Quick question: What is your agency worth? Well, it depends. Whois the buyer? Why would the buyer dictate the value of an insuranceagency? How can an agency have different values depending on whothe buyer is?

Broadly speaking, every agency has two values:

o The value to an external buyer (an "externally perpetuated"agency).

o The value to internal buyers (an "internally perpetuated"agency).

With the recent acquisitions of USI by Goldman Sachs and Hub byMorgan Stanley/Apax, an already overheated acquisition market hasmoved into hyper-drive. Never before have more external buyerscompeted head-on for quality agency acquisition opportunities.

As a result, external agency valuations are at an all-timehigh.

I remember when the "Holy Grail"--a two-times-revenue agencydeal--was reserved for only the best of the best, meaning thoseagencies with 25-to-30 percent margins and double-digit annualgrowth.

Now, external deals for quality agencies with single-digitgrowth and low 20s EBITDA margins routinely price out in thisneighborhood. Deals for truly excellent firms in desirablelocations can go much higher.

If you're an agency owner, this is all good news, right?

Well, it's interesting news, anyway. It's great news if you'reconsidering a sale of your agency to an outside buyer. If properlypositioned and negotiated, the timing to sell an agency has neverbeen better.

But what if you're the owner of an agency planning to perpetuateinternally? In that case, current external valuation multiples havelittle bearing on your agency's value to internal buyers.

The average agency in our Reagan Value Index (an index of 30independent agencies we value for internal perpetuation purposes onan annual basis) is valued at 1.34 times revenue. A review ofseveral recent agency transactions for which we represented theseller reveals an average purchase multiple of 2.05-times revenue.That's a difference of 53 percent!

How can an external valuation qualify for a 53 percent premiumover an internal valuation? There are several reasons for this:

o Supply and demand:

A large number of external buyers competing for deals willnecessarily push values higher. This phenomenon does not exist forinternal agency valuations, where there are generally a limitednumber of capable buyers.

o Current stock market valuations:

As of the end of 2006, the average publicly traded insurancebroker was valued at 3.2-times revenue. This means that for every$1 of revenue they acquire, the market rewards them with $3.20 intheir own valuations.

This financial arbitrage allows the public brokers to pay a 2.0multiple (or more) and still have it be highly accretive toshareholder value, since they are rewarded themselves at 3.2-timesrevenue. This, too, has no bearing on internal agencyvaluations.

o Different economics:

Most external acquisition valuations take into considerationnumerous economies of consolidation and compensation adjustmentsthat materially improve the profit margins of an agency once it'sowned by the external buyer. With these higher margins comes highercash flows--and, appropriately, higher valuations.

Think about it this way: Let's assume you're buying a share ofABC Company stock. Let's further assume that ABC Company has twoclasses of stock--A and B--and the only difference between the twois the dividend percentage each class of stock pays. Class A sharesgenerate a 3 percent dividend, whereas Class B shares generate a 1percent dividend.

Would you pay the same price for a Class A share that you wouldfor a Class B share? Of course not--the investment return on theClass A shares is much higher and warrants a higher value.

The same is true with an insurance agency under an externalbuyer assumption set. An external buyer can generally operate anagency at a higher level of profitability than it generates on astand-alone basis. Thus, it is worth more to the external buyerthan to an internal buyer.

Any agency valuation--external-buyer or internal-buyer--shouldbe based on actual cash flow projections.

Remember this: Internal buyers of agency stock generally requirefinancing to purchase stock. If a buying shareholder's cash flows(the after-tax cash he will receive as an investment return on hisstock) don't position him to service the debt he assumed, the dealtypically won't work.

Given the debt associated with most internal agency purchases,if an agency's value is not tied to actual cash flows, the debtservice will end up becoming a real problem. What happens then? Theagency is typically sold to an external buyer.

From time to time, I hear selling shareholders say somethinglike this: "I'm willing to be reasonable in selling the stock backto the agency/employees...as long as they pay me what the agency'sworth (that is, the value to an external buyer)."

Unfortunately, that's really not reasonable from an economicpoint of view, because generally the internal cash flows can'tsupport an external valuation.

Both internal and external perpetuation can be attractiveoptions for agencies, but it is important to keep in mind thatvaluations will likely be materially different under eachscenario.