All values of an insurance agency will derive from that agency’s :
- FUTURE EARNINGS POTENTIAL
- UNDER THE SPECIFIC CIRCUMSTANCES OF THE VALUATION
- FOR AN AGREED UPON REASONABLE PERIOD OF TIME
In other words, whether a transaction occurs or not, the value of a business depends on how much a specific willing buyer can expend of the ready cashflow presumed generated by the agency over period of time acceptable to the buyer and seller.
Example A: If an agency intends to continue in operation relatively similarly to its recent history under relatively the same management and direction, then its historical growth, profitability and cashflow is the best predictor of its future growth, profitability and, most importantly, its cashflow from which any buyout of existing owners will occur. The agency is valued as a Going Concern and the value is based on the cashflow the agency will turn in an acceptable reasonable period of time.
Example B: If an agency is to be purchased by another business then its future performance may still find a basis from its historical performance but a pro forma must be created identifying the growth, profit and cashflow potential changes resulting from the conditions of the new ownership. So, if the firm will no longer need certain managers, core expenses (i.e. rent), functions (i.e. reception, accounting, etc), and external expenses (legal, CPA, separate automation, etc) those changes must be considered in the future cashflow potential that constructs the Fair Market Value of the agency under the specific circumstances of the potential sale.
These two different scenarios identify why a Fair Market Value is often greater than a Going Concern Value. However, it is unfair to use a Fair Market Value scenario for the valuation of an agency when the intention is to keep the agency performing as a Going Concern.
Imagine that a Going Concern Value of an agency is $1,000,000 based on the cashflow expectation over the next five years of performance. If an outside agency who will cut costs and/or change marketing to enhance growth finds that it fully expects the same five-year period to generate $1,500,000 of value, thereby permitting it to offer the owner of the agency a premium over its Going Concern value without losing future earnings potential after the same five-year payout commitment.
Imagine that if the outside agency owner is young and would offer a price over ten years instead of five (he is willing to give up his profits for a decade in order to obtain the agency), he could offer $2,000,000 for the same agency assets. Most mature owners who may expect to cash in their investment in their agency within several years would probably not be interested in a long-term deal in which they continue to pay a selling owner of an acquisition most of the agency’s profits for a longer period of time than the buyer has to remain in the business.
If a retiring owner wants to maximize his return by seeking the highest possible value for his stock, a third option should be considered.
Example C: The sale of the agency asset (book of business) to a viable entity that will close the agency, eliminate the staff and service the business through local or regional offices and national service centers will absolutely maximize the potential return and value of the agency to its current owners. It will create a high Fair Market Value in which the buyer can offer the seller a high price and still earn a profit and positive cash flow from the acquired business.
Unfortunately, this method will eliminate dozens of careers, may affect any close customer relationships and will eliminate the possibility of the continuation of a generations-old business that would provide longevity and ownership for at least one, and potentially several further generations of owners, whether in the same family or not of the originators of the business. A Dissolution Value of a similar business would likely allow for a further premium over the Fair Market Value of the agency. Most of the time this method is used in a single owner agency with no perpetuation and a slim staff in which the owner is at physical peril in the near term or is prepared to leave the geographic local for retirement. It simply maximizes the value received for the asset being sold.
PURPOSE OF THE SALE
In many cases (but certainly not all) of the sale of stock, especially for minority stock holders, the stock holder desires the maximum value for the stock being redeemed. However, if the agency will remain in operation in the future as it has in the past, the Going Concern Value is the appropriate cash flow value for the redemption. The use of the Going Concern Value allows for the orderly transition of some or all of the stock from one generation to another of a continuing business.
If, through valuation or genuine offers, the redemption value of stock is pegged to a Fair Market offer from an outside entity, the future cash flow of a continuing agency will be stressed, sometimes beyond tolerance, by a price that is far beyond the agency’s cash flow potential during a reasonable period of time.
So, for example, if the payment for stock redemption is proposed for a five year period in a Going Concern scenario and, instead, a Fair Market Value is used to redeem the stock, the agency will have to pay for (or finance) the stock re-purchase over a longer period of time to allow for the higher value estimate for the retiring stockholder. This will also cause the remaining (or new) stockholders to claim a higher than actual cash flow basis for their stock in the future. Buying stock at a Going Concern Value and selling it at a Fair Market Value will eventually erode the agency’s Tangible Net Worth.
SOLUTION
The key to stock redemption is for the stockholders to know, understand and agree to the method of stock redemption long before an event. The Stockholders’ Agreement should contain a clause that any change to the stock redemption portion of the Agreement should be made by the majority vote of all stockholders NOT expected to redeem their stock within a stated period of time (i.e. one year or two years).
The value of stock being redeemed in a retirement of stock in a Going Concern should be defined by the owners who are not involved in any upcoming redemption.
All owners must recognize that there is a visible and recognizable amount of cash that can be expended in a healthy business without eroding its Tangible Net Worth by borrowing money for no better reason than the redemption of stock. That recognizable value is based on the projected reasonable cash flow of the agency during the period of time agreed upon for the payout of the stock redemption.
If the agency can support a $1,000,000 cash flow payout over an acceptable period of time, “fooling” the numbers by asking for a premium based on Fair Market Value is ludicrous if the agency is not expecting to be sold to an outside firm. The reason it is ludicrous is that no single Fair Market Value exists. The FMV will change based on the economies of scale constructed by each potential buyer and by the percentage of cashflow each is willing to give up and the time period each is willing to give up profits to the sellers.
If a minority interest is being sold, FMV as a basis of value is only viable if the entire agency is being sold. If only a minority interest is being sold, Going Concern Value is the only fair identifier of the value of that minority interest. However, for the protection of the seller of the minority interest, an agreement should include the enhancement of the value to the actual FMV of the agency if the entire agency is sold within a two- or three-year period after the sale of the minority interest.
WARNING
THE PRESUMPTION THAT THERE EXISTS A STABLE “MULTIPLE” (OF ANYTHING) THAT REPRESENTS THE VALUE OF ALL INSURANCE AGENCIES IS THE WORST KIND OF SLIGHT OF HAND. IN FACT, EVERY AGENCY HAS A REAL VALUE BASED ON ITS HISTORY AND THE WAY IT OPERATES – ITS CASH FLOW POTENTIAL. USING ANY MULTIPLE INSTEAD OF CALCULATING THE AGENCY’S LIKELY CASHFLOW WILL EITHER UNDERVALUE OR OVERVALUE THE ASSET BEING PURCHASED.
So if someone offers you TWO TIMES or THREE TIMES ( or more) for your agency the buyer has either calculated the cash flow potential of the agency and translated that to some mysterious “multiple” or is rolling the dice hoping that a 7 or 11 comes up and he has understated the cashflow instead of throwing CRAPS and having to pay more than the agency is earning for many years in order to buy its cashflow. It’s not a great deal if you have to pay 100,000/yr to principal and interest for five or ten years and only get $50,000/yr from the agency being purchased. There better things to do with your excess cashflow from agency operations than to use it to pay for new cashflow that can’t pay for itself.