Often insurance agencies are passed from owner to owner at a time when the retiring owner is at the peak of his/her earning potential while the incoming owner is at the height of his expense load while raising a family. We have seen many instances where agencies were sold to an outside party simply because the internal successors were unable to sponsor the buyout of the departing owners.
Happily, the means exist to avoid the loss of internal succession simply because of financial reasons.
What Does the Owner Want/Need?
A departing owner wants to know that the agency’s value will be secure when he sells. That could mean a large cash payment financed through a bank or other financial institution. In many cases financial security means some cash payment and a note to the retiring owner for the balance of the agency’s value.
For Every Benefit, Drawbacks Also Occur
The benefit of large cash payments is obvious (‘A bird in the hand is worth two in the bush’). However, substantial drawbacks strike both the buyer AND the seller. The buyer must raise substantial cash during the period of time in his life that he is least able to do so. Even the friendliest financial institutions will charge substantial premiums (higher interest) for the purchase price of a business and the borrower must secure those funds with all of his own assets as well as with the agency, itself. Most financial institutions don’t understand a cashflow business like an insurance agency and will not accept the security of agency renewals as collateral. In any event, raising even 20% or 30% of an agency’s value and securing 70% to 80% through outside financing is difficult at best and financially paralyzing at worst.
The drawbacks of cash payments aren’t limited to only the buyer. The seller will face tax bills that will be staggering if he sells an agency that he began (a zero basis business). No one wants to lose from 20% to 40% of the value of his agency to immediate taxation if it is avoidable.
Stock Options – One of Many Potential Solutions
As I’ve said numerous times, if we’ve helped a thousand agencies transition ownership, we’ve seen a thousand DIFFERENT ways of completing the transaction based on the needs of the seller and the needs of the buyer. One way we’d like to discuss is the prudent use of Stock Options to lighten the load on the buyer while annuitizing the value of the agency to the seller through timed purchases of segments of his stock back to the agency.
An “Option” gives the buyer the right to buy stock at an agreed upon price within a specified period of time. This method can be used to bonus stock to an employee without requiring him to pay for the transaction as long as the option hasn’t expired. And, by anchoring the price, if the stock (value) of the agency continues to increase it doesn’t affect the strike price of the stock option and the employee can find himself in a profitable situation by simply exercising his option.
To use this method in agency succession and perpetuation we simply extend the option to the duration of the employee’s tenure at the agency. If the agency owner’s retirement is imminent, the new owner would have to buy (or be gifted) at least one share of stock to become an owner. If the agency owner is staging his exit over time this is an excellent way to incent and reward the future owner with stock as the agency continues to grow and prosper during the remainder of the current owner’s tenure.
The agency uses its cash flow to purchase the owner’s stock either the total holdings or in sections with the stock going into Treasury Stock that would be available to option to the next generation of owners. The agency could borrow to pay the owner if the cash flow is insufficient to sponsor the payout to the owner for the value of the agency’s stock that he is redeeming. We have ready access to funding as long as the cashflow is sufficient to sponsor the principal and interest payments for the borrowed funds.
The agency’s cashflow, usually increasing substantially at the owner’s retirement, becomes the vehicle that permits the agency to purchase itself over time. The goal of the new owner is to grow the agency to afford the cashflow expense to the owner in payment of his stock back to Treasury Stock.
The retiring owner has the benefit of a long term payout including an interest rate that will add to the value received from the sale of his agency.
The buyer will be granted stock options at beneficial strike prices every year by achieving agency goals that will both assure the retiring owner of the ability of the agency to continue to pay for his stock buy-backs and will eliminate the need for the buyer to make himself cash-poor at the time in his life when his financial needs are the greatest.
How Stock Options Work In Insurance Agencies
We always recommend that stock options be granted for results-based growth of the agency. If the internal buyer is a producer that means revenue growth. If the internal buyer is responsible for service, the option is achieved for retention goals (customers and revenue). If the internal buyer is a manager, the option is triggered by profitability to expectations (dollar and percentage of revenue). In any of these cases positive results yield options for a pre-determined amount of stock at a beneficial strike price (the value of that option through the option period).
Pre-determined amount of stock optioned: The owner determines how much stock to be optioned to the employee as a reward beyond normal compensation for the achievement of the employee’s goals for the year.
Beneficial Strike Price: The most attractive part of this type of option is the ability to sell the stock at an anchored option price that does not increase as the agency value increases and may even be discounted to benefit the buyer. In the case of producers earning stock options some agencies have offered discounted value for stock options to further incent producers to continue to grow the agency. The difference between the actual stock value and the discounted value, whenever the stock is redeemed, is charged against the agency’s Tangible Net Worth on its Balance Sheet. As long as the agency is growing value, the Balance Sheet can normally easily withstand the discounting of stock options.
Option Period: The other magic part of options used to transfer stock ownership is the ability to exercise the option as long as the employee is employed by the agency. The risk is that the option automatically expires upon the death or departure of the holder from the agency. This acts to cement the relationship between the option holder and the agency and many agencies have used Key Man Life Insurance to replace the value of the optioned stock in the event of an unforeseen death of an option holder. Many times the options are not exercised until the day before the buyer, himself or herself, retires from the agency. At that point all options are exercised on paper and the sold back to the agency the next day to sponsor more Treasury Stock for the next generation to use in the same way.
Stock options is one of many ways of creatively transferring the value of an agency from one generation of owners to another. Call Al Diamond at 856 779 2430 to permit him to assist your agency in the most effective and efficient way to internally or externally perpetuate your agency in order to provide the value you so richly deserve from your decades of hard work and allow youngsters to assume ownership without paralyzing them financially to do so.