Developing Your Perpetuation Strategy

Why are so many insurance agencies selling to third party buyers? Many valid reasons exist: record high valuations, desire for resources, legislative changes, competition, etc.

However, I believe the primary reason agencies sell is due to a lack of a formalized and funded perpetuation plan. Many agencies have informal perpetuation plans in place, but an agency must have motivated employees and sufficient cash flow in order to turn their plan into reality. If your agency desires to formalize its perpetuation plan, I would refer you to Reagan Consulting’s Private Ownership Study. The study is designed to help agency principals navigate the maze of perpetuation alternatives and create effective strategies to remain privately-held, if desired. In this study, we highlight four key elements that should be incorporated into your agency’s perpetuation plan: (i) healthy operations, (ii) reasonable sellers, (iii) able buyers and (iv) an effective transfer mechanism. Without any of these four key elements, your perpetuation plan will likely fail.

A high-level summary of the four pillars of perpetuation and a few key findings from The Private Ownership Study are outlined below for your quick reference:

1. Healthy Operation

The ability to perpetuate any business begins with the operational health of the business. For an insurance agency, operational health encompasses two key factors:

• Organic growth. Organic growth refers to the rate at which an agency grows its revenue through expanded sales efforts rather than by acquisition of existing revenue from another agency or agent.
• Profitability. Profitability is the measure of an agency’s true financial viability. If an agency isn’t turning a profit, it is unlikely to hold long-term value.

In order for an agency to perpetuate, there must be a healthy balance between growth and profitability.

Reagan Consulting developed a simple growth and profitability balancing equation called “The Rule of 20.” This metric is calculated by adding half of an agency’s earnings before interest, taxes, depreciation and amortization (EBITDA) margin to its organic revenue growth rate. An outcome of 20 or higher typically means a firm is generating a shareholder return of about 15% to 17%, which is generally considered a normal return under ordinary market conditions.

2. Reasonable Sellers

Our research indicates that a reasonable seller possesses three key characteristics:

• Valuation. A reasonable seller is willing to sell shares internally at a discount to third party valuation multiples.
• Financing. A reasonable seller either personally finances the sale of his or her ownership stake, participates in agency financing or assists in arranging suitable third-party financing for buyers.
• Timing. A reasonable seller is willing to sell his or her shares to the next generation of shareholders once they are ready to buy into the firm. Further, a reasonable seller is willing to time share sales to avoid redemption title waves – situations where one or several large shareholders need to be redeemed simultaneously.

3. Able Buyers

Finding able buyers is the biggest challenge to internal perpetuation. Our Baseline Perpetuation Survey asked agencies about their biggest challenges with finding able buyers. Over 60% cited a lack of financial resources. An able buyer must be financially capable of purchasing equity in the firm, and a buyer’s financial capability can generally be boiled down to one question: how much must he or she come “out-of-pocket” to purchase equity in the firm?

To evaluate this question, we look at a metric called the “Buyer Coverage Ratio.” The Buyer Coverage Ratio is calculated by dividing the buyer’s ownership distributions or bonuses by the annual principal and interest payments due on their ownership purchase notes. Our research revealed that a typical agency has a Buyer Coverage Ratio of 100%. This means that over half of firms structure their perpetuation plans to ensure that a buyer’s principal and interest payments are entirely covered by shareholder distributions or bonuses. While there is not a “correct” Buyer Coverage Ratio, determining whether or not your firm has able buyers is impossible without considering the Buyer Coverage Ratio and the resulting out-of-pocket requirements for the buying group.

4. Effective Transfer Mechanism

An agency must have an effective mechanism in place to facilitate the transfer of ownership from one generation of owners to the next. In our In-Depth Perpetuation Survey, over 60% of firms reported their primary method of transfer is ownership purchases whereby an individual buys ownership shares either from another shareholder or from the company.

In determining which transfer mechanism is right for an agency, the owners must match the transfer mechanism with the agency’s unique DNA and circumstances. This is a critical process, as not all transfer mechanisms will work for every agency. The agency’s distribution philosophy, shareholder distribution, growth prospects and other attributes will influence the appropriateness of any given transfer mechanism. Reagan Consulting specializes in designing transfer mechanisms to ensure that your agency’s perpetuation plans will work successfully.

Ultimately, successful agency perpetuation – whether it is a merger or sale to a third party or an internal transaction – is about protecting the owners’ ability to choose their direction without limiting their range of choices by preventable factors or circumstances.

For more insights on perpetuation and key findings from The Private Ownership Study, watch the Developing Your Perpetuation Strategy webinar I recently hosted or contact me, Harrison Brooks, at hbrooks@reaganconsulting.com.

Best Practices, 2018

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