A recent question was asked regarding the appropriateness of ceding the contingencies earned by an agency in the last year before a sale to the buyer or to the seller.
For those of you who know me, you already understand that my answer always begins with “IT DEPENDS!”
Since this question arises often, I thought it wise to share the response to allow others to see the methods of handling contingency income generated in the last year before a sale, but paid after the sale date.
There are 2 ways to value an agency, with and without contingency expectations. Whether you include contingency expectations (including next year’s contingency income) in the valuation depends on whether contingencies are reliable enough historically to project them with relative accuracy. The Contingency Percentage is determined by dividing this year’s contingency income by last year’s P&C Commissions. Do this for five or more years and you will see if the Contingency Percentage is up, down and all over the place or consistent and trending. If contingencies can’t be trended; they go from zero to thousands and back to minimal numbers, then you should value the agency without contingencies and yield the contingency income (if any) generated in the first year after a sale back to the previous owners.
IF you value the agency including the expectation of contingency (i.e. you expect $20,000 of contingency and include that 20k in the valuation), then the buyer is purchasing the upcoming contingencies. IF you are just buying the commissions generated from the book of business and have not considered contingency expectations, especially in the year following the purchase as a part of the price, then the seller gets the first year contingency income, that which was earned while the seller still owned the business.
The foolish child who just ‘shoots from the hip’ with a “multiple” of something as a value might as well throw a dart at a chart to figure out whether the value is appropriate and then contingency is just another moving target, negotiable by either party.
It’s much like buying a car: If you analyze all parts of the car to determine what will need repair costs, the gas mileage and the true condition of the car, then you buy the car full of gas (even though the gas was put into the car before the sale), you don’t repay the seller for the tank of gas – it’s a part of the deal. If you negotiate an ‘as is’ price and the car is purchased without a tank of gas and you ask the seller to fill the tank so you can drive it home, it makes sense that you pay him back for the gas – the car wasn’t sold full of gas – it’s the seller’s gas money that was used. But if you buy the car for blue book value without ever seeing or driving it, then any negotiations are fair. You have no idea if you’re getting a bargain or getting raped with a lemon. — HOPE THIS HELPS!