This article was derived from a presentation at the ThirdAnnual Target Markets Program Administrators Summit, which was heldin October in Tempe, Arizona.

FEW transactions are more important to agents and brokers thanselling their business-or buying that of another party. Forsellers, the transaction can represent an opportunity to remain inbusiness in an improved position or the cashing in of a life's workin preparation for retirement. For buyers, acquisitions representthe fastest route to growth and the furtherance of strategicplans.

At last fall's Third Annual Target Markets ProgramAdministrators Summit, mergers and acquisitions were exploredduring a workshop presented by Kevin P. Donoghue, managing partnerof Mystic Capital Advisors Group, a consulting firm; and ScottReynolds, chief actuary and operations manager for AmericanWholesale Insurance Group, which has made several acquisitions inthe past couple of years. Their presentation examined the processprimarily from the standpoint of buying or selling programadministrators, but much of what they said was germane to any agentor broker involved in such transactions. Following is an editedtranscript of their comments.

Kevin: The first step in selling your business is todetermine what it's worth. Before you solicit bids you should getan independent appraisal from someone who knows the insurancemarketplace. What is the after-tax value that you need to realizefrom this business to make it worth selling? If, following anappraisal, you don't think you can get it, why go through theprocess of selling your business? Often people discover that theiragency is not worth what they think it is and decide they'd ratherkeep it. Sometimes an owner, acting without the guidance of anappraisal, asks for an outrageous price. Such owners do themselvesan injustice. Down the road, when they decide they're really readyto sell, potential buyers may assume the sellers still haveunrealistic expectations. Valuations also are vital to buyers. Thetime for a buyer to get a fix on the value of an acquisition isbefore making an offer. That's because offers, once made, arealmost impossible to renegotiate.

Generally, the value of a firm is expressed as a multiple of aparticular statistic. More often than not, that statistic is EBITDA(earnings before interest, taxes, depreciation and amortization).For agencies and brokerages, however, I generally favor a multipleof EBITA. I drop the “D” (depreciation) because I find it's offsetby a buyer's ongoing need for capital expenditures following anacquisition. Buyers usually pay a multiple of EBITA (or EBITDA)ranging from 4.0 to 6.5. Profitable, growing agencies will go forsomething close to 6.5. Smaller businesses whose growth has beengoing downhill might go for less than 4.0. Retail agenciesgenerally trade for higher multiples than wholesale businessesdo.

There are any number of factors that can affect the multiple,including whether the seller is a C corporation or an Scorporation, and the condition of its balance sheet. How the sellerwill be paid for the agency-whether in cash up front or inretention-based installments-also affects the multiple.

Scott: What I hope to bring you is a buyer'sperspective. In the past two years, we've entertained about 30possible acquisitions of program administrators, MGAs orwholesalers, and we've closed five of them. We aren't interested inall-cash deals. Rather, we offer sellers three payment components,and usually they are roughly equal. First, there will be a cashcomponent maybe equal to a third of the selling price. Then therewill an equity component-stock in our combined, post-mergerorganization. Last, there will be a series of installment payments,usually retention- or performance-based, over a period of three tofive years or whatever span is negotiated.

We structure payments in this way because we generally are notinterested in acquiring a business whose owner simply wants to cashout and retire. If we were to offer an all-cash deal to a seller,he or she then might not have the incentive to continue to lead agrowing business that can leverage the resources that our combinedorganization creates. The equity component of the payment gives theseller a vested interest in the growth and performance of thepost-merger company.

Kevin: When an agency is bought with cash up front, theseller will get a lower multiple. If it's a pure “earn-out” deal (aseries of performance-based installment payments), with no cash upfront, the seller will receive a higher multiple. Deals generallyare struck somewhere in the middle, where you have a fixedcomponent (cash) and a variable component (the earn-out).

Sellers should assess the structure of the earn-out. Is itachievable, or is it unrealistic? Occasionally, a buyer will offerwhat looks like a breathtaking multiple for an agency. But then thesmall print compels the seller to do the impossible, like doubletheir growth rate within a year, to fulfill the earn-out. Beforeyou sign a letter of intent, know how you are to earn the variablecomponent of a deal. Does it require you to grow 20% for each ofthe next two years? Does it require you to just maintain thecurrent volume? Know where the risk is.

Also, keep in mind the time value of money. A buyer might sayyou're going to get $1 million a year for the next five years, ifyou reach a set of goals. Well, the value of that offer isn't $5million. Its present value is probably closer to $4 million. And ona risk-adjusted present-value basis, it's likely considerably lessthan that.

The other issue is equity. Scott's crew is building a largerorganization. Maybe they one day hope to do an initial publicoffering of stock. National brokerage houses, which also are activein mergers and acquisitions, already are publicly owned andgenerally pay for an acquired agency at least partly with theirstock. Publicly traded stock is easily sold, but when sellersexchange part of the value of their agencies for a minority equityposition in a privately held company, their stock will be highlyilliquid. So understand what you are getting into. Ascertain underwhat circumstances you can get out, and how your stock will bevalued when you do.

In summary, cash is great. Equity is fine if you can getyourself out of it or it has a minimum guaranteed value. Then inregard to the earn-out, you really have to assess whether or not itis achievable.

The confidentiality agreement

Scott: In the course of a merger oracquisition, three major events take place. The first is thesigning of a confidentiality agreement. Based on initialconversations we've had with the seller, we decide we want to talkfurther and share information with each other. So we each signconfidentiality agreements and then start sharing summaryinformation. Among questions we ask are: Who owns the business?What is its corporate structure? What is its nature? Why are youconsidering a sale? The seller would ask us similar questions.

At this stage of the process, we are looking at the big picturerather than all the details. We ask ourselves how the agency wouldfit into our organization. We're not doing “roll-ups,” in which abuyer simply assimilates acquired books of business. Rather we'relooking for strategic fits, agencies that can continue to operatemore or less independently within our organization. So if wealready have one MGA that writes ocean marine insurance, wewouldn't be looking to acquire another. Although we might increaseour market share by doing so, we'd be creating internal competitionand failing to enhance our product portfolio. In short, we'reinterested in acquisitions that give us a presence in some part ofthe country where we currently don't have one, or that provide aproduct or program that blends well with our portfolio.

Another business that would interest us would be one whose valuewe could somehow leverage. We may have resources that the sellerlacks: financial resources, financial oversight capability,actuarial resources, marketing or technology resources, humanresource management, etc. None of that has to do with brokeringinsurance, but it's everything behind the scenes. Sometimes a firmwill have a weakness in one or more of those areas. If we caneliminate that weakness and thereby increase that firm's EBITDAmultiple, it could make an attractive merger candidate.

At this stage, we also examine all of the seller's relevantfinancial statements and, assuming the seller would make anattractive strategic fit, make an offer that will be subject toconfirmation of the seller's representations via the due diligenceprocess.

The letter of intent

Scott: The next phase of the transaction startswith the signing of the letter of intent. At this point, we havedealt with the big-picture issues and are now ready to get into thedetails to see if they confirm what we've seen so far.

Kevin: When the parties sign that letter ofintent, the deal is not over. The LOI typically is nonbinding.After it is signed, the buyer does due diligence on the seller-andoften the seller does some due diligence on the buyer. A lot ofthings can go wrong between the time the LOI is signed and theclosing. The buyer will go though the seller's data with afine-tooth comb. In doing so, it may find that some of the seller'sprevious representations do not pan out. If so, the buyer in alllikelihood will lower the previous offer. So sellers need to becertain-well in advance of putting themselves onto the market-thattheir house is in order and that their records reflect that.

Scott: After the letter of intent is signed, webasically have access to all of the seller's data. Likewise, theseller has access to our information, so the LOI is not a one-waystreet. And given that both parties have signed confidentialityagreements, they should be comfortable with sharinginformation.

At this point, we are ready to get into the heart of thedue-diligence process. Among the matters we look into are thefollowing:

?Underwriting results: The first thing we're going tolook at is the underwriting. (This discussion assumes theacquisition of an MGA or program administrator. Obviously,underwriting wouldn't be a consideration if we were acquiring apure wholesaler, which has no underwriting authority.) We look atthe carrier underwriting audits. If we ask for the latest audit andthe seller says he can't find it, that's a red flag. Usually thereason a seller “can't find” an underwriting audit is because itwas a bad one. We like to see two underwriting audits. One badaudit may be understandable. But two in a row calls into questionthe soundness of a program and the long-term relationship with thecarrier.

We look at premium and claim details and from them deriveprogram loss ratios. If the numbers jibe with the loss ratios theseller previously gave us, that's a strong green light to proceedwith the deal. Often, however, the premium and claim detail is notavailable, and that's troubling. Sometimes when it is available,it's 18 months old. As with “missing” underwriting audits, currentdata might not be available because the seller fears it will appearunflattering. But having as much up-to-date information as possiblemakes the merger or acquisition move along more quickly than itwill otherwise.

The exact form the information takes (spreadsheet, database,text file) doesn't matter, so long as it's detailed. As long as itincludes data for individual policies and associated premiums, wecan sort it as we wish. We also need claims details, with claimnumbers and associated policy numbers. Summaries really are notsufficient, because they allow us to look at the information onlyas it's presented in the summary. With the detailed information, wecan build the summary any way we wish.

I'm an actuary, so naturally we pay attention to the actuarialanalysis of a program. We love to see a carrier's actuarialanalysis, and we also appreciate any third-party analysis that aseller may have obtained. Then we'll take the seller's premium andclaim data, update it and analyze it ourselves. Usually ouranalysis comes in pretty close to a carrier's or a third party's;major discrepancies are usually not an issue.

We look at how closely the seller has adhered to hisunderwriting authority. We determine whether the proper accountsare being written for a program and whether they've appropriatelypriced. If this information is available, that's a good indicationthat the program is sound and that the carrier will remain onboard.

?Carrier relationships: Good carrier relationships areimportant to the successful conclusion of a deal. We want to makesure the seller has sound, carrier-supported programs. Copies ofthe seller's correspondence (letters or e-mail) with his carriersare helpful, as well as letters of authority that may have beengranted.

Of course, we contact the seller's carriers at an early stage ofthe due diligence process to inquire about their relationships withthe seller and whether they will stay on after the sale. Generally,they give their blessing. That's a plus; it is indicative of astrong book of business that won't have to be remarketed. Thatsaid, if a carrier is looking to get out, a change of ownership inthe agency provides a good pretext for the insurer to end therelationship.

We look at the commission rate the carrier has been paying theseller. Maybe it has been knocked down a couple of points or hasbeen made dependent on underwriting results. Maybe we see evidencethat the seller's underwriting authority has been reduced overtime. Such things raise concerns about the status of the carrierrelationship. It's nice to see multiple carriers for a givenprogram. That means we still would have options if one carrierdecided to depart.

We look at cancellation clauses. Once, carriers commonly grantedsix-month-or even nine-month-program cancellation clauses. Now, itseems you can't get anything more than 90 days. We consideranything longer than that a real plus. Anything less than 90 daysconcerns us, because trying to move a program in a shorter timeframe can be difficult.

?Claims: If the seller is using a third-partyadministrator to handle a program's claims, we will examine theclaims audit to see if the carrier's figures match the TPA's. Ifthey don't, we may need to rework our actuarial analysis of theseller's underwriting performance. If the carrier is adjusting theclaims, the claims audit usually is not a critical concern tous.

If the seller can readily get loss runs from the carrier, that'sa plus. I'm not sure why, but sometimes it seems difficult for aseller to get loss runs during the due diligence process. Perhapsinsurers are afraid the information is going to get shared withoutside parties (other than us).

?Financial controls:[ We require an aged accountreceivables report. Without one, it will be difficult to produce anaccurate balance statement. We also need information about anycurrent litigation, as well as an E&O claims history. We wantto see records for the premium trust account. Going out of trust,unfortunately, has been the downfall of more than one program. Wealso want to examine all leases-on real estate, software, officeequipment, etc.-to see what kind of ongoing commitment we would beassuming if the deal goes through.

?Distribution: We carefully examine the seller'sdistribution system. We examine the contracts and incentivearrangements a program administrator has with retail agents. Welike to see exclusivity agreements signed by qualifiedretailers.

?Technology: We examine the seller's software systemsand procedures. A major point is how submissions are processed andhow the data on submissions is captured. Depending on the seller'scurrent platform, this may be an area where we can bring value tothe deal through our own technology resources.

?Human resources: We ask for a detailed organizationchart, as well as information about employee salaries and benefits,bonus plans, etc. Sometimes we've discovered that key employeeshave been promised future equity in the firm. We want to make surethat all arrangements are disclosed during due diligence.

Kevin: Deferred compensation is another issuethat sometimes is not reflected in the information initiallyprovided to a buyer. Sellers should make sure that all suchliabilities are clearly disclosed in advance. Don't hide anything,because it's going to come up in due diligence. It's much better toget all the issues on the table up front and let buyers determinewhether they want to proceed. But don't withhold important factsbefore signing the nonbinding letter of intent and hope buyerseither won't discover them or will accept them without loweringtheir price if they do. That just doesn't happen.

Wrapping it up

Kevin: The final event that takes place in themerger and acquisition process is the signing of the purchase andsale agreement. Unlike the letter of intent, this document, ofcourse, is binding. All the hard work of a sale should come afterthe signing of the confidentiality agreement and the letter ofintent. If that work has been done well, the only remaining choreafter this final document is signed will be the popping ofchampagne corks.

Kevin Donoghue can be reached at [email protected]. ScottReynolds can be reached at [email protected].