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WHEN DOES IT MAKE SENSE TO SELL AN AGENCY

WHEN DOES IT MAKE SENSE TO SELL AN AGENCY

INSTEAD OF INTERNALLY PERPETUATE?

THE DIFFERENCE BETWEEN GOING CONCERN VALUES

AND FAIR MARKET VALUES

We won’t bother to discuss the obvious situation in which a retiring agency owner has no internal perpetuator available to whom to sell the agency.  Those circumstances require an outside transaction at Fair Market Value to provide the asset value of the agency to a retiring owner.

But what happens when an agency with children or qualified staff successors begins getting offers (that are usually quite lucrative)?  In order to evaluate the offers vs. selling down to internal successors, the agency owner must understand the difference between the Going Concern Value and the Fair Market Value of his business.  The more the departing owner understands these two critically important valuations, the more intelligent he can be about the disposition of the business.

The first certainty that all business owners must understand is that (with a few exceptions) a business must pay for itself with its own earnings and cash flow over a period of time.  For all practical purposes a buyer whether from inside the agency or outside, understands that he is giving up future earnings of the agency for some period of time to allow principal and interest payments to be made up to the value he agreed to for the agency.

Going Concern Value

The GOING CONCERN VALUE of an agency is its future earnings capacity over a reasonable period of time as the agency has been operated historically.  The best way of looking at this definition is for a continuing agency owner’s purpose of purchasing key man insurance on the agency owner to allow for replacement of the agency’s potential earnings to him if something unforeseen was to happen.  It is the estate planning value of a continuing business.  It also describes the potential value of the agency book of business if the successor is from inside the agency and the agency is not expected to change appreciably in the transition of ownership.

In practical terms this value defines how long it will take the new owners to pay for the value of the agency that they are purchasing.  During this time all or most of the agency’s free cash flow will be devoted to principal and interest (if a note is required from the seller or from a financer).  So if an agency has $50,000 of cash flow (after tax earnings and other free cash available) and the agency is priced at $250,000, the new owners will not be able to take any earnings from the agency for over five years (considering interest) as the benefit of their purchase.  That’s fine if the new owners are 40 years old but not so much if the new owners are 65 years old and expect to retire before they are 70.

So the consideration of passing an agency down to the next generation is keyed to the value of the agency, its cash flow and the timing tolerance of the new owners.

 

Fair Market Value

The FAIR MARKET VALUE of an agency still defines its future earnings capacity over a reasonable period of time.  The government’s definition is “the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with both being required to act, and both having reasonable knowledge of the relevant facts.” (Pub 561 (4/2007))

When an outside agency considers buying another agency they calculate the future earnings capacity including two very important ingredients, the savings generated from the loss of the current owners and the economies of scale that they can generate by spending less money on redundant or undesirable costs.

If old owners remain with the agency they may be paid at a lower scale to help retain the business.  The economies of scale depend on the intention of the buyer to keep the purchased agency open or to consolidate it into other offices.  The buyer may also need less staff and other operating expenses that are redundant.  The end result is very specific to the buyer’s ability to generate more profits, earnings and cash with which to pay the seller for the agency.  This results in different buyers having different models and different values for the same agency – and all of them are correct.  This is especially true for the “reasonable period of time” each buyer selects for the maximum payout period.

Reasonable Period of Time

What is a REASONABLE PERIOD OF TIME?  This is a subjective measurement from the perspective of the person financially responsible for the valuation.  For instance if you are planning for life insurance and you are 60 years old, five years may be a viable “reasonable” period of time to project earnings potential.  If, under normal circumstances, you expect to still be in the business at the end of the period it is reasonable to project that need in life insurance to protect your family in the event of your death.  If you are younger and conservative, you may wish to provide ten or fifteen years’ worth of earnings to your family in the event of your death.  But if you are 70 years old, the projection of ten or more years of continued earnings may be a stretch.

On the other hand, if you are buying an agency, the “reasonable” period of time is defined by the maximum duration of the payments you will make to purchase an agency.  Do you want to take ten years to pay for the agency, during which you will take no (or less) profits from the agency than it earns in order to devote the bulk of the agency’s profit and cash flow to paying the former owners?  If you determine that you must fully pay off the agency within five years, then the earnings value of the agency over that period of time becomes your outside limit for your valuation.  That’s one of the reasons that multiple suitors may well propose multiple values, each quite different from the others – with all of them being reasonable to the potential buyers because of their specific needs and conditions.

 

 

Considerations of whether to sell to internal perpetuators or to outside buyers

  1. If the owner is primarily concerned with maximizing value, the outside sale will normally generate a higher price. However, we have seen agencies in which an inside buyer matches an outside offer using a longer payout period to allow the agency cash flow to still be manageable.
  2. If the owner is concerned for the successors (i.e. children and loyal employees), concerned about long term employees well-being and concerned about the consistent treatment of clients who were (or have become) friends more than just customers, perpetuating the agency internally makes a lot of sense with terms long enough to satisfy the seller within the scope of a buyer’s ability to pay. For instance, an agent’s child may have no problem with a long term payout to manage a higher price.
  3. Financing is NOT a problem in either Succession or Perpetuation as long as the price and terms make financial sense to a lender (cash flow).
  4. Whether internal or external sales, Agency Consulting Group, Inc.’s Liquidity Audit can assure a seller of the buyer’s ability to continue to make payments throughout the payout period. (Link Liquidity Audit).
  5. Most internal sales involve the buyer acquiring the company including its stock, assets and liabilities. The internal successor has been involved in the agency for years and is well aware of the strengths, weaknesses, and procedures of the agency already.  They buy the cash of the agency through the calculation of Tangible Net Worth as a component of the price (dollar for dollar value).  This way they simply continue the bank accounts, receivables collections, payments, etc. of the agency.
  6. External sales are most often asset purchases to allow the buyer to take advantage of the 15 year amortization rules applying to agencies. Assets can be the book of business alone, but often includes both tangible and intangible assets.  Buying assets does not involve the buyer in the prior acts of the previous agency owner nor does it assume any previous liabilities.

The key to deciding whether to sell internally or externally is more in the mindset of the owner than in the mechanics of the transaction.  Finances (or lack thereof) should never be a deciding factor since any “good” deal (in which the value can be substantiated over a reasonable period by agency cash flow) can be financed, if needed.  Most deals are determined by whether the agency owner trusts the buyer to be able to meet the total financial obligation.  Call Agency Consulting Group, Inc. for assistance on either (or both) sides of potential transactions to get an impartial view of the deal and to create Win/Win situations.