A Common-Sense Approach to Agency Valuation in Divorce Situations
No agent wants to consider divorce as a reason for valuation. However, divorces do occur to some agents and the agency business sometimes does become a part of the marital asset considered within the divorce. Agency Consulting Group, Inc. handles scores of divorce valuations each year, a minority, but significant percentage of its insurance agency valuation practice.
A great deal of discussion has been created over the concepts of Personal Goodwill and Enterprise Goodwill. In various states, the separation of these goodwill categories has significantly altered the permitted agency value in divorce situations. It is incumbent on agents to understand how agency valuation differs in divorce situations from those for estate planning, partner acquisition, loan substantiation and mergers, sales and acquisitions. Let’s begin with simple definitions with respect to insurance agents:
Personal Goodwill is the business goodwill (value) attached to the personal efforts of an agency owner. Personal Goodwill is relevant and prevalent in other Personal practices (i.e. law firms, medical practices and CPA firms) in which the continuing revenue stream depends primarily on the personal efforts of the business owner. The best way of looking at this is by examining what would happen if the principal of a single owner law firm, medical practice or CPA were to suddenly die. He (the owner/business producer) would not be available to take on new cases or clients and the business income would melt away. Even if the practice were sold, the continuing revenue stream would be much more dependent on the personality and activities of the new principal than on the goodwill value of the old one. These practices certainly bear a viable value for prudent estate planning purposes – how much life insurance do you need if you would generate several million dollars in future after tax earnings to benefit your family if you live? But the Fair Market Value of these practices (if the principal dies or sells and retires) is much more limited to a new owner’s potential earnings capacity.
Enterprise Goodwill is the business goodwill (value) attached to the on-going revenue stream of the agency generated irregardless of the particular owner’s participation. A good example of Enterprise Goodwill is the business continuation of an established dry cleaner. The owner may greet customers and take the items for cleaning, but he probably does not clean the items himself (many are reception storefronts only and send cleaning out to bulk operations) nor would his customers refuse to drop off cleaning if he were not there. If another person replaced the owner and provided the same level of service, there is no reason to believe that the dry cleaner’s revenue stream would be appreciably altered.
An insurance agency’s value is primarily gleaned from its goodwill. Goodwill includes the value of its insurance clients future earnings potential as well as the other normal intangibles of company name, location, identifying image and advertising, known telephone numbers and existing staffing. The other part of value in the agency (much more important in other types of businesses) is the Tangible Net Worth (TNW) or the value of its owner’s equity and its tangible assets (including its cash, equipment, business-owned building, and business owned vehicles). Since most agencies no longer own their own buildings and vehicles and since many don’t even own much of their automation equipment, their TNW is limited to retained earnings and may even reduce the agency’s value if cash has been taken from the agency by the owners for other purposes.
But back to Enterprise vs. Personal Goodwill –
The primary source of Personal Goodwill in insurance agencies is the personal life insurance production of the principals. Life insurance is not a mandatory product and must be sold. Much of life production depends on the sales ability, personality and knowledge base of the particular producer. This is one reason that life insurance sales may be a form of Personal Goodwill. A second reason that life insurance sales fall into the category of Personal Goodwill is that very little service occurs after the sale that cements the relationship between the agency and the client. Most valued goodwill is from the relationship that permits future income streams from the same clients. The third reason that life insurance sales is considered Personal Goodwill is the fact that the income from Life Insurance sales is heavily front-end loaded with very small renewals and for only a limited time. So the future income stream normal to Enterprise Goodwill as a source of value is omitted from this income source.
For this reason, the Personal Goodwill of a pure life insurance agent is at or near 100%. Yes, he still has a valued asset for his own estate planning purposes and for some perpetuation purposes (i.e. bringing in a partner who will increasingly generate more income for the firm and to whom the firm’s ownership will transition over time). However, in the event of a marital separation, valuing the Personal Goodwill of a life agent is considering his future income potential as a part of his asset value. This is especially important when alimony or other forms of support payments are considered within a divorce settlement. In those cases, considering the value of Personal Goodwill as a marital asset AND considering the person’s future income potential in consideration of support payments is ‘Double-Dipping’ the same income source.
However, many life agencies also write other forms of insurance that does qualify in the Diamond 3-Form Test for Enterprise Goodwill.
The Diamond 3-Form Test for Enterprise Goodwill:
1. Is the product available and sold to clients without the need of the specific principal salesperson?
2. Once sold, does the product have a sustainable revenue stream?
3. Irregardless of the method of sale, can the product be sustained, renewed and/or continue its revenue stream through the efforts of administrative or service staff of the agency?
All products that meet the Diamond 3-Form Test will qualify as the basis of Enterprise, as opposed to Personal Goodwill.
Financial Services insurance agencies (like Life & Health Insurance agencies) include service intensive products (like Group Health Insurance) that fit the 3-Form Test. Most of the products of traditional Property & Casualty independent agencies qualify as the basis of Enterprise Goodwill – even though these products may be sold by the owner or other specific insurance agents.
Standard personal lines Property/Casualty products like auto insurance, homeowners insurance, umbrella liability policies, boat and recreational vehicle policies and personal property floaters are all commodity insurance products, some of which are mandated by state law or by lienholders. While they may be sold by individual insurance agents, they are easily transferable, can be sold by any licensed employee, are service intensive after the sale and generate a sustainable renewal income stream that requires the efforts of a service or administrative, rather than a sales staff, to retain. They are perfect fits for Enterprise Goodwill.
Most standard commercial lines of insurance fall into the same categories as personal lines. Packages, Auto, Property, Liability, Umbrella, and Workers Compensation policies are competitively sold by many agents, are generally similar in nature within a geographic area and require service to maintain and renew in order to retain the income stream from year to year. Many licensed agents are qualified to sell these products and no uniqueness exists that requires the services of only the specific agent to create and maintain.
Exceptions exist, even in P&C agencies that may cause certain customers and products to become Personal Goodwill, rather than Enterprise Goodwill. Those exceptions are in cases in which the specific agent has unique skills, talents, experience and product availability that would a) make it difficult to replace his skills through hired agents or competitor agencies, require only his/her participation to service and/or sell or retain the client and/or develop one-time, non-recurring income without internal service needs by the agency. These exceptions exist, but are quite rare. In most cases, independent Property/Casualty insurance agencies’ goodwill is Enterprise Goodwill.