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Factors Impacting the Value of an Insurance Agency

4/22/2015

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The first item we discussed on valuing an insurance agency was size.  Now let's take a look at seller's discretionary earnings.

2. SELLER’S DISCRETIONARY EARNINGS


Agency cash flow, or as it is often called “Seller’s Discretionary Earnings” (SDE), represents the cash available to an agency owner for debt service (if any), return on investment, and personal remuneration.  The reason SDE is widely used rather than net income, EBITDA, or simple cash flow is that many independent insurance agency owners have expenses that are not essential to running the agency and other expenses that will not pass-through to a new owner.  We have seen many non-essential expenses on agencies’ financial statements, and understandably, a lot of these are used for tax purposes.  Many of the expenses that will not pass-through to a new owner are one-time expenses such as completely remodeling an office building, purchasing a new office or agency, etc.  These non-essential and one-time expenses are added back to cash flow in order to calculate a true SDE.

Naturally a higher SDE usually means a greater value for an agency, as it provides more remuneration as well as more cash to service debt.  This produces more buyers with the willingness and ability to purchase the agency.  However, there can be some exceptions, with the most common one being a current year spike in SDE due to slashing expenses.  In these cases, the office may now be under staffed which will hurt customer service and thus future business. On the other hand, for independent agencies which can show a history of consistent SDE, buyers will often times pay a premium to acquire these proven agencies.

The SDE multiple used for valuing an agency varies.  They range from as low as 2X to as high as 7X with the majority being around 4X.  The agencies that sell for 2X SDE are mostly smaller agencies with declining revenues and where the current owner is leaving soon after the acquisition.  They agencies that sell for 6 to 7X times SDE are typically agencies with over $3MM in commission income and that are acquired by large regional or national brokerage firms such as Brown and Brown, Arthur J Gallagher, Marsh, etc.  

Next we will look at the seller's transition plans.

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Factors Impacting the Value of an Insurance Agency

4/8/2015

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The old adage used by many independent agency owners for valuing their agency was 1.5 times gross income.  I often still hear this today when speaking with agency owners.  However, today buyers have become much more sophisticated in their approach to acquiring other agencies.  Sophisticated buyers now look at things such as seller’s discretionary earnings (SDE), appointed carriers, market conditions, create pro-forma financial statements, etc…  Nowadays there is no well accepted standard multiple to use when valuing an insurance agency because no two agencies are created the same.  Therefore, we have decided to offer a list of the most important items to consider when valuing an independent agency.

1. SIZE – Size continues to be the most important factor driving the value of an independent agency.  The reason is relatively simple.  Larger agencies are able to utilize economies of scale which increases profit margins and net income.  In addition, larger agencies will attract more potential buyers.  This is simple Economics 101 on the supply and demand curve.  With fewer large agencies (supply) and an increase in demand, the price invariably is driven up.  Many of you may now be asking what is considered a large, medium or small agency.  These can generally be divided into five categories based on gross income.

Before we get into describing each category let us first explain why we do not use written or earned premium, and also why we use gross income instead of gross commissions.  We do not use written or earned premium simply because neither one is included in a seller’s income statement.  The reason we use gross income and not gross commissions is that many agencies are now charging fees such as application fees, new policy fees, reinstatement fees, etc… These fees impact income.  However, one thing to consider is that some buyers will not include all of the fees in their calculations since many of the fees are one-time events.  Buyers are more willing to include on-going fees in their calculations as long as they occur on a regular renewal basis.  The use of fees varies from buyer to buyer and is often influenced by the insurance regulations of the buyer’s home state or the buyer’s general policies.

Now let’s take a look at the five categories by size:

The first size agency labeled “micro” is for agencies with less than $100K in gross income.  These agencies are typically only marketable to neighboring competitors.  The majority of them do not have enough net income to justify other buyers spending the time, money, and resources to acquire an agency of this size.  The key to creating value for a micro agency is to develop a specialty that other competitors do not currently offer.  

The second size agency categorized as “small” is for agencies with gross income ranging from $100K to $500K.  Small agencies typically have an established book of business with positive cash flow.  The buyers of small agencies are usually other local agencies looking to merge the agencies together, or an individual looking to get into the industry with an existing book of business without having to start from scratch.

The third size agency termed “medium” is for agencies with gross income ranging from $500K to $1M.  These agencies have an established book of business and are usually known throughout the local area.  These medium sized agencies usually attract local agencies looking to expand as well as some regional agencies with existing business in the area.  

The fourth size agency which we call “medium+” is for agencies with gross income ranging from $1M to $3M.  These are called medium+ because they are still not what we consider to be large, but there is a clear distinction in the number of potential buyers once the agency hits a million dollars in gross income.  The medium+ agencies attract other local agencies of similar size looking to merge or create a partnership.  They also attract regional agencies both with existing business in the area as well as ones looking to expand into a new market.  In addition, they attract some national brokerages with either existing business in the area or that are in the process of acquiring other agencies nearby.  

The last size agency categorized as “large” is for agencies with gross income above $3M.  The reason we use $3M is that many of the national brokerages use this as the point where they will consider acquiring an agency and creating a regional office.  As buyers the national brokerages have the ability to use their economies of scale, relationships with carriers, brand, and financial strength to pay higher multiples than other potential buyers. 

In our next blog we will discuss the second most important factor to consider when valuing an agency, which is 
SELLER'S DISCRETIONARY EARNINGS.
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    Jeremy Hovater

    CEO
    Sunset Insurance Group

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