payroll (including owners) and operating expenses, Agency A will have $130,000 /yr. in excess profits, yielding the owners a net $100,000/yr. in after tax earnings.
To its current owner, Agency A is worth $100,000/yr. for as many years as the owner expects to remain in business. If he intends to perpetuate the agency internally and the new owner would give up his earnings (profits after taxes) for ten years to buy the agency, the Going Concern Value (GCV) of the agency is $1,000,000. Of course there are more intricate calculations to be done to calculate risk to the potential earnings, but, in a nutshell, earnings over a time agreed upon by the buyer and seller will define value.
If that same agency is approached by a neighboring agency for an acquisition, that agency will determine what economies of scale it will generate to increase profits over that which has been generated by the seller and will calculate the value it can afford to pay the seller based on that profit (and earnings) potential, its Fair Market Value (FMV) to the specific buyer. If it can generate $250,000 a year by eliminating selling owners’ expenses, other redundant personnel and occupancy costs and redundant operating expenses, it could afford to pay the seller substantially more over a more likely five year period ($1,250,000) than he could get from the internal buyer over a longer period of time.
Quite often, an internal buyer will allow for a longer time to pay the buyer, assuming that revenue growth beyond that of the former owner will sponsor his own income growth during the time that all agency profits (earnings/cash-flow) are devoted to paying for the agency. So it is not unusual to see 5 year, 7 year, 10 year and longer payout terms for an internal perpetuation.
Conversely, few outside buyers would invest in purchasing an agency and melding it into their own if they were expected to commit all earnings to paying for the acquisition for a prolonged period of time. We often see three year to five year commitments for this purpose from outside buyers.
And since every internal and external perpetuator will have different expectations of growth, profits, earnings and the definition of a “reasonable” period of time for a payoff, it is not unusual to have several potential perpetuators each with a different concept of VALUE.
Happily, the value of an agency, alone, is rarely the determining factor in most agency sales any more than the price of insurance, vehicles or clothes is the determining factor in other personal decisions in life. Sellers become much more concerned with treatment of clients, employees and chemistry between buyers and sellers before a final determination is made regarding to whom to sell and for how much.
A Fair Market Valuation (FMV) establishes the value of a host agency to another like-kind agency wherein there is no compunction on ether the buyer to buy or the seller to sell. A Going Concern Valuation (GCV) establishes the value of a host agency to its current owners under the circumstances of continued operation according to means and methods common to the agency in question.
A FMV considers the elimination of one or more owners, any personnel commonly or specifically redundant to a buyer and any economies of scale normal to or specific to a buyer’s value of a host target agency. On the contrary, a GCV uses historical trends to establish the continued revenue and expense stream of the agency, whether remaining in the hands of the current owners or transitioning into the hands of new owners who are likely to manage the agency’s growth, productivity and cash flow similarly to the prior owners.
For instance, if Occupancy cost have increased by 2%/yr. historically and the agency intends to stay in place and not require substantial changes to this expense, future trended growth of Occupancy cost will remain at 2%/yr. However, if a specific buyer does not need the facility of the seller’s location, all or most of the occupancy cost (except the additional cost of occupancy in the buyer’s location) may be eliminated, lowering the Occupancy expense for the maintenance of the book of business.
The importance of adjusting for generic or specific buyers in a FMV will depend on the potential earnings (profits after taxes) that a buyer can expect from the acquisition over a reasonable period of time. The economies of scale can change what had been the historical, trended expenses for the maintenance of the seller’s book of business. Reducing those expenses increase the potential profitability (and earnings) that help a buyer determine how much they can afford to pay the seller.
The other ingredient in the value of FMV is the retention of revenue expected of the seller’s book of business. In a GCV, the seller’s historical trended retention is applied and assumed to be the same as his future retention. The agency’s growth is projected according to historical trends (including retention losses) to yield projected annual future revenues for the agency. That projected revenue less projected expenses will yield a profit (and earnings) potential that defines the value of the agency to its current owners assuming continued ownership and performance or an internal transition that will not change the trended revenues and expenses.
The day a buyer purchases a seller for presumed FMV all future new business is generated by the buyer’s, not by the seller’s agency. The buyer’s staff, management and style may increase, diminish or maintain the new business production and the buyer, not the seller, has control over new business production. The Operating Income (Commissions and Fees) of the seller is frozen and may only diminish through attrition of clients. New business results from the efforts of the buyer and the buyer’s management and no longer credits to the seller’s value of the agency.
So, generally, expenses in a FMV are lowered by some factor but revenues diminish as well. The combination of revenues subject to attrition and expenses reduced by economies of scale result in an earnings potential that helps define the agency’s value.
In a GCV, the trended growth of both revenues and expenses combine to yield future earnings potential that define the agency’s value.
When valuing an agency for estate planning for continuing owners, for internal perpetuation or for external perpetuation, it is important to understand the factors that are employed to establish value. Value is in the eye of the beholder. The science of valuation is in deriving historical revenues and expenses. The art of valuation is in creating the scenario that is most likely to occur to generate earnings potential for the person or group doing the valuation.
The application of both the science of trend analysis and the art of projections make a simple multiple a ludicrous method of establishing value. If you apply simple multiples to create a value assumption, you will inevitably cheat either the buyer or the seller. In a worst case scenario the valuation will not be supported by agency cash flow and a buyer will be forced to use all of his reserves to sponsor an agency that will not pay him back for the duration of his effective work life. This is the reason that so many agency ownership transfers fail several years after the transaction requiring expensive litigation to resolve when the buyer can no longer afford to pay the seller.
Go through the process of determining historical and projected revenues and expenses within the scope of the valuation that you are conducting. If you are selling your agency, remember that different buyers will look at your agency differently and SHOULD come to you with different valuations and offers. If any try to simply give you a multiple, do the valuation yourself as if you were the buyer to determine if their value is high or low. Be aware that simple multiples may yield an attractive offer. But what happens if the agency cash flow cannot support the payments over time?
If you need a valuation or assistance valuing any other agency’s future earnings, call us at 800-779- 2430.