Agency Consulting Group, Inc. performs many valuations annually for agencies to identify the current value of an agency for both Going Concerns (in which the agency does not expect to change ownership) and for prospective mergers and acquisitions (internal or external).
For many years we have encountered a condition that we have labeled as the DEBT SPIRAL that occurs to otherwise healthy and well-run agencies that erodes agency value, whether a transaction is being considered or not.
Like a cancer, this condition may appear and grow without the notice of the agency owners if they are not concerned with the inherent (Balance Sheet) value of their business. But this condition is truly insidious and destructive and, without attention, will erode the eventual value of the agency until it becomes relatively worthless.
What is a Debt Spiral?
A debt spiral occurs when an agency spends more than it generates in revenues, eating into retained earnings (prior years profits that remain in the agency after taxes to form a cash buffer for the future).
Whenever you see a negative profit (a loss) in your Year-End (or Rolling 12 mo) Operating (Profit & Loss) Statement, it means that your financial manager had to penetrate the Equity Value of your agency to make up the difference. Unlike the US Government, you cannot print money and must take living cash from some other form of equity to allow your Company to continue to operate.
Why Does a Debt Spiral Happen?
There are only a few reasons for a Debt Spiral.
First and foremost is when agency income diminishes or doesn’t keep pace with increased costs. Typically, those costs are in the compensation lines with most of the increases accruing to owners’ compensation. Imagine what happens if you clear all profits each year as bonuses to owners and contingency income declines or disappears. If you continue to take the same amounts in compensation each month, you will soon run out of operating cashflow and begin penetrating the agency’s savings and retained earnings.
If compensation costs (or other operating expenses) continue to increase without commensurate growth in revenues (or re-occurrence of contingency income) YOU ENTER THE DEBT SPIRAL.
Many agencies have sufficient reserves to withstand one or two years of negative equity – but as many as 25% of the agencies in the U.S. are living with NEGATIVE TANGIBLE NET WORTH, defining the Debt Spiral.
How Does the Debt Spiral Affect the Agency?
First, even stable Going Concern agencies will eventually reach the end of their cashflow. It will happen when the combined losses of the agency reach its Equity Potential. When that occurs, the agency runs out of money and requires additional-paid-in-capital infusion or loans for Operations. Your first indicator will be when you have to borrow against Lines-of-Credit and can’t readily pay them off within a few months.
The second indicator is when an agency feels pressured to merge with (or sell to) another agency because of financial pressures. The problem is that the return for the agency will not be enough to overcome the negative Tangible Net Worth the agency has built.
What that means is that the agency does not have sufficient reserves and Equity to repay all of its obligations (to carriers, to return premium accounts and to debt) with the value received for the transaction. This puts the seller into an untenable position requiring infusion of the owner’s cash simply to pay off the agency’s debts before the transaction.
How to Avoid the Debt Spiral
- Don’t spend more than you take in every year!! This usually means that the agency owners must tighten their belt and take less to permit a Break-Even cash situation or better.
- Use your Lines of Credit during weak months ONLY if you know that you will be able to pay off the LOC in the following 1-3 months when cashflow is known to be stronger.
- Make YOUR compensation a percentage of income, rather than simply the amount that you need to support your personal expenses. The ratio of your compensation vs. Operating Income (commissions and fees) at the end of the last positive results year is the percentage of operating income you should take from the agency every month of the new fiscal year.
The DEBT SPIRAL does not have to be a DEATH SPIRAL but could certainly become one if the agency owner(s) don’t pay as much attention to their Balance Sheet as they do to their Operating Statements. Remember, you didn’t get into the negative Tangible Net Worth position in any single year. If you are only showing a negative TNW for one year, it should be easy for you to exit to a positive position in the next year or two. But most agents have been in negative TNW positions for several years and they should expect to “bite the bullet” and take the hard steps needed for as many years to get out as they took to get into trouble in the first place.
Call Al Diamond at 856 779 2430 to discuss your situation in total confidence and we will help you exit the Debt Spiral.