Quick question: What is your agency worth? Well, it depends. Who is the buyer? Why would the buyer dictate the value of an insurance agency? How can an agency have different values depending on who the buyer is?

Broadly speaking, every agency has two values:

o The value to an external buyer (an "externally perpetuated" agency).

o The value to internal buyers (an "internally perpetuated" agency).

With the recent acquisitions of USI by Goldman Sachs and Hub by Morgan Stanley/Apax, an already overheated acquisition market has moved into hyper-drive. Never before have more external buyers competed head-on for quality agency acquisition opportunities.

As a result, external agency valuations are at an all-time high.

I remember when the "Holy Grail"--a two-times-revenue agency deal--was reserved for only the best of the best, meaning those agencies with 25-to-30 percent margins and double-digit annual growth.

Now, external deals for quality agencies with single-digit growth and low 20s EBITDA margins routinely price out in this neighborhood. Deals for truly excellent firms in desirable locations can go much higher.

If you're an agency owner, this is all good news, right?

Well, it's interesting news, anyway. It's great news if you're considering a sale of your agency to an outside buyer. If properly positioned and negotiated, the timing to sell an agency has never been better.

But what if you're the owner of an agency planning to perpetuate internally? In that case, current external valuation multiples have little bearing on your agency's value to internal buyers.

The average agency in our Reagan Value Index (an index of 30 independent agencies we value for internal perpetuation purposes on an annual basis) is valued at 1.34 times revenue. A review of several recent agency transactions for which we represented the seller reveals an average purchase multiple of 2.05-times revenue. That's a difference of 53 percent!

How can an external valuation qualify for a 53 percent premium over an internal valuation? There are several reasons for this:

o Supply and demand:

A large number of external buyers competing for deals will necessarily push values higher. This phenomenon does not exist for internal agency valuations, where there are generally a limited number of capable buyers.

o Current stock market valuations:

As of the end of 2006, the average publicly traded insurance broker was valued at 3.2-times revenue. This means that for every $1 of revenue they acquire, the market rewards them with $3.20 in their own valuations.

This financial arbitrage allows the public brokers to pay a 2.0 multiple (or more) and still have it be highly accretive to shareholder value, since they are rewarded themselves at 3.2-times revenue. This, too, has no bearing on internal agency valuations.

o Different economics:

Most external acquisition valuations take into consideration numerous economies of consolidation and compensation adjustments that materially improve the profit margins of an agency once it's owned by the external buyer. With these higher margins comes higher cash flows--and, appropriately, higher valuations.

Think about it this way: Let's assume you're buying a share of ABC Company stock. Let's further assume that ABC Company has two classes of stock--A and B--and the only difference between the two is the dividend percentage each class of stock pays. Class A shares generate a 3 percent dividend, whereas Class B shares generate a 1 percent dividend.

Would you pay the same price for a Class A share that you would for a Class B share? Of course not--the investment return on the Class A shares is much higher and warrants a higher value.

The same is true with an insurance agency under an external buyer assumption set. An external buyer can generally operate an agency at a higher level of profitability than it generates on a stand-alone basis. Thus, it is worth more to the external buyer than to an internal buyer.

Any agency valuation--external-buyer or internal-buyer--should be based on actual cash flow projections.

Remember this: Internal buyers of agency stock generally require financing to purchase stock. If a buying shareholder's cash flows (the after-tax cash he will receive as an investment return on his stock) don't position him to service the debt he assumed, the deal typically won't work.

Given the debt associated with most internal agency purchases, if an agency's value is not tied to actual cash flows, the debt service will end up becoming a real problem. What happens then? The agency is typically sold to an external buyer.

From time to time, I hear selling shareholders say something like this: "I'm willing to be reasonable in selling the stock back to the agency/employees...as long as they pay me what the agency's worth (that is, the value to an external buyer)."

Unfortunately, that's really not reasonable from an economic point of view, because generally the internal cash flows can't support an external valuation.

Both internal and external perpetuation can be attractive options for agencies, but it is important to keep in mind that valuations will likely be materially different under each scenario.

Special Reports /

Internal Perpetuation Suffers In An M&A-Hungry World

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