When ‘push comes to shove’ the answer to that question is hidden in the cash flow analysis of the agency in question.
The first thing you must ask yourself is whether the price of the agency and the terms of payment can be managed with the loose cash that will be driven from the agency operations during the term of your payout. If you buy the agency for cash, requiring a personal loan or from other people or entities, unless you or they never expect to get their money back, you have enough free cash (earnings after taxes) as if you were paying the seller directly over time. If you buy the agency for cash, you will likely pay a higher interest rate to a bank or to a venture capitalist than if you use seller-financing or other creative ways of getting cash to the seller.
But the fact remains that if you buy an agency for $100,000 or for $1,000,000 or for $10,000,000, you must earn that price beyond normal agency expenses in order to complete the purchase. Remember, the agency may be yours to operate and be concerned over, but it isn’t yours to enjoy the financial benefits until the last dollar is paid off.
The way Agency Consulting Group, Inc. determines the affordability of an agency is to do three things, 1) we value the agency based on the conditions of the acquisition to determine if the entity’s future earnings should be sufficient to pay for the agency over a reasonable period of time, 2) we create historical cash flow analysis to determine if the agency operations has been throwing off sufficient cash to provide the new owners positive cash flow within a short period of time (one to two years), and 3) we periodically run the agency’s balance sheets to gauge the liquidity of the business.
Imagine for a moment if the agency you want to purchase is living ‘hand-to-mouth,’ paying for its expenses every month with income generated in the next month. If it struggles to find enough cash to make payroll and to satisfy its carrier accounts current, its historical cash flow is not good. If we can enhance the cash flow of the agency through economies of scale, it may still be a viable acquisition. If not, this will be a bad business deal for the buyer. If the seller can’t afford to free cash and has low liquidity in the agency, how will you do better?
We recently pointed out to both a buyer (a 50 year old) and a seller (a 65 year old) that an agency being perpetuated only threw off $25,000 of excess earnings (cash after taxes) each year for the last five years. The new owner was going to replace the old owner, so the new owner was going to need to take the same level of compensation in order to make a living and pay his family’s bills. It was an internal perpetuation issue so no changes in operations were considered to lower costs further. The buyer’s plan was to ‘sell more insurance’ to provide the funding to pay the seller $50,000/yr. plus interest over ten years to buy the agency for $500,000. The buyer had been in the agency for at least 10 years, so it was unlikely that the income stream would change dramatically except without the old owner, it was likely that some of his clients wouldn’t stay. It didn’t take a financial genius to tell that this perpetuation was unlikely to succeed for the seller who was rightfully concerned over getting the value of his agency, and for the buyer who was risking his career and future without a plan to pay for it. And, even if he was able to pay for it, he was almost making himself indentured to the seller until it was almost time for the buyer to retire.
The answer to the question of affordability is to analyze the value of the agency to make sure it can be paid off quickly enough for the new owner to enjoy the benefits of ownership for a moderately long part of his career. Agency Consulting Group, Inc.’s agency valuation does this in great detail as a third party analysis. Agents who are very familiar with insurance agency finances and balance sheets may accomplish the same effort with the benefit of running ‘what-if’ scenarios by purchasing an annual subscription or a lifetime subscription to The Agency Valuer, a software solution (in Excel) that performs the same analysis in house that Agency Consulting Group, Inc. does within its extensive Agency Valuation service. And, a further benefit is that the cost of The Agency Valuer can be applied against a full valuation if the self-evaluation tool is found to be insufficient for the practicalities of agency acquisitions (all financial firms require a third party valuation to validate the agency value).
The second tool that is available to agents is the Agency Consulting Group, Inc. Liquidity Audit. This tool protects a financing entity, the existing owner of an agency or any financial institution or funding source, by auditing the agency’s balance sheet on a monthly basis to assure the seller of the buyer’s continuing ability to pay for the agency. Agency Consulting Group, Inc. performs a liquidity audit on the agency prior to the transaction to determine the baseline Liquidity Ratios defined is the ratios that determine the agency’s ability to pay its bills every month. It then creates a trend analysis of on-going liquidity to assure both buyer and seller that the liquidity doesn’t diminish to the point at which the agency has trouble supporting its obligations. This is a low-cost and low-impact way of keeping an agency from slipping its cash flow or profitability during the entire term of a payout.
The most important thing you can do, with or without Agency Consulting Group, Inc.’s assistance, is to determine what can be done differently within the agency to reduce unneeded expenses and/or to grow the book of business. If you are considering the acquisition of another agency or book of business, your pro forma should analyze the cash flow of the agency without the seller’s participation and including the economies of scale you could apply to better utilize your assets (people, vendors, automation, equipment) as well as how you can integrate the businesses together for more efficient administration. In this scenario, you already have the advantage of earning your living from your pre-existing agency. A much greater proportion of the seller’s expenses can be freed to help pay for the agency over a shorter period of time (good for the seller as well as for the buyer).
We invite your call to discuss any phase of your Succession Plan or Perpetuation Plan at 856-779-2430.