Producer Compensation Shift Can Boost Agency's Valuation

This gap between internal and external agency valuations continues to frustrate many agency owners who would like to perpetuate internally, without significantly discounting the value of their agencies in the process.

Although it is unlikely you'll ever bridge the internal versus external valuation gap entirely, there are a number of steps you can take to increase your agency's value on an internal basis. Many of these steps are the very same ones that third-party buyers take to justify their higher valuations.

Projected profitability weighs heavily in the third-party valuation equation.

Generally, when an agency prepares to sell, a historical pro forma income statement is prepared to give the buyer an indication of the profits the agency could have/would have generated under third-party ownership. This pro forma profit is most commonly expressed as EBITDA–earnings before interest, taxes, depreciation and amortization.

As you might imagine, the profit numbers look very different than the actual reported numbers in this analysis.

For internal agency valuations, pro forma EBITDA is generally calculated on a going-concern basis, after adjusting for certain discretionary owner compensation issues. In other words, pro forma profitability is largely measured in light of the agency's actual existing expense structure.

Properly done, an internal valuation does not generally value an agency on the basis of how profitable it could be, but rather how profitable it likely will be before discretionary adjustments are made.

In an external valuation, pro forma EBITDA is generally calculated on a will be basis. The numbers are adjusted to show how they would have looked under third-party ownership. Therein lies much of the differential in internal and external valuations–assumptions made regarding future profitability.

Under third-party ownership, agencies are generally considerably more profitable than they were as an independent. To be sure, a number of factors allow for this, including consolidation economies and other expense eliminations.

However, the single issue that typically most influences the internal versus external profitability picture remains compensation. There are generally a few specific compensation practices a third-party buyer will address to arrive at a higher level of profitability.

o Producer compensation percentages is one critical factor.

Many of the national brokers and large bank buyers seem to be settling on a 40 percent new/25 percent renewal commission arrangement for commercial property-casualty and benefit producers. This one change to an agency's expense structure can materially increase an agency's profitability and, thus, its value in an external agency sale.

In the accompanying example, the EBITDA profitability of a hypothetical agency with $5.5 million in income increases by almost 23 percent simply by decreasing the producer commission arrangement by five percentage points–from 35 percent new/renewal to 30 percent new/renewal.

Assuming a 6.5-times-EBITDA valuation, this one change results in a 22.7 percent increase in agency value.

o External EBITDA calculations also contemplate go-forward compensation assumptions for agency owners that often look materially different than they do at a privately held agency.

These changes, in the form of payroll compensation and other owner perks, also tend to improve the profitability picture, further enhancing the agency's value to an external buyer.

o Other go-forward compensation adjustments leading to a higher level of profitability may include underperforming employee terminations, the elimination of compensation to nonactive family members, and deferred compensation payments made to former employees.

The intent of this article is not to imply that you should overhaul your compensation plan, but rather to remind you that a compensation overhaul often accompanies an insurance agency sale–and, to a large degree, helps to generate the strong values paid by third-party buyers today.

For those planning to perpetuate internally, the application of a third-party-like valuation without implementing third-party-like compensation practices is highly problematic.

In the real world, many agency owners will say these compensation practices, especially with respect to producer compensation, are unrealistic and would hinder their agency's ability to attract talent.

This may be true in certain cases, but it also raises an interesting question: Do you really need to pay higher-than-market compensation to attract talent?

If so, what other noncompensation benefits (private ownership opportunities, selling and service resources, quality of life, etc.) might you stress to make sure you get your fair share of available talent, while at the same time ensuring your agency's internal valuation is maximized?

Does it make sense to trade compensation for a higher agency valuation? In certain cases, it may.

Quid pro quo–this for that–why wait to sell your agency to consider this question more fully?

For table: