The thing I like least about my work is delivering unexpectedly low agency valuations to agency owners. Most handle the news well, but it still is difficult to tell them that they have not built valuable agencies. The upside for these owners is that they can use this knowledge to increase their agencies' value, and the result inevitably is a smoother-running, more profitable agency.

A handful of owners, though, do not take the news so well. Most have achieved high incomes for many years, and issues that negatively affect their agency's value have not (seemingly to them, at least) adversely impacted their earning power. If their incomes are high, they seem to reason, how can their agencies' values be low? In many cases, the owners simply have been lucky that certain factors have not taken a heavier toll. In others, especially with small agencies, the impact often isn't realized until a valuation or sale has been initiated.

When valuing agencies, I encounter four common issues that often take owners by surprise.

The balance sheet
The insurance industry has long been plagued by a myth that an agency's balance sheet is not important. But the balance sheet is important, even if the agency seeks a valuation for selling only its book of business.

The first big issue is an agency's trust ratio. Many agency owners tell me, “My state is not a trust-law state, so I don't have to be in trust,” which is simply not true. When an agency is out of trust, it uses clients' money for something other than paying the carrier, but hopes to eventually pay the carrier–usually with someone else's money–before it is too late. Doing so creates a cycle of paying Client A's company with Client B's money. Agencies generally can maintain this cycle because cash flows usually are consistent, but that does not make it right. At any time, if the cycle stops, the agency will not have enough money to pay its companies, which is why being out of trust decreases an agency's value.

Would a buyer pay as much for an agency that owes its companies more than it has available as it would pay for an agency that is in trust and handling customers' and companies' monies appropriately? The answer, clearly, is no. The out-of-trust agency's value is going to be discounted.
Even with an asset-only sale, where the buyer is purchasing only the book of business, the buyer must consider the liability of being out of trust. Eventually someone has to pay the companies. If the seller cannot, the carriers are going to come after the buyer. The buyer needs to consider this risk before closing the deal.

Another big balance-sheet issue is working capital. Many agency owners do not believe working capital is required to run a company, but it is required for running a growing and professional company. If the owner of a small agency never hopes to grow it, working capital may not be terribly important–until it's time to sell the agency.

Whether the buyer is buying the stock or the assets, he or she should always obtain at least 30 days of working capital with the sale, or discount the price appropriately. If a seller does not provide 30 days' (or more) working capital with the sale, or discount the agency's price, the buyer is significantly over-paying.

Working capital is important because growth costs money. According to best-practices reports, the fastest-growing agencies are significantly less profitable than average. In these companies, the expenses come before the revenues. For small bootstrap-finan- ced agencies, this sometimes is difficult to see, but it becomes clear as agencies grow. As one example, hiring and successfully developing a new producer costs $200,000 before he or she generates any real revenues. Without adequate working capital, where does an agency get the $200,000?

Sometimes buyers believe they don't need working capital for a small acquisition, but that's not the case. This notion reminds me of an exhibit at the science museum in Toronto in which a person can hang from a steel I-beam, while a digital reader displays how much it bends under the weight. The beam can hold tons, but it bends slightly even when supporting only one person. If enough people hang from the beam, the distortion eventually becomes quite noticeable. Similarly, I have seen agencies make serial acquisitions without obtaining adequate working capital from sellers. Doing so may at first seem innocuous, until management suddenly realizes they cannot make payroll.

The balance sheet is important! I continually find that agencies with strong balance sheets are more professionally managed, and their overall results are significantly better, than those without them.

Accounting
Good accounting means more than keeping enough money in the checking account to pay bills. Good accounting practices increase an agency's value because they increase the buyer's confidence that they know what they are buying.

Conversely, poor accounting increases the risks involved with buying an agency. I see a wide variety of poor accounting practices and irregularities beyond such run-of-the-mill issues as paying personal expenses through the business. Some examples are missing or misstated accounting records; lack of such financial statements as income statements, balance sheets and receivables; failure to return credits to insureds; failure to pay people per their contracts; crediting (and paying) producers with more commissions than the agency itself earns; and not even trying to keep accurate data in the agency management system. Many agencies can run for a long time despite such practices, but their values decrease as a result.

Even if the terms of the deal are for an asset acquisition, with the purchase price subject to renewal rates, the unknowns associated with poor accounting create significant risks. I have seen many agency buyers depend on the terms of the deal to protect them, only to later realize they would have been better off not buying the agency because of all the surprises that surfaced.

Employee turnover
A high turnover rate suggests management problems. If an agency has a high employee turnover rate, even if a rational explanation exists for every employee departure, management is the root of the problem. Managers may use a faulty selection process, be poor interviewers, create an unpleasant work environment, or simply be bad managers. High turnover introduces a number of risks, all of which decrease an agency's value.

Growth
Many agency owners believe that because they have earned nice livings without significantly growing their agencies, buyers should be willing to pay a high price for them. Buyers, however, have different considerations because the dynamics change when an agency is sold. The buyer must make the agency pay for itself, and solid growth is key to making that happen. An agency may have a history of slow growth because growth wasn't important to the owner; but growth is important to buyers, and slow growth decreases an agency's value.

Because agency owners may not concern themselves with such issues as balance sheet, accounting, employee turnover and growth until it's time to sell, I suggest having an agency appraised at least five years in advance. The appraiser can point out opportunities to increase the agency's value, and the agency owner will have time to correct problems.

Selling an agency is similar to selling a house, although it usually takes much longer to prepare an agency for the market. A person can live in a house with serious problems for a long time and not mind them, but those problems will often make a difference to buyers. When the homeowner decides to sell, the Realtor likely will suggest fixing this or that. The same is true when selling your agency. Do not wait until a deal is on the line to learn that an appraiser has given your agency a poor value. I have seen many agencies do so and suffer large losses as a result. Or, if the deal crumbles, shock leads to denial, which delays any improvement for months or years, and sometimes forever.

Many opportunities exist for increasing an agency's value. Some issues may have no apparent impact on the current owner, but buyers look at the agency from a different perspective. The keys are recognizing problems that need to be corrected and then taking steps to get an agency in top condition to sell for the price the owner desires.

Chris Burand is president of Burand & Associates LLC, an agency consulting firm. Readers may contact Chris at (719) 485-3868 or at Chris@burand-associates.com.

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