Fighting Fire With Fire

A Due Diligence Guide For Agency Deals

By Wayne Walkotten

After months of dating and negotiating, you have struck a deal to buy another agency.

Through a variety of methods, you have arrived at a purchase price and both parties have agreed on the general terms.

Your attorney, while drafting the letter of intent or term sheet, includes the phrase, subject to due diligence.

The buyer asks, Isnt that what I have been doing the last several months?

Granted, during the negotiating process, you have gathered a great deal of information. You have probably looked at financial statements, insurance company volume and loss reports, and producer contracts.

If you have priced the transaction appropriately, you have prepared a set of proforma financial statements, forecasted the cash flow, and structured the transaction from the standpoint of downpayment, earn-out, and upside to the seller for exceeding expectations.

What is there left to do during due diligence?

Due diligence is the process of reviewing all aspects of the business for areas of trouble for the future owner. Some areas of trouble, it turns out, arent always evident during the negotiation phase.

For example, the buyer may have seen seller financial statements, but not a report generated by the sellers agency management system that balances payables to the general ledger. The reason for the oversightthe sellers hard-working controller may not have known that the report existed.

Or, the seller, believing that employment agreements are often in place, may have forgotten the time a new producer was hired while the agency president was on vacation. No one realized the high-performing producer had never executed an employment agreement.
Due diligence is the opportunity for the buyer to systematically review the detail within the targets books and to read employment contracts. The purpose is to isolate issues that will impact the acquisition.

While this list must be tailored to every transaction, it should help the parties understand the general areas of review. The issues uncovered in a due diligence review may fall into three categories:
Misstatements of the general ledger and financial statements.
Lack of proper documentation during the historical operation of the target.
Issues not disclosed, either through omission or commission, between the seller and the buyer.

The general ledger and its detail provide the financial history and current financial position of the firm, if its balances are accurately stated. In much the same way as you reconcile your checkbook to the bank statement every month, there is detail that comprises the balances re-ported on the general ledger. The following are just a few areas to which a buyer should pay special attention:
The aging of accounts receivable provides detail, and the total should agree with the general ledger balance.
However, are there customer credit balances that mask the true level of delinquent receivables?
A very important area is the detail of insurance company payables.
Does the detail report from the automation system agree with the general ledger balance of each insurance company? Historically, this is a very common area of misstated financial statements.
Outside commission expense, or broker expense. Such expenses indicate the agency may not own all the business flowing through their financial statements.

In the area of documentation, employment contracts are an obvious set of documents a buyer should scrutinize. A review should pay careful attention to clauses related to ownership of the business, non-competition, and non-piracy.
In addition, in the area of documentation, a buyer should also review insurance company contract files for correspondence from carriers, special deals, or restrictions by carriers. Other areas of documentation include:
Income tax, property taxes, payroll taxes and withholdings, Form 1099s.
Real and personal property leases.
Debt agreements, including notes and lines of credit.
Shareholder agreements, buy-sell agreements, previous acquisitions, or sales of business.
The insurance agencys insurance policies, especially the errors and omissions policy and the agencys application for E&O insurance.
Documentation of employee benefit programs and retirement plans
Organizational chart and other internal reports for managing the agency, including new business reports, and other sales management reports.
Copies of agency and employee insurance licenses, including correspondence from regulatory bodies.

The buyer should also review a sample of customer files from each line of business, as well as comparing them to the electronic file, making note of documentation, organization, and consistency.
A buyer should also review reports off the automation system, including:
Production by line of business, insurer, customer, and producer.
Expiration lists for the future, paying special attention to multi-year policies.
Binder bill listings, pre-bill listings, future installment listings.

These help a buyer understand the way the seller runs the business.
The last area of due diligence is good old-fashioned asking questions. Through conversation, a buyer can see trouble spots, ask for more documentation, all with the purpose of preventing future problems.

Very important discussions should occur regarding any promises to producers regarding ownership of the agency or ownership of their book, or other deferred compensation arrangements, not reflected on the agencys books. Also, be sure to discuss:
Accounts or business relationships in jeopardy if the agency sells.
Past joint ventures, acquisitions, and purchases of books of business.
Uncovered claims and errors of omission, litigation or threatened litigation, and employee terminations.

During the above procedures and others tailored to the specific agency, a buyer will likely uncover various issues. This is the opportunity to clean up the books, execute new agreements, and verify representations and warranties the seller will make at close.
Note, however, that not all areas can be solved without adjusting the purchase.

On the other hand, one of the most important ancillary benefits is getting to know the seller and management team. There may be no better time to accurately assess the integrity of your future partner, then during a thorough due diligence review.

Wayne A. Walkotten is a vice president for Marsh Berry Inc. Marsh Berry, headquartered in Concord, Ohio, is a national management consulting firm dealing exclusively with insurance agencies and companies and with banks.

Reproduced from National Underwriter Edition, July 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.