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.