Two agencies that look like this example exist in most areas of the United States even though the agencies in this example are taken from real life examples in a suburban Midwest state.
Agency A: Commissions $1.5 Million (50%: 50% PL/CL); Total Revenues $1.85 Million (includes P&C, L&H and Contingency Income); five years ago, the agency was $2.4 Million revenue. 2 owners are both in their mid-sixties, one (the producer) wants to retire, the other (Inside Manager) wants to continue working indefinitely. 16 employees, most in their fifties and sixties, none are dedicated producers but the owner. Taxable profit is minimal each year.
Agency B: Commissions $1.5 Million; (60%CL, 40% PL) Total Revenue $1.8 Million (includes P&C and Contingency Income); 2 owners (both producers) in their mid-thirties started the agency five years ago and have grown through aggressive sales and an acquisition of $500k two years ago. 10 employees (4 including owners are producers). Agency books about 10% pre-tax profit each year.
1st question – You have two relatively equal top line revenue agencies – would you pay the same price (assign the same value) for each of them?
Assuming that you see sufficient differences to know that Agency B is worth more than Agency A, this simple example debunks the Multiple of Revenue basis of valuation of agencies. Of course, once you know the acceptable value of the agency that number can easily be converted to a multiple of revenue (or of anything else you choose) to express the value without actually telling anyone the actual value, revenue size or other private details about the agency.
SO – WHAT IS EBITDA?
EBITDA is defined as Earnings Before Interest, Taxes, Depreciation and Amortization. However, when used as a valuation term, most appraisers will add – ADJUSTED to the term EBITDA. What are the adjustments?
Some appraisers will go through the historical, current or trended lines of expenses and ask the client, “How will this expense change in the actual situation of the valuation? If the agency is not changing hands, the likelihood is that the historical trended expenses will continue in whatever trend they have proven – no adjustments are needed unless the agency has experienced non-recurring expenses in the last year that needs to be adjusted out for future earnings projections. However, if ownership is changing, the adjustments reflect what the new owner will likely expend in each expense into the future to correct the earnings path.
Other appraisers, seeking to use industry data to prove adjustments will “adjust” expenses to industry averages (like the ones we publish annually in October of each year since 1985). Every year we specifically state that industry averages cannot be used to judge the validity of any agency’s performance. We urge agents to measure their progress against their own historic performance to judge the progress of their productivity and profitability as an agency. But since the Composite Group tests so many agencies annually, others in the industry continue to mis-use the results to evaluate their performance against industry averages. My question, “Since when do we strive to achieve average scores in anything???” More importantly, adjusting to industry averages is INCREASING the basis of value without any evidence that the agency can or will increase its earnings according to the appraiser’s adjustments!!
WHY ARE WE VALUING EARNINGS EXCLUDING INTEREST AND TAXES?
The exclusion of Depreciation and Amortization along with any other non-cash expense is explainable by suggesting that we are determining the agency’s post-valuation cashflows with which the value of the agency is supported by repayments of principal and interest. However, Interest and taxes are certainly required to be expended after a transaction. Yet the infamous EBITDA creates a dollar amount that purports to be related to value. Meanwhile it is important to note that EBITDA is not and has never been a recognized metric under GAAP (Generally Accepted Accounting Principles) because it can be used to paint a misleading picture of a business and its profitability when arbitrary changes are made to adjust earnings in one direction or another.
So, the appraiser has created a financial marker that does not reflect the historical earnings of the agency in questions (because of the adjustments) and that doesn’t reflect the cashflow with which the agency can be paid for if a transaction is pending.
WHERE DOES THE MULTIPLE COME FROM THAT IS USED TO DEFINE A “VALUE” TO THE AGENCY?
This is the greatest part of the “shell game” – The appraiser uses a “multiple” of EBITDA that is supposed to be a current average EBITDA for similar types, sizes and location of the agency being valued.
This example cites two medium sized agencies with similar books of business in a similar geographic area. However, there is no common data base of transactions that occur for P&C agencies with generally 50/50 PL/CL books of business in the region of the country. The best that an appraiser can do is draw from published reports of some (only publicly traded company transactions are published and they are not easy to find). So, it is likely that the appraiser will use some factor that is familiar to the appraiser without the data set that allows averages to be published (and available to everyone) in a heavy transaction industry like the Real Estate industry.
So, not only is it inaccurate to define the value of an agency as a multiple of revenue but, since EBITDA can be “engineered” to whatever earnings are desired through the adjustment process it cannot be used as an expression of future or proforma earnings capabilities of the business.
Finally, a common database of transactions by type, size or geography simply doesn’t exist in the insurance agency industry so whatever “multiple” of created adjusted EBITDA bears no relationship to the cashflow of the agency that will likely be used to pay for a transaction that transfers ownership internally or externally.
The value of an agency is its future earnings potential for the number of years that is acceptable to its buyer. This requires the projection of both revenues and expenses over the period that the buyer expects to pay for the agency in order to assure that the buyer will have sufficient cashflow to sponsor the transaction. Of course, it’s not quite as simple as this implies, but it is no mystery, either. Believe me – every buyer will mentally or physically calculate whether the amount he’s paying over the period of time he needs to buy the agency can be covered by the cashflow of the agency during that period of time.