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OID = OWNERS IN DEBT

TRYING TO FILL-IN AN AGENCY SINKHOLE

It is important to note that the true value of any business is its future earnings potential for the sponsor of the valuation.  This means that the most accurate determination of value would be to measure the profit results of the target company for as many years as the transaction is negotiated.  The total of those earnings (profits after taxes) represents the maximum that someone will spend (or earn) from the operation of the business. 

For instance, if YOU wanted to value the agency as a Going Concern, continuing in operation as you have operated in the past and wanted to replace the value of the business over five years, you can easily take the value of the earnings of the agency including the earnings of the owners in excess of the fair compensation to replace the efforts of the owners for the past five years.  Unless you intend to change the way you do business, building out the revenues and each line of expenses for the next five years will tell you how much you are likely to “earn” from the agency as its owner.  The total of those future earnings equates to the five-year value of the agency to its current owners.  This is most often done to sponsor sufficient life insurance to make up for what you would have earned.  The lovely part is that, assuming that nothing happens to you, after that fifth year, you still have the agency asset to add to your total estate value.

On the other hand, if you were to sell the agency to a local competitor who doesn’t need your location, only needs a few of your service or administrative employees and has the production staff to take over your key clients (your top twenty to fifty customers who need a relationship to warrant their staying with you), his proforma operating profit and earnings potential could be far in excess of YOUR internal track record of earnings and he could offer you substantially more for the agency than you would earn yourself.  Of course, the results might not be pleasant for your staff and for your customers, but the value would be maximized.

These examples are the reason that “multiples” of revenue, commission, earnings, EBITDA, etc are truly invalid as a valuation tool and actually often cheat either the appraiser or the owner of the organization being appraised.  And every agency has a different set of criteria that applies based on the specific conditions of the agency, its book of business, its staff, its history and its goals and intentions.  By casting a “multiple,” agents have often found that their cashflow cannot match their obligations and they are OID (Owners In Debt) for the rest of their careers.

The same agent who was previously earning a good living off his new and renewal sales finds himself using every dollar of agency net income and his prior commission income to pay the principal and interest on the loan that was sponsored by a bank or by the old owner.  In a soft market, an economic downturn or losing a few large accounts can make the new owner lose sleep over the possibility of defaulting on the note to purchase the agency for an amount that sounded reasonable as a multiple of (something) payable over a long period. 

During any of our analyses or valuations, we construct a Cashflow Analysis that tests debt tolerance.  Too often we find that the deal that seemed reasonable when the retiring owners sold to his next generation permanently seals the new owners as OID (Owners-In-Debt) and the agency becomes the debtor’s prison for between five years and the rest of the new owners’ careers.  Often, the rationale for the price tag for the agency was an offer made by another agent seeking to purchase the agency before (or without) the analysis that most agents conduct between the agreement and the closing date that allows for changes in case the cashflow doesn’t meet the price of the agency.  In many cases the other offer is “reasonable” as made because it considered not hiring some or all of the staff, retaining the location or changing the servicing method to outside vendors (regardless of the impact on the customers).  So, the other agent could afford the higher value – the cashflow would be there for the debt. 

Then the owner offers the agency to his internal successor at the price offered by the outside agent.  The retiring owner thinks, “if it’s reasonable for the other agent to buy at that price, it should be reasonable for my successor to buy it under similar terms.”  Unfortunately, the successor is burdened with the staff, location and any inefficiencies that are normal to the operation of the agency (unless serious changes are made in the agency’s operation).  In short order the new owner realizes that there isn’t enough money every month to sponsor the principal and interest.  Either the new owner devotes part of what his earnings to the operation of the agency or he must trim expenses or grow quickly to solve the problem.

The obvious answer is to value the agency based on the specific buyer/owner’s circumstances.  Typically, our valuation service serves this purpose well.  We have you complete a very deep questionnaire that explains all of the vagaries of the agency to us including personal earnings of the owners and every line of revenue and expense for at least five years.  The result is a projection that has proven uncannily accurate in projecting the future earnings potential of the agency if all conditions of the future operations are met as expected.  And, a part of every valuation is a Cashflow Analysis that indicates what the cashflow tolerance is for the agency under the circumstances specific to the conditions of the valuation.  Change the conditions and the cashflow analysis changes instantly.

Every agency, whether changing ownership or not, deserves annual or occasional valuation.  Whether you are validating your estate plan, planning for you next generation of owners or planning for sale when you retire, you will need to set your goals based on the actual value you will receive for your agency.  The Valuation and Cashflow Analysis that is a by-product of the valuation will give you valuable information that you can use now or in a Contingency Buy/Sell Agreement that is only triggered upon death or disability.

Call Al Diamond at Agency Consulting Group, Inc. 856 779 2430, al@agencyconsulting.com to get more information or if you have any questions.