NEED AND CASH FLOW AGENCY VALUATION FROM BOTH BUYER'S AND SELLER'S PERSPECTIVE
FOR THE BUYER -- VALUE VS. CASHFLOW
A valuation defines the expected earnings potential of an agency over a reasonable period of time. But it is critically important to understand the difference between the needs of the buyer and the needs of the seller. Those needs define the value established for a business beyond its corporate value (Tangible Net Worth).
Balance Sheet Value
Tangible Net Worth in most agencies is a minor part of the agency’s value. The primary value in most agencies is the future earnings potential of the agency’s book of business, its primary Asset Value. Anyone purchasing an agency or defining its value for an existing owner is certainly concerned with the amount of money the agency will earn after taxes over a reasonable period of time. However, future earnings (the real basis of value in any business) depend on many variables that change with the needs and requirements of both the seller and the buyer.
Value for a Seller with an Unknown Buyer – Going Concern vs. Fair Market Valuation
If an seller determines the need to either perpetuate or to dispose of a business and if no specific buyer is identifiable at the time of the valuation, the value is normally expressed as a Going Concern (the earnings potential if the business continued into the future based on the continuation of its historical performance). This presumes that the trend of revenue, expenses and profit potential historically evident for the agency will likely continue into the future. This value is the estate planning value of the current agency owner to replace his/her earnings potential for the owner’s family in the event of the owner’s demise while still in place as the agency proprietor. As you can imagine, if the owner expects to remain in place for 10 years it is appropriate to consider the earnings potential of that agency over that period. If the owner expects to leave the agency in five years it is appropriate to consider the earnings potential of the business over those five years when planning for life insurance to replace the potential loss of income to the owner’s family should something happen to the owner. However if a sale is contemplated instead of a continuation of the business a Fair Market Valuation should be constructed.
Casting the agency’s value as a Fair Market Value (its worth to a buyer) without knowing the potential buyer includes “assumed” changes in retention, growth and expense load resulting from its acquisition by another agency or owner. The value of the business could be constructed to include only the value of the book of business (an asset sale/purchase) or it could include the agency’s Tangible Net Worth (its total equity position less intangible asset balance sheet value – usually a stock sale). And the expectation of future performance goes a long way in determining value.
For instance, if an agency is expected to continue to perform in the future as it has in the past historical trends can determine future earnings potential. But if a new owner will integrate the agency location into its own and assume the seller’s employees needed by the buyer, the historical performance of the seller is less important than the trended historical performance of the buyer.
But even beyond the construction of the future earnings potential of the selling agency, the personal needs of the buyer and seller have a lot to do with whether a deal will be struck and the price at which such a deal must be negotiated.
We often say that there are as many ways of buying and selling agencies as there are agencies. The reason for this is because every agency will eventually transition ownership and the unique needs of the sellers and those of the buyers always change the picture of the transaction.
Creating an agency ownership transition is much like putting together a puzzle. You know what the end result must look like from the picture on the box. But there is only one correct way of putting the pieces together for any specific buyer and seller transaction. Forcing even one piece that doesn’t belong ruins the entire puzzle and renders it useless.
Value Vs. Need – The SELLER’s Requirement
The importance of the agency’s value to a seller is whether that dollar amount will be sufficient to sponsor the purpose of the sale. For instance, if the sale’s purpose is to add funds to a retirement nest egg to support the seller after the sale or if the purpose is to satisfy seller debt, the amount needed and duration of the time needed will determine whether or not the stated value of the agency is sufficient to meet the seller’s needs.
Value Vs. Cashflow – The BUYER’S Requirement
The critical concerns of the BUYER are always different than the needs of the seller. While the requirements of the seller are needs-based, the seller may have needs like consolidation or addition of carriers, matching or creating common target markets, gathering human assets to continue growth, and gaining market share by eliminating competitors. However, one of the most critical requirements of the buyer is based on the cashflow potential of the business being purchased and the time tolerance of the buyer before expectation of full profit potential of the agency. If pro forma expectations of cash flow are negative for some period of time in an ownership transition, it means that the buyer doesn’t truly benefit from the transaction -- potentially for years.
The Bottom Line – is the Bottom Line
Regardless of the needs of the seller, if the acquisition’s cash flow to the buyer cannot support its annual cost (principal and interest) it is typically a bad transaction for the buyer. Similarly, if the price offered by the buyer is insufficient to sponsor the seller’s needs it is similarly a “bad” deal for the seller. Sometimes the seller has the option to seek another buyer. Other times, the seller will not achieve the needed price for the agency to satisfy the seller’s needs and must decide to either scale down the expectations for the value of the agency or must continue to manage the business to earn enough over time to fulfill his needs.