The late chef Anthony Bourdain once relaunched his storied career by penning an article, “Don’t eat before reading this.”
To independent agents and brokers, I would say, “Don’t sell without reading this.”
The agency consulting community earns its income primarily by representing parties on transactions and advising selling agency owners. In recent years, you’ve probably heard warnings like “Prices will never be this good,” or “You’re getting too old and stale to keep up with the industry,” or “You can’t get enough value for your agency if you perpetuate.”
You also may have heard that the risk of financing even a small amount to buying parties is so excessive that after you perpetuate internally, your firm will bomb and your successors will fail to execute the most basic responsibilities of running an agency.
But none of the above is true. There is strong economic justification for retaining your agency—and maintaining a legacy for your firm through internal perpetuation.
A Brief History
First, let’s examine the term “perpetuation.” It’s unique to insurance distribution—every other industry calls these types of transactions “management buyouts” or “leveraged buyouts.”
The term “perpetuation” was coined many years ago, based on the concept that you wouldn’t want to interrupt an agency’s perpetual cash flow by selling to a third party. Unfortunately, buyers and their representatives have convinced agency owners that an outright sale is preferable to structuring a transition that enables owners to perpetually receive cash flows.
Compared to distribution businesses in other industries, insurance agencies have a lower risk profile, due to the predictable recurrence of business and the ability to add scale without as much working capital. This recurring revenue and the ensuing cash flow creates tremendous value and makes your agency attractive to a purchaser.
Note that acquirers, even at current high prices, are likely not paying enough for your business, considering what you’re giving up.
Because it’s difficult to predict financial performance of a business with certainty after an ownership change, financial experts consider leveraged buyouts to be among the riskiest of all transactions.
But this is not the case for an insurance agency with capable leadership and a strong brand. The failure rate for an insurance agency perpetuation is microscopic relative to that of ownership transfers in other industries.
The Long Game
As the agency owner, you can realize greater value over time by retaining and investing in your firm. After doing the math, you may find that internal perpetuation is potentially more attractive than an outright sale, even in light of recent deal valuations.
Consider what happens when you completely sell your agency to a third party. In exchange for a lump sum, you give up future cash flows, as well as the clients and relationships whose trust you have earned.
Chances are, the guaranteed portion of the sale is all you’ll realize, because directing the achievement of the full earn-out is probably beyond your control. Also, since you no longer own the shares, you cannot enjoy any future appreciation.
Furthermore, replacement investments with sales proceeds likely will not produce returns as great as running and owning a well-performing agency. You won’t be able to replicate the return with securities or any alternative investment approaching a similar risk profile.
But if you begin to perpetuate your agency internally, even if you sell just a small share to your best people, you are likely to end up with a more valuable firm in the coming years.
How It Works
Why? Your (smaller) ownership share is worth more down the road than the full share would be worth today to an acquirer. Some quick math illustrates the point:
Consider a $5-million commission agency with relatively good performance. Delivering a 22.5% EBITDA margin, the value on an outright sale may be $9.5 million.
Conversely, the theoretical value for an internal sale, of less than a full interest, might be $5.6 million, using conservative EBITDA valuation multiples of 8.5 and 5.0 times, respectively.
Assume the owner sells 30% of the shares of their agency to their best producers. Because the owner retains their best people with equity, those people become more productive. The agency records organic growth of 5% per year and grows to $6.4 million in revenue in five years.
At the 22.5% EBITDA margin and the same 5.0 multiple, the agency is now worth $7.2 million—and the owner’s 70% interest is worth $5 million.
Over the same period, however, the owner also received annual cash flows from their 70% stake, totaling $4.5 million. Add that to the projected value, and the owner’s “total investment” is worth approximately $9.5 million.
These numbers are simplified and ignore taxes and the time value of money, but they make the case that internal perpetuation is very attractive. Modest growth and retention of cash flows yield similar value after five years—and the best part is that you can repeat this process for as long as you care to bring on additional owners, or allow a widened group of owners to increase their shares.
Additionally, you always can sell out in total, down the road, should you want to. Naturally, you will require sound legal advice to craft the share purchase and redemption agreements to retain acceptable control.
What It Takes
Talent flows to equity. Producers who aspire to be owners exhibit a greater sense of commitment and engagement.
That’s why it makes sense to approach perpetuation candidates at an earlier age by offering equity ownership in your business. Equity ownership is the proven way to attract and retain the best talent and is not an available option in private equity-backed brokerages.
Extend this opportunity to individuals who:
- Have demonstrated high performance.
- Can produce business and manage relationships.
- Exhibit your same passion for your business and want to be part of its future.
- Are willing to devote some financial resources to buy into your business.
Then, encourage potential owners to actually “buy” the equity, possibly by obtaining a loan secured by the stock purchased. This places financial discipline on the buyers, readying them for greater responsibilities in the future.
To facilitate financing as the seller, agree to repurchase shares to regain control of the stock, at a discount, in the event that one of the minority principals defaults. This greatly diminishes your downside risk as a seller. Be careful to avoid giving producers equity arrangements in their books, which can hurt you.
But what’s the best way to start the perpetuation process based on selling stock to your future leaders? As principal, you must have a good assessment of the current value of the firm, in addition to a projection of the what the agency’s value will be several years from now after implementing the perpetuation plan and making appropriate investments in the business.
If you run your agency with the goal of carefully widening ownership, you can improve your agency’s performance and value without selling in total.
The myth [see sidebar] that an agency owner can’t extract enough liquidity in a perpetuation environment ignores two important facts: that the owner sacrifices recurring cash flows when they sell, and that specialty lenders are very willing to finance perpetuations.
There is only upside to committing to undertake an internal perpetuation strategy as you plan for your agency’s future. A solid strategy gives you more flexibility, enabling you to maintain ownership of an agency that will continue to provide the income and lifestyle that make ownership so appealing in the first place.
We’re all constantly reminded of the challenges currently facing the independent agency system, including attracting talent. Crafting and implementing an internal perpetuation strategy cements your potential for a solid financial future by widening ownership and talent in your agency, while giving you the best options for maximizing your investment.
Robert Pettinicchi is executive vice president and chief lending officer at InsurBanc, a division of Connecticut Community Bank, N.A. InsurBanc is committed to focusing its core competency on providing the necessary capital to keep the insurance industry thriving.
Several myths serve as natural deterrents to agency owners who are considering an internal perpetuation strategy.
You’ve probably heard the common belief that internal perpetuation plans take years to formulate and even more years to implement. You’ve also heard that these plans are prohibitively costly and difficult to put in place.
Similarly, the widespread belief that internal sales require lower values corroborates the myth that internal perpetuation can’t generate values comparable to third-party sales.
But many agency owners may come to realize that widening ownership and gradually selling to internal parties can generate comparable value.
And the belief that there is no intrinsic value in maintaining a legacy for the successful agency you have built is false, too. Ownership of clients and the successful relationships you have built hold value far beyond the offer from a large acquirer.
Buyers believe the price they’re paying for your agency is a bargain because of the stream of future earnings that will inure to them. Do you think a car dealer is really giving you more for your trade-in than it’s actually worth? —R.P.