Voodoo Valuations Curse Agency M&As

Deep in the Louisiana swamps, there lies the legend of the voodoo queen Marie Laveau, who provided simple but costly answers for people in search of hope.

According to legend, she would concoct a potion that caused a mans heart to change with just one short kiss from a young girls lips. Forever after, he would be devoted only to her. For 1,000 Spanish bits or possession of the womans first born, Marie would undo the spell. Marie became a rich woman.

People pay dearly for simple answers, and a lot of insurance agencies pay dearly for similar voodoo valuations. Voodoo valuations are powerfully attractive. They offer a quick and cheap way to pacify an agency owners curiosity and worry. Unfortunately, the owner inevitably pays for his or her haste in the end, and dearly.

Voodoo valuations are not easy to recognize. They are often disguised as legitimate valuations. Here are a few keys to recognizing voodoo valuations:

The final price does not consider terms.

I have seen many agents agree to terms like 1.5 times commissions based on retention, and they end up earning less than one time. They never would have sold for one time even if it were cash, but they were told a good multiple and that was all they needed to hear.

The answers they sought were simple. Unfortunately, the right answers were complex. They involved a complete valuation, thorough due diligence, and an analysis of cash flow and return on investment based on different terms and scenarios.

In the long run, the complex answers actually cost less than those sellers eventually paid.

For example, I recently researched a group of sellers. These sellers all received excellent prices, but they all ended up receiving significantly less money than they expected. The result was great financial pain. Not one had hired anyone beyond his or her local accountant. Most accountants I have met are good at what they are trained to do, but most are not trained to complete valuations or advise about terms.

The valuation is not accurate.

Today, we expect answers to be just a click or phone call away. There are some valuation practitioners who pretend valuations are simple affairs and use customers desires for a quick, simple solution to turn a swift buck. Principals receive a simple formula to use, or the practitioner might suggest that agents can do the valuation themselves by completing a canned spreadsheet.

So many agency owners are desperate for simple solutions, hardly a week goes by where I do not get at least one e-mail from an owner asking: “Is 1.5 (or whatever multiple) still the appropriate multiple?” With the simple answer, I could get rich quickly as if dispensing sugar pills or Cajun spells!

Agents should recognize practitioners who do not understand the complexity of valuations. For example, before a valuation is even started the best definition of value must be agreed upon. The tip-off that there is lack of understanding about the process is that the practitioner never asks the client what definition of value is appropriate for the specific situation. If a consultant does not discuss the appropriate definition of value before starting the valuation process, the agent should consider seeking assistance elsewhere.

In my experience, I have helped several agencies dig themselves out of deep financial holes resulting from a series of acquisitions. When these agencies hired a consultant, the original consultant used the wrong definition of value for the acquisition targets. The practitioner did not consider working capital, which caused the buyer to severely deplete their own capital, and the consultant did not complete adequate due diligence. But the valuator did supply seemingly simple answers.

The buyers financial strength is not considered.

A large proportion of agency sales contain a seller “carry loan” that in some cases is also based on retention. This means the sellers are incurring significant risk when they sell, yet very often they do not adequately adjust their price for this risk. Again, this is the result of searching for simple answers.

If the buyers risk of default is high and they are not paying cash up front, then the buyer should pay more. For example, a fair price for an agency with $750,000 in revenue might be $900,000 for a buyer with strong financials and a minimal risk of default. However, if the buyer has poor financials, is requiring a seller carry-note and a retention factor, or just one of the combination, then the price should be at least $1 million, or more, depending on the buyers financials.

Recently, I met with several buyers who had what I considered extremely weak financials. They each touted their positive EBITDA (earnings before interest, taxes, depreciation and amortization) while downplaying their negative cash flows. A timely Wall Street Journal article dated Jan. 24, headlined: “How to Predict the Next Fiasco in Accounting and Bail Early,” said: “A telltale sign of trouble is negative cash flow from operations while the companys so-called EBITDA is positive.”

These are words worth noting.

The Security and Exchange Commission recently released a warning to investors regarding companies that report or stress pro forma earnings or EBITDA earnings. If a seller is carrying risk, then the buyer should have a positive operating cash flow. Otherwise, they probably have financial problems. When buying an agency, the buyer must achieve positive cash flow, not just positive income, within a very specific period to make the acquisition profitable.

Getting big for the sake of being big.

Some agency owners dream of going public. Others just want to get big. Other owners are bored running their agencies or selling insurance. Instead of expanding internally, they decide to go after bigger fish. They begin acquiring other agencies.

Acquisitions can be exciting. They drive the ego. One study of acquisitions involving publicly traded companies “noted that the undeserved premium paid is linked to the number of magazine covers the acquiring boss has graced before the deal.” (The Economist, January 9, 1999). It does not require much skill to buy an agency if a person is willing to overpay (which a lot of buyers seem willing to do).

There are agencies that feel pressure to grow by acquisition regardless of profitability. This might explain why every study I have seen, read or heard of in the last 27 years has shown that 50 to 80 percent of all acquisitions fail. If being profitable concerns you, look toward internal growth first.

Marie Laveau made a lot of money giving simple answers to desperate people. Her magic potions were hard to resist. Agency owners are often just as eager for voodoo valuations, but the cost for quick, easy answers is often steep. An agency principal has experience, wisdom and alternatives. Do not purchase or practice voodoo valuations.

Chris Burand is president of Burand & Associates, LLC, a consulting firm for independent agencies based in Pueblo, Colo. He can be e-mailed at chris@burand-associates.com.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, April 1, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

Special Reports /

Voodoo Valuations Curse Agency M&As

Related Stories

Recommended For You