The history of insurance agency transition and of other small, closely held businesses (less than one million or two million revenues) implies borrowing money to give to the seller and paying that money back through the cashflow of the agency including a fair interest rate over time. The higher the price the greater the cashflow commitment becomes. And the cashflow potential is limited to the available cash available from the agency’s current revenue generation. So if the price is large enough that it will use all of the agency’s available cashflow, the only way that the buyer can proceed with the transaction without devoting his own personal assets is to extend the time that the buyer needs to devote to paying the seller before the buyer can take full advantage of the income potential of the agency.

So the two components of affordability is proforma agency cashflow and time available to conclude the payments to the seller. Notice the difference between affordability and the concepts of value or price. Value is the expression of the earnings potential of the agency over time from the perspective of the appraiser (the owner, a family member or staff member desiring to perpetuate the agency or a buyer). The longer an appraiser is willing to wait to glean full profits from the agency, the higher the value potential. Price is the extension of value to include the risk of exceeding, achieving or missing the earnings potential derived by valuing the agency based on risk factors associated with the specific agency situation.

So an agency that throws off $130,000 of available cashflow (usually from the elimination of compensation to the selling owner) growing by 1% each year after a sale only has that amount to spend annually for principal and interest toward paying off the seller. If the agency value is $1 Million (from the perspective of the buyer) and a 5% interest rate is negotiated with whomever will sponsor the investment, the agency will yield NO additional cashflow for the buyer (unless the buyer grows the agency beyond the amount needed to sponsor the purchase) and will need 10 years of $10,606/mo payments (principal and interest) before the buyer will see his first cashflow profit from the original acquisition. The actual cost to the buyer of this transaction will be the $1,000,000 price and $272,786 in interest and can be managed through the cashflow of the agency over 10 years. The buyer must decide whether this investment requiring 10 years to come from break-even to profit levels is worthwhile.

What if the buyer only has seven years before desiring his/her own perpetuation? Is this still a viable transaction?

What if the buyer is already in the agency and making a reasonable living? If young enough, the purchase of the agency over a long period would still provide substantial agency value by the time of the new owner’s retirement and can provide further earnings if the agency is growing.

What if the seller (or the financial institution) requires five year terms? Where will the rest of the cashflow come from? Suddenly, from a cashflow perspective, the buyer can only afford to pay approximately $500,000 for the agency if the money to pay for the agency must come from the agency’s cashflow and the buyer (or lender) needs to be repaid in five years.

Please notice we haven’t ever mentioned the amount of premium or commissions written by the agency. Because premiums are the visible and important component to insurance companies and because commissions appear to be new income to the buyer we are sorely tempted to base our concept of agency value on the gross numbers. But the top number (the total premiums written) is meaningless to the agency’s value and the commissions are only important as the primary ingredient to determine the agency’s profit and cashflow. Unless you create the cashflow potential to you as the buyer you risk being short of money when paying principal and interest to the detriment of your other assets.

But whether you borrow money from a lender or from the seller to purchase the asset, the example cited above proves that you will pay 27% more (through interest) for the agency at 5% interest over 10 years that must be generated from the agency’s cashflow or from your other sources. Obviously the prudent buyer will seek to minimize the cost beyond the agency’s value by using any additional available cashflow to prepay as much of the principal as possible. This will accelerate the timing at which the agency pays the new owner profits and cashflow and/or uses the excess earnings to sponsor further growth and asset value build-up.

The rule is to project your cashflow realistically and conservatively to project the value and price, then control costs and grow the asset beyond financial projections to shorten the payout period before which the new owner can take full advantage of the asset. A buyer will secure better terms and lower interest rates AND the seller will enjoy more income if the conditions of the agency transaction permits the seller to finance the transaction instead of going to a third-party lender.

The primary concern of the seller is always the question of whether the agency will be able to continuously sponsor the principal and interest payments. This is a bigger concern with internal ownership transfers because the agency’s own cashflow must continuously support the payments to the seller. In a transaction in which an existing agency purchases another agency, the combined cashflow should be used to secure the principal and interest payments. This is important for the seller. By negotiating that the combined assets of the buyer be at risk in the sponsorship of the seller’s payments the likelihood of a default decreases substantially. In addition to the conditions of the sale, we recommend the use of a Liquidity Audit (call us for more information – (800 779 2430) that can be done at little cost to assure the seller of the buyer’s continuing financial capability to sponsor the required payments through the testing of the agency’s Liquidity Ratios on a monthly basis. Agency Consulting Group, Inc. has designed and implemented the Liquidity Audit for several decades but it can also be implemented by the seller or by his accountant, if so desired.