DON'T SELL YOURSELF SHORT

Rough Notes, Apr 2005 by Linnert, Patrick T, Skowronski, Daniel E

Bottom-line earnings determine your agency's value, not top-line revenue

Most independent agency owners believe they have a pretty good idea as to the value of their firm. Principals will often cite 1.5X to 2.0X revenue, with some suggesting even higher multiples. When discussions turn to the agency's method of calculating value, however, it becomes evident that many owners are uncertain as to how value is really determined.

Of agencies that have sold externally for the highest price relative to revenues, virtually none of the owners focused on revenue multiples. All were well aware of their earnings and cash flow and its impact on value. These high-performing agencies understood 1.5X revenue to be a thing of the past and drove the total purchase consideration of their agency well beyond yesterday's norm. This serves to confirm an opinion shared within our firm since its inception: The only agencies that sell for 1.5X are the ones that are worth less than that. The unenlightened buyer dwells upon the top line. The enlightened seller is driven by the bottom line.

The more you as an agency owner know about internal agency valuations and the merger and acquisition environment that drives sales price, the better positioned you will be in managing the value and sustainability of your agency.

The 1.5X revenue myth explained

In the 1970s, independent agencies became fixed on the 1.5X revenue multiple as the standard calculation of value. The 1.5X revenue multiple is actually the expression of an earnings-based calculation. During that time, value in the public sector was pure earnings. Then, as today, when a stock is quoted in the market, there is no mention of tangible net worth (TNW) in the earnings multiple-everyone presumes it is already reflected in the earnings multiple being quoted. In the 1970s, the public insurance brokers were trading at roughly 10X after-tax earnings. However, included in this multiple was the inherent value of the balance sheet. The public brokers maintained average tangible net worth equal to about 15% of revenues. Thus, the true earnings multiple, excluding the balance sheet, was closer to 9.0X after-tax earnings. Based on these internal numbers, the public brokers preferred acquisition structure that looked something like the following:

This structure illustrates that if an agency could return 15% on an after-tax basis, was deemed average from a risk factor perspective (impacting the after-tax multiple), and maintained 15% of revenues as tangible net worth, then the agency was probably worth somewhere around 1.5X revenue. While this concept was sound, tax rates, average multiples and average agency earnings have all changed over time. The actual method of arriving at value was lost, but the 1.5X revenue multiple was ingrained in the minds of insurance agencies.

The point is this: While fair market value may be expressed as a multiple of revenue, it is calculated based on a multiple of earnings plus or minus the value of the balance sheet. It also should be noted that revenue multiples fail to take tangible net worth into account. Buyers will pay dollar for dollar for the balance sheet in a stock transaction; so tangible net worth should play an important role in the purchase price and is an important reason why not to use the revenue multiple method to calculate overall total value. The model shown in the chart above uses an after-tax earnings approach for valuation, an approach that can be applied to any size agency. Discounted cash flow and EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) models can be used as well.

Fair market value vs. sales price

According to the IRS, fair market value is defined as the following:

"The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts." (Revenue Ruling 59-60: 1959-1, Cumulative Bulletin 237)

Many individuals will suggest that the value of an entity is whatever someone is willing to pay for it, which leads us to the difference between value and consideration. Value is what your agency would command in the general marketplace according to the definition above. This is how appraisers treat the valuation process. Consideration, however, is what you would receive in an actual sale, which can be influenced by compulsion (a buyer's need to acquire earnings, an owner's need to sell, etc.) or the structure of the transaction (guaranteed vs. earn-out).

Agency owners often rely on the sales consideration of other agencies in the marketplace to estimate the value of their own operation. This "me-too" scenario has permeated the industry and continues to inhibit the proper financial management of many independent agencies. Too many times, agency owners prepare to perpetuate the agency (whether internally or externally) and focus solely on the top line. Owners who have historically focused on maximizing earnings and mitigating the risk factors associated with the organization can indeed command and realize higher consideration than many of their peers when selling. Other owners, however, who focused primarily on maintaining revenue without regard to earnings and risk mitigation, will most likely realize less than their peers.