TWO DIFFERENT values are important to the owner of an expensive antique. If it is passed on as an inheritance, the IRS wants to know the fair market value; an insurance company, however, might want to know the item's replacement value. A slum landlord might only be interested in the actual cash value of rental units, but an insurance company might want to know the replacement cost. A homeowner in an economically depressed town might only want to insure his or her home for market value, but an insurance company will probably want to insure it for replacement cost.

Most insurance agency owners, to whom these different values are almost second nature, think of their own agencies as having only one value. Like the above examples, though, agencies have more than one value. Given the number of agency sales today, I have a strong feeling that some owners are selling for less than they could, and others are asking for too much, because they do not know enough about the different values that apply to every agency.

Caesar's Palace is a good example of the importance of different values. When Caesar's was first rumored to be for sale, its stock price immediately increased 15%, despite no change in expected sales or profits. This was because of the higher value of owning all of a company, instead of small, minority positions-in other words, the difference between a controlling position value versus a non-controlling position value.

It is important for agencies with multiple shareholders to understand the differences between these values. A controlling shareholder can pull much more money out of a corporation than can a non-controlling shareholder, which is one reason (though not the only one) agency owners should seriously consider using a discounted price in their buy/sell agreements for the purchase or sale of non-controlling shares.

The sale of Caesar's provides a great example of another kind of valuation, too: strategic value. Because the buyer in this case is Harrah's-another casino-Caesar's is believed to be worth more to it than it would be to most buyers. (This logic is probably erroneous, considering the numerous studies concluding that most acquisitions fail to produce adequate profits for the purchaser. But that is a subject for another article.) Thus the value in this example could be considered a strategic value.

Most agency owners are interested in fair market value. This is the IRS's definition of value and the same definition used in the antique example above. Agency owners usually assume that a fair market value is the same as a strategic value. But fair market value has a specific definition, which states that the buyer is without synergistic benefit.

On the other hand, a buyer's synergistic benefit is a key factor in determining strategic value. Some firms buying insurance agencies depend on premium increases and acquisitions for 100% of their growth, so they are willing to pay inflated prices for agencies. The growth they gain from acquisitions is synergistic, so the inflated prices could not be considered a fair market value. Also, some buyers manage to greatly reduce their tax rate. This advantage does not fit the IRS definition of fair market value.

Agency owners considering the sale of their agencies must understand their potential buyer(s). Many who don't may be leaving a lot of money on the table. On the other hand, some agency owners have been led to believe their agencies are worth far more than they really are. Consider the case of a real estate appraiser who recently made the news. He was appraising many small businesses in various small towns for potential litigation related to a highway project. He appraised all the businesses at a far higher value than did anyone else. After some evaluation, it was determined that his valuations were not wrong, but his assumptions were. He assumed that the businesses should be valued as if the area in which they were located was not so depressed. In fact, his appraisals assumed the local economy was booming, which more than tripled the real estate values.

Some agency owners make a similar mistake. Prices for insurance agencies may be high today, but they are not high for all agencies. If an agency is in poor shape or has a poor balance sheet, is too small or even too big for its geographic area, or is in a depressed region, it could be worth considerably less than strong agencies in bustling economies. More than one agency owner has passed up good deals because he thought his agency was worth far more than it really was.

Several additional definitions of value are also sometimes used. One such definition is fair value. Fair value is often used to determine agency values in divorce cases, which can become problematic because no standard definition exists. As an analogy, using a fair market value definition instead of a fair value definition is like valuing a Louis XIV chair as if it were available every day. More than one "expert" appraiser or attorney have been effectively laughed out of divorce court for using the wrong definition of value. The key is to make sure everyone involved uses the same one.

A variety of additional factors make valuing agencies even more complex, including the methodology used, the differences some believe exist between "S" corporation and "C" corporation values, and the almost total lack of understanding most attorneys and accountants have regarding agency values.

Different definitions of value apply for different purposes. Using the correct definition can help agency owners avoid costly mistakes such as leaving money on the table, owing the IRS extra taxes or overpaying the IRS.

Special Reports /

For The Manager: Picking the right valuation in buy/sell transactions

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