The value of an agency should be cast as a Going Concern for its primary asset, its book of business. What that means is that the value is comprised of its future earnings potential to its current owners based on the agency continuing to perform as it has historically. The only exception is that we cannot assume value based on future potential acquisitions. Acquisition value can only be considered for completed transactions.
This Going Concern value is important because it expresses the value of the agency’s shares to its owners in the event of the death or departure of an owner requiring redemption of that owner’s share of the business. The Going Concern Value reflects the value that the agency can substantiate in the reasonably near term (whatever the owners consider “reasonable”) that should be redeemed if the ownership interest is bought back into the agency. This value can be supported by agency cashflow as it continues to operate in a similar fashion as it operates currently.
The Going Concern Value is critically important when the agency considers additional acquisitions to identify the opportunities for its future growth (of revenues and of value) by adding new agency assets. For this reason, the valuation and cashflow potential of an agency must be determined before valuing any new agency acquisition.
We could also create a Fair Market Value for an agency – the value of the agency as an acquisition by or merger into another agency.
The differences between a Going Concern Value and a Fair Market Value are immense.
A Going Concern Value shows the agency owners how much the agency projects it will generate in after-tax earnings if the agency continues to perform as it is currently and has historically under the circumstances of new ownership. The Fair Market Value tells agency owners how much the agency is worth to another buyer who would likely change staffing, surviving locations and operating methods to maximize the earnings potential of the agency under new ownership and management.
Obviously, the Fair Market Value of an agency is often substantially greater than its Going Concern because of the economies of scale that can be enjoyed by a buying entity. If the agency’s owners were seeking the maximum they could generate from the sale of the agency, the Fair Market Value should be done based on the buyer’s expectations of economies that could be created.
Too many owners request a Fair Market Value because ego demands the highest value estimate for their asset. Multi-owner agencies who request a Fair Market Value and try to use it to support Owners’ Buy/Sell Agreements find that the value is so overstated compared to its earnings potential as a Going Concern that the agency MUST BE SOLD in order to accommodate the redemption of ownership interest by a selling owner or an estate. This means that if the owners agree that the value of their agency is equated to its value if sold to an outside entity, then if one owner dies or departs, requiring the redemption of his/her interest in the agency, the “accepted” liability to the agency may be far more than the actual cashflow of the agency as it currently operates. In other words, the agency could not afford to buy back an owner’s interest with current cashflow.
For instance, if an agency can generate 400,000/yr in earnings to its two owners and they project continuing operations for the next five years, it is logical that their value as a going concern be in the vicinity of $2,000,000. However, a purchasing agency might close the agency location in favor of moving the book of business to the new owner’s existing location, reduce several agency staff member positions whose jobs become redundant and would not need a second accountant or attorney and save money on those outside services as well. That means that the acquiror could earn substantially more from the acquisition of the agency than the current two owners could earn, thereby permitting the buyer to offer more than $2,000,000 for the agency assets, its book of business, and still turn a profit on the transaction.
If the agency in question valued itself at Fair Market Value and used that value in the Owners’ Buy/Sell Agreement then the death or departure of one owner would require the remaining owner to purchase the departed owner’s interest at a higher price than could be justified by the agency as a Going Concern (generating $200,000 /yr to each owner in total earnings (compensation, benefits, perquisites and profits). The remaining cashflow after the departure of the former owner would be insufficient to sponsor the value of 50% of the Fair Market Value of the agency under different circumstances. And, worse yet, financial institutions who would be used to finance the re-purchase of the departed owner’s stock could not justify loaning the agency more than the $1,000,000 of cashflow freed by the departure of the former owner. The Fair Market Value that was used to sponsor the Buy/Sell Agreement would likely be much more than the Going Concern Value and the free cashflow to pay the bank’s principal and interest.
We have seen many agencies forced to sell because the owners agreed to redeem stock at FMV rather than Going Concern value.
An agency acquisition, as opposed to a Going Concern Value, is correctly valued for its Fair Market Value. While the owners of the acquired agency may stay and hopefully enjoy the economies of scale that can only be achieved by their joining buyer’s agency, the value that the buyer can afford to pay the seller will be determined by how much additional cashflow and earnings potential can be enjoyed by its acquisition of the seller.
The value of the selling agency is the reasonable maximum value that the buyer can afford that is supportable by both the increased cashflow and the increased value potential from acquiring the seller’s assets. How that value is transferred to the owners of the seller (cash, Down Payment and terms, finance, buyer’s stock, shadow stock, or a combination of any of these tools) is a separate issue and should be discussed once the buyer presents an acceptable offer to the seller.