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

A handful of owners, though, do not take the news so well. Mosthave achieved high incomes for many years, and issues thatnegatively affect their agency's value have not (seemingly to them,at least) adversely impacted their earning power. If their incomesare high, they seem to reason, how can their agencies' values below? In many cases, the owners simply have been lucky that certainfactors have not taken a heavier toll. In others, especially withsmall agencies, the impact often isn't realized until a valuationor sale has been initiated.

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

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

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

Would a buyer pay as much for an agency that owes its companiesmore than it has available as it would pay for an agency that is intrust and handling customers' and companies' monies appropriately?The answer, clearly, is no. The out-of-trust agency's value isgoing to be discounted.
Even with an asset-only sale, where the buyer is purchasing onlythe book of business, the buyer must consider the liability ofbeing out of trust. Eventually someone has to pay the companies. Ifthe 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 agencyowners 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, workingcapital may not be terribly important–until it's time to sell theagency.

Whether the buyer is buying the stock or the assets, he or sheshould always obtain at least 30 days of working capital with thesale, or discount the price appropriately. If a seller does notprovide 30 days' (or more) working capital with the sale, ordiscount the agency's price, the buyer is significantlyover-paying.

Working capital is important because growth costs money.According to best-practices reports, the fastest-growing agenciesare 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 becomesclear as agencies grow. As one example, hiring and successfullydeveloping a new producer costs $200,000 before he or she generatesany real revenues. Without adequate working capital, where does anagency get the $200,000?

Sometimes buyers believe they don't need working capital for asmall acquisition, but that's not the case. This notion reminds meof an exhibit at the science museum in Toronto in which a personcan hang from a steel I-beam, while a digital reader displays howmuch it bends under the weight. The beam can hold tons, but itbends slightly even when supporting only one person. If enoughpeople hang from the beam, the distortion eventually becomes quitenoticeable. Similarly, I have seen agencies make serialacquisitions without obtaining adequate working capital fromsellers. Doing so may at first seem innocuous, until managementsuddenly realizes they cannot make payroll.

The balance sheet is important! I continually find that agencieswith strong balance sheets are more professionally managed, andtheir overall results are significantly better, than those withoutthem.

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

Conversely, poor accounting increases the risks involved withbuying an agency. I see a wide variety of poor accounting practicesand irregularities beyond such run-of-the-mill issues as payingpersonal expenses through the business. Some examples are missingor misstated accounting records; lack of such financial statementsas income statements, balance sheets and receivables; failure toreturn credits to insureds; failure to pay people per theircontracts; crediting (and paying) producers with more commissionsthan the agency itself earns; and not even trying to keep accuratedata in the agency management system. Many agencies can run for along time despite such practices, but their values decrease as aresult.

Even if the terms of the deal are for an asset acquisition, withthe purchase price subject to renewal rates, the unknownsassociated with poor accounting create significant risks. I haveseen many agency buyers depend on the terms of the deal to protectthem, only to later realize they would have been better off notbuying the agency because of all the surprises that surfaced.

Employee turnover
A high turnover rate suggests management problems. If an agency hasa high employee turnover rate, even if a rational explanationexists for every employee departure, management is the root of theproblem. Managers may use a faulty selection process, be poorinterviewers, create an unpleasant work environment, or simply bebad managers. High turnover introduces a number of risks, all ofwhich decrease an agency's value.

Growth
Many agency owners believe that because they have earned nicelivings without significantly growing their agencies, buyers shouldbe willing to pay a high price for them. Buyers, however, havedifferent considerations because the dynamics change when an agencyis sold. The buyer must make the agency pay for itself, and solidgrowth is key to making that happen. An agency may have a historyof slow growth because growth wasn't important to the owner; butgrowth is important to buyers, and slow growth decreases anagency's value.

Because agency owners may not concern themselves with suchissues as balance sheet, accounting, employee turnover and growthuntil it's time to sell, I suggest having an agency appraised atleast five years in advance. The appraiser can point outopportunities to increase the agency's value, and the agency ownerwill have time to correct problems.

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

Many opportunities exist for increasing an agency's value. Someissues may have no apparent impact on the current owner, but buyerslook at the agency from a different perspective. The keys arerecognizing problems that need to be corrected and then takingsteps to get an agency in top condition to sell for the price theowner desires.

Chris Burand is president of Burand & Associates LLC, an agencyconsulting firm. Readers may contact Chris at (719) 485-3868 or at[email protected].