Agency perpetuation plans written in stone?

Rough Notes, Aug 2003 by Di Stefano, Paul J

Changing circumstances can necessitate the reassessment of a perpetuation plan

In the course of Harbor Capital Advisors' consulting practice, we discovered that the many agencies do not have formal perpetuation plans. A number of these agencies are family-owned agencies whose continuation plans are based on the assumption that the second generation members will "inherit the earth." Similarly, other agencies have informal understandings among key individuals within the agency that they will be the future owners.

All perpetuation plans are based upon the best information available at the time; however, everyone should be open to opportunities that arise from changing circumstances. For example, a merger opportunity may surface and should be considered on a strategic basis. Those individuals who are expecting to buy out the principals could see this as a threat to their future, when in reality it may be an opportunity. Even those agencies with ESOPs have from time to time decided to sell to third parties when that has proven to be the right decision for all the equity holders.

While it is understandable that agencies might struggle with any change to their formal perpetuation plans, we have also encountered agencies that are ambivalent about addressing the issue of altering informal plans. The problem usually centers on the fact that internal perceptions about the perpetuation issue may vary among those individuals who will in theory benefit from those plans.

A perpetuation plan is an exit strategy for agency principals. Initial decisions regarding agency perpetuation may well have to be altered over time if the plan is no longer the optimal financial and operating strategy. One of the primary reasons for altering previous decisions to perpetuate internally is that the dynamics of the insurance marketplace have changed. For example, in today's overheated merger and acquisition market, it might be decided that an original plan to perpetuate the agency internally should be scrapped for an outright sale to a third-party acquirer who has approached the agency with an outstanding financial offer.

Building a consensus to change course in midstream is usually far from easy. Although in many cases the controlling shareholders can make this decision unilaterally, the realistic approach would be to bring on board any minority shareholders and those individuals designated to perpetuate the agency. In a case like this, building that consensus requires focusing on the specific opportunity at hand and assessing its perceived and actual impact on all interested parties.

A great example of building a consensus involved a family-owned agency client of Harbor Capital Advisors. The senior principals were approached with-as the prospective well-funded buyer described it- "an offer that they couldn't refuse." The problem was that the principals had committed themselves to turning the agency over to several members of the second generation who were active in the agency. The magnitude of the unsolicited acquisition offer forced the family as a group to revisit the original internal perpetuation commitment.

After objectively considering the facts, those involved concluded that the risk/reward ratio for all family members had shifted dramatically. When considering the net revenue to be derived from the sale with the newly enacted reduction of capital gains tax rate of 15% to the present value of the income stream taxed at ordinary income tax rates, a third-party sale scenario appeared by a wide margin to be the option to take. Another key element of the decision process was a consideration of the risks associated with sustaining the current cash flow of the agency over the next five to 10 years. The risks that the second generation would assume in purchasing the business now outweighed the potential rewards when compared to the tender offer.

Although the economic facts were clear in this case, other intangible factors had to be considered, including the emotional ties to the ownership of the agency. In addition to the purchase consideration, it was clear that it was in everyone's ongoing best interest to consummate the transaction because the acquirer had a business model that would greatly enhance the future compensation prospects for the second generation. This case is reminiscent of the decision by the Rockefeller family to sell Rockefeller Center to the Japanese at the height of the real estate boom of the 1980s.

In cases like this, other intangible factors can be at work, including ambivalence about the prospect of working for a large organization. This initial reaction is understandable, especially when the second generation has worked only in the protective environment of the family business. Unfortunately, perceptions all too often become reality. They are best dealt with through discussions with the buyer in which the culture and related philosophy of the buyer become more fully understood. In this case, the second generation members were minority shareholders. Discussion becomes less difficult when all parties will be rewarded with the security of participating in the proceeds of the sale.