Much has been written and spoken about agency valuations. In all the discussion, though, a few subtle points- critical to protecting an owner's investment in his or her agency-often are overlooked.
Who will read the valuation report? Unless otherwise stipulated, a valuation report should always be written for two audiences: 1) the client, and 2) attorneys and/or the IRS.
Some appraisers write only for their clients, producing reports that are inexpensive, short and easy to read. However, if an agency's value is ever contested by a spouse, a partner or the IRS, such a report can cause more harm than good because it will not hold up to scrutiny.
An appraisal has two purposes. The first is to calculate a reasonable estimate of the agency's value. The second is to prove to anyone who might contest the calculated value that it is accurate. Extensive details are required to deter another party from challenging the value. The report must include the definition of value, a description of the various methods available for calculating value (including common methods that were not used for the valuation and an explanation of why they weren't), a complete analysis of the agency's operations and financials, an analysis of the industry and the economy in which the agency operates, and many other factors as well.
Good valuation reports are therefore necessarily thick, often containing information the agency owner has no desire to ever read. While the agency owner may think some of the detailed data pointlessly increases costs, it is necessary to help protect him or her.
A valuation is a valuation is a valuation, right? No. Different situations require different values. While the recipe for a Snickers bar might be complex, a Snickers bar can only be made with one recipe. That's not the case with an agency valuation.
Many factors contribute to the complexity of an agency's value. Attorneys, legislators and others have developed many valuation recipes, and they dictate which one to use and when. For example, the IRS and case law developed the concept of fair market value. Wall Street, investment bank-ers and MBAs invented "strategic value." "Fair value" was largely created by legislators and divorce attorneys, and the list continues with even more definitions. (For a detailed description of different valuation definitions and their applications, see my column in AA&B's July 2001 issue.) Any agency, then, can have more than three-often very different-values, depending on the definition used.
With so many definitions of value, how does an agency know which one to use for a buy-sell agreement? Many buy-sell agreements use an unreasonable or incorrect definition of agency value. The most common standard is fair market value, but it often is not adequately discounted for a minority position. As a result, someone buying less than 50% of an agency is often faced with an unaffordable purchase price.
Consult an appraiser before drafting a buy-sell agreement. Do not rely on your attorney to know which definition is best; he or she may not be qualified to advise on the various definitions of value.
How does a minority position affect value? Compared with majority positions, minority positions are worth less (and maybe even worthless). No market really exists for selling minority positions in insurance agencies, so if the buy-sell agreement is not crystal clear about a minority position's value, a minority partner may discover his or her interest has no value.
How does a majority position affect value? If a minority position is worth less, then it stands to reason that majority shares are worth more. Therefore, if a majority interest is sold, a majority premium likely will apply, especially if the buyer is a large firm.
Public companies rarely sell control for less than a 20% premium over their stock price. (Their stock price is considered fair market value). A controlling interest in an agency should command a premium, though the amount of that premium will vary significantly among agencies. This majority position premium particularly applies when a single buyer purchases a majority of the agency now and the rest later. In the initial sale, the buyer gets control of the agency and, if the contracts are written without careful protection for the seller, the seller could find his or her minority position worth little when the remaining shares are sold, as I described earlier.
Get representation. Most agency owners have little or no experience selling an agency. These transactions involve huge sums of money, and many sellers rely on the proceeds to fund their retirements. The magnitude of the transaction warrants proper representation. Also, many agencies are sold to large corporations experienced in acquiring other firms. In such cases, the gap between the buyer's experience and the seller's renders the seller vulnerable. If you are involved in buying, selling or merging an agency, you should be appropriately represented by a consultant, an accountant and attorney knowledgeable about these matters. The money you save will be your own.
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