We’ve spent countless hours explaining why multiples of anything (commissions, revenue, earnings, EBITDA) is an easy way to express the value of an agency when the value is already known BUT NOT AN ACCURATE WAY OF DETERMINING THE UNIQUE VALUE of a specific agency.
You either understand our rationale or you will keep guessing that your agency is worth 2X, 3X or some other multiple (of something) that will make you feel good about the prospective value of your agency.
But I’ve never really explained the process of “CLEANING” your cashflow to determine its actual value to a specific buyer (whether within the agency in question or an outsider buying the agency).
The value of any agency is its FUTURE EARNINGS POTENTIAL (in the hands of the person buying the agency) over a reasonable (to the buyer) period of time, inclusive of the risks and rewards that may increase or lower the chances of those future earnings potential from occurring. After all, why would ANYONE want to buy a business for more than it is likely to earn over a reasonable period of time???
The big question is “How do I determine a) what the future earnings potential is for the business? And b) what are the risks of NOT achieving the reasonable earnings potential (either falling short or earning a lot more than expected) that could discount the value of a business or appreciate the value further?
The answer to determining the likely value of future earnings in an agency is NORMALIZATION of revenues and expenses that is likely to occur once the specific transaction is made.
Normalization can result in either increases or decreases in specific income or expense lines IF the transaction occurs as you would expect. For instance,
If an owner is retiring and (s)he generates $50k of life insurance NB each year, that income stream would cease if the owner retired and if you didn’t replace that sales effort. It would DECREASE the gross income projected in the future from life sales.
Similarly, if the retiring owner was an active producer of P&C new business, you will lose that level of production (all or some of it) if that owner retires. Your projections for income should be projected accordingly.
If you are buying an agency with similar markets, you should calculate the effect of that agency’s production on YOUR contingency income potential – it could very well have a greater positive impact on the combined volume contingency of your agency than it had on the acquired agency historically – a positive projection caused by normalization of income.
On the expense side, all expenses that are associated with the departing owner should be addressed and adjusted in your proforma projections of the agency’s expenses because NOT having those expenses will INCREASE your earnings potential (and the value of the agency’s earnings to you over its historical earnings for the former owner). Examples of owner’s expenses are T&E, auto, occupancy costs (especially in owner-occupied buildings) and personal expenses previously assumed by the agency. Lowering expenses increases earnings potential and the value of that agency to you over the value of the agency as a Going Concern to the departing owner.
When you do your proformas of expenses to estimate what YOUR earnings potential will be in the calculation of an agency’s value you also need to consider the ECONOMIES OF SCALE that will return you more profit when you operate the agency than the former owner earned. For instance, you may not need his location (a major earning gain for you). You certainly won’t need his professional administrative expenses (legal, accounting, etc), especially after the first year of extraordinary expenses related to the acquisition) and may not need some of his staff if they are redundant to your support team in an agency acquisition.
Even if you are the selling owner, you can determine your Fair Market Value by eliminating, adding, or changing revenues and expenses that would not be the same if you sold the agency. You may not be able to do it as accurately as the buyer (because (s)he knows exactly how much more or less it will cost to operate your volume and expenses within his/her shop) but you will still be able to see how much you can expect from a buyer as a premium over your earnings as the owner of your agency.
Transacting an agency is not as much a guessing game as it is an exercise in projecting earnings.
If you go down through your P&L Statement on a line-by-line basis and ask yourself, “What would change if the ownership of the agency changed (whether internally, to a specific outsider, to maximize value)?” This is the core of our Valuation services to agencies. We help you determine the value of your agency or one that you’re considering buying by determining its earnings potential based on its historical performance NORMALIZED to its expected performance (income, expenses, profits, and EARNINGS AFTER TAXES) to determine what the likely value will be to you, to your successors, to your perpetuators, or you for the purchase of another agency.
Our mantra has been De-Mystifying Agency Valuation – we do it for a living and we do a LOT of valuations annually. But, you can also do it yourself by understanding the historical revenues, expenses, and profit potential of the agency you’re valuing. Normalization is one ingredient for identifying the value potential of your agency or of an agency you’re seeking to purchase. Just don’t be fooled into using a multiple to try to establish the value of your agency or of one you’re considering acquiring. Without going through the exercise of identifying cashflow (including the Normalization process) you will either cheat the seller or the buyer and might create a nightmare when the cashflow is insufficient to pay for the acquired debt service.
Please call Al Diamond (856 779 2430) email al@agencyconsulting.com website www.agencyconsulting.com with questions about agency valuation.