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Agency Acquisitions and Due Diligence

We are currently assisting one of our clients in an acquisition. The target agency appears to be a good fit with our client. The agency wants to sell to our client. But, for some reason, the acquisition target is reluctant to provide any detailed data for analysis and due diligence in the formation of a fair and cogent offer by our client. The target agency has sought our client’s offer with little or no solid data. Has this ever happened to you?

The target agency has sought our client’s offer with little or no solid data. Has this ever happened to you?

In this case, the agency in question wanted more for their asset than the valuation constructed by their own expert. So they wanted my client to ‘make an offer’. However, they didn’t see why we needed anything but their financial information. As far as they were concerned, it provided the information needed regarding their revenue and expense performance. And, in most agents’ opinions that is the primary need when purchasing another agency.

After 20 or so years of buying and selling agencies, I can assure you that MUCH more information is needed before spending hundreds of thousands (or millions) of dollars for a book of business, for a location and personnel or for an entire agency corporation.

The agency in this example didn’t understand that we need as much data as their valuer needed to form a complete picture of the operation, retention potential, carrier position and stability, book of business and its profitability (for contingency considerations) and a myriad of other issues. They also didn’t understand that the price of an agency is based on, but not limited to, its Market Valuation. Extended terms, retention contingency and many other variables can extend (or contract) price offered based on a static valuation.

So, by not providing that information, they stymied a very serious buyer from providing a fair price for their business.

How was this issue resolved?

We created a proforma cashflow analysis from the financial data provided and extended an offer, albeit vague, for the agency based upon the conduct of due diligence after the acceptance. Pricing and terms were discussed, but assumptions were also covered in the Letter of Intent that would not otherwise have been needed if all agency information were provided at the outset of the process. If the assumptions were proven inaccurate, the buyer had the right to amend the offer prior to closing.

Both the buyer and seller would have preferred a nice ‘cut and dried’ offer and acceptance but Due Diligence could not be avoided. Either it would be done before the offer or between the offer and closing. Court cases have often blossomed in cases in which anomalies and inaccuracies are identified long after the contract is closed. The worst case scenario is in cash deals where the actual statistics or facts of the agency are different than represented.

So what IS “Due Diligence”?

Due Diligence is the analysis of all phases of an agency’s operation from a buyer’s standpoint.

Yes, financial information is important. If you have historical data (five years) for commission income and total revenue and can determine how that revenue flowed (retention of accounts, hard market increases, pure growth, book of business acquisitions), you can then estimate the effect of the future on that revenue flow to determine how it will react in the hands of the buyer.

Similarly, expenses are to be analyzed to determine what recurring expenses will be assumed by the buyer versus non-recurring or personal expenses that will be eliminated by a change of ownership.

The net result will be a profit (earnings, after tax effect has been taken) stream that will be used as the basis of value and price.

Now, the non-financial Due Diligence can begin.

We break our due diligence into 17 Segments:

Profitability – Pro-forma earnings potential
Revenue Growth – Both historical and potential growth
Account Concentration – Book of Business analysis by line including volumes and loss ratios
Carriers and Markets – Similarities, differences and complimentary and conflicting carriers with historical loss ratios, growth trends and specialties
Compensation – How are employees and producers compensated compared to your own
Specialization – Areas of specialty, relationship of specialty to departing owners and to purchaser’s agency
Retention – Historically - measured by Customers, Policies, Premium and Commissions
Performance vs. Industry and your own agency – Productivity (Revenue, Compensation and Spread per employee and expense ratios)
Organizational Structure – compare and contrast to your own
Succession Plan – Are there senior managers and/or their replacements in place?
Personnel Quality – evaluation of existing personnel
Receivables – condition of historical as well as current receivables and Bad Debt potential
Training and Professional Development – of employees
Size and Stability – Are there economies of scale possible?
Liquidity – Especially in corporate purchases, an evaluation of Balance Sheet liquidity ratios are a must
Automation and Other Systems – Procedures and systems in place, manual and automated and the degree of training and acceptance of them
Marketing and Sales – Advertising and marketing efforts carried out – sales professionalism and aggressiveness

Our assessment of risk that adds or subtracts from a Market Value estimate is based on these categories. Our valuation analysis includes between ten and twenty questions asked for each of these categories to determine risk and value potential. We urge all agents either using professional help in acquisitions or performing their own assessments of value potential of an acquisition to at least consider each of these areas within the Due Diligence that will permit you to assess the true earnings potential of any acquisition or merger potential.