Perpetuation Plan; Retirement Plan; Exit Strategy Call It Whatever You Want, Just Do It

By Andrew R. Gioseffi

Many agency owners have a difficult time planning for the next big chapter in their life. No one wants to admit their mortality, but the reality is fairly clear. If you are 50 years old, the chance that you will die before reaching retirement age is more than 20%. While there has been significant improvement over the last decade in the number of agencies that have realized the necessity of having a perpetuation plan in place, further improvement is still needed.

A study I read not too long ago indicated that the average independent insurance agency owner is almost 60 years of age. The median age is not available but I think it would be fair to assume that approximately half of all owners are approaching 60 years of age. Therefore, approximately half of all agency owners are going to retire, try to retire or begin initiating their retirement within the next five years.

The industry is changing so fast that writing a perpetuation plan today when you are not planning to retire for five years may seem irrational. However, developing a perpetuation plan is a key step in positioning your agency for future opportunities. An agency that is well prepared for long-term perpetuation has more value than one not so well prepared. An important element of a perpetuation plan is an exit strategy for the agency principals. This article offers one approach outlining the steps that must be addressed in developing an effective plan.

This is something that you want done properly, so perpetuation planning may require help from experienced specialists and entails the following: 1) an agency appraisal; 2) consideration of your agency's legal and business structure; 3) a thorough review of your personal goals; 4) designation of your successor and 5) development of specific business plans.

1) The appraisal

The first step in this process is the completion of an agency appraisal. The agency appraisal represents the foundation of the perpetuation process. Most agency principals are not aware of the many misconceptions with regard to the valuation process. In many cases, multiples are applied to commissions or revenues to try to ballpark a value. Unfortunately the old rules of 1.5 to 2.0 times revenue are no longer valid. One could use these multiples as ballpark valuation methodologies as long as profit margins were in the 20% range. Agency profit margins today are in a much lower range, and thus the multiples must be lower to appropriately reflect those lower margins.

When analyzing transactions structured as a multiple of revenues or commissions, one must be aware of the time period over which payments are being made, whether a retention formula is applied and whether interest is being paid on the outstanding principal balance. Only then can one accurately discuss the valuation of that transaction.

The professional appraisal utilizes the two main drivers of value from a financial statement perspective. These are the earnings stream of the agency and the balance sheet value. The professional appraisal addresses the valuation of an agency, taking into account many factors, including a projection of future expected cash flows with appropriate discount rates applied to those cash flows.

In addition to the earnings stream, tangible net worth of the agency balance sheet must also be computed. Assessing the tangible net worth of the agency balance sheet can be a fairly complicated exercise. In many cases, former shareholders are being bought out with the use of continuing commission payments. These obligations are not usually reflected on the agency's balance sheet. Therefore, the present value of those payments must be added on a proforma basis as liabilities to the balance sheet.

A buyer who dismisses the off-balance sheet liabilities is putting the agency's cash flow at risk. The off-balance sheet liabilities should be added to the balance sheet liabilities. One must also realize that utilizing the agency's cash flows to pay down those liabilities means that those cash flows are not available to the shareholders.

2) The business structure

The next step in the process is reviewing the agency's legal and business structure. A good number of agencies are structured as corporations or sub-chapter S corporations. The main distinction for the purpose of this topic is that the S corporation is not normally subject to corporate tax at the federal and state level. Earnings of an S corporation are taxable directly to the shareholders. Thus, while many C corporations accumulate retained earnings, there is little or no motivation for an S corporation to retain earnings.

In planning an exit strategy, the distinction between the S corporation and C corporation has significant implications from a tax standpoint as well as a deal structuring standpoint. In light of the fact that S corporation earnings and capital gains are taxable directly to shareholders, the purchase of assets from the corporation, namely the book of business, will not create negative tax implications.

Acquirers prefer buying assets since purchasing the stock of an agency entails a much more intensive due diligence process. The more extensive due diligence process results from the fact that the buyer assumes the on- and off-balance sheet liabilities of the corporation in a stock purchase, including potential tax assessments on audit. Although the buyer will require representations and warranties from the seller, the potential difficulties in recovering future liabilities make the purchasing of stock the least desirable of transaction methodologies.

Since a stock sale may be the only deal structure alternative for the C corporation owners, shareholders should be diligent in running the corporation in a professional manner from a business point of view. Some of the more obvious areas of concern are the elimination of personal expenses flowing through the corporation and the proper accounting and tax treatment of the amortization of intangible assets related to the acquisition of other agencies or purchased books of business.

3) Personal goals

The third step in the process is for owners to spend time reviewing personal plans. Many agency owners have found themselves in a position of suddenly deciding to sell, not realizing that a buyer will want a commitment from the seller for a transition of the business which may last up to two to three years.

Selling shares internally creates its own set of dynamics. Do the internal buyers have the financial resources to purchase the selling shareholder's equity? Do the internal buyers expect bonuses to cover all or a portion of the buyout? Is the selling shareholder secure in the prospect that the internal buyers have the capacity to run the agency on a profitable basis? If the selling shareholder is taking notes, what is the security behind those notes? If external financing is available, are the internal buyers taking advantage of that opportunity? Should the principal consider selling to a third party?

4) The successor

Perpetuation can be achieved in one of two forms: internal and external. Under an internal arrangement, the agency is sold to key employees, who may include family members. In external perpetuation, an outside entity--agency, brokerage, bank, or other financial services provider--purchases the agency. Ideally, a perpetuation plan contemplates both of these alternatives, with one choice designated as primary and the other as secondary.

Internal perpetuation

Generally when agency owners talk about perpetuation, they mean internal: selling the agency to people who already work there and will keep the business going as it's currently operating, If you're going to do that, you have to invest your profit back into the business and the people you want to take over the agency someday. You might have to begin selling these people stock earlier than you intended, and that's hard for some owners to do; they don't like giving up the control. Not only are some agency owners reluctant to let go of financial control, they also may be less than eager to spend time training younger associates who someday will be running the agency. For some entrepreneurs, that's not how they enjoy spending their time, as they're not naturally inclined to be thinking about everything they know and what they need to teach younger people. But preparing your successors is essential if you want your perpetuation plan to work.

To prevent misunderstandings from wreaking havoc, a vital first step in internal perpetuation planning is communication and sharing of expectations. It is important to bring together the senior people and the junior people and try to identify what everybody wants; both financially and in terms of how the agency will operate. When do the senior people want to retire, and what kind of buyout will they accept? For the junior people, what roles do they see themselves playing in the future? Further, it is necessary to get things out in the open--things that people may not be openly discussing. Another goal of such a session is to secure a commitment from the senior people to a specific time frame for the transition. This is one of the hardest things for owners to agree to. It is hard to get some owners to talk about retirement, but putting a date down on paper can be even more difficult.

External perpetuation

When internal perpetuation is either impractical or undesirable, agency owners can choose external perpetuation: merging with or being acquired by another agency. The key here is to effect the transaction while the agency is in good shape and the owner is still active in the business. The latter consideration is important because the buyer often wants the seller to remain active for a period of years before retiring. Accordingly, for external perpetuation, the planning horizon may be a bit longer, anywhere from three to seven years.

A merger or acquisition also can be a good way to find prospective buyers for a future internal sale. Suppose an agency has two or three owners, all of whom plan to retire at about the same time. For whatever reason, there's no one within the agency who can buy it. These owners can acquire or merge with another agency whose principals are younger, and who can purchase the firm when the older owners retire. Such a strategy offers the added benefit of promoting a smooth transition to new ownership.

5) Business plans

The final step is the development of specific business plans. If the plan to exit is several years off, the agency principals should seek to maximize shareholder value. Building the agency through internal growth as well as acquisitions can create an attractive asset at the point in time when the principals are ready to sell. Larger agencies, by their nature, are more attractive to consolidators than their small counterparts. Larger agencies typically have a greater depth of management and thus can stand on their own as potential hubs for other consolidators.

Three to five years is the typical time frame in which to prepare for a perpetuation transition, although there are situations in which agency principals have a compressed time frame in which to position the agency for a sale. The first step is to analyze the current situation and decide what corrective action is needed. Next, a plan needs to be crafted and implemented.

One of the major problems with agency management is a failure to deal with morale issues such as dissatisfaction with the management structure and a perceived lack of accountability. Compensation and bonuses are not always reflective of the relative efforts of the key employees. The obvious result is the potential dissatisfaction with the status quo. Accordingly, it may be necessary to redefine accountability and responsibility within the agency. If done well, the attitude and effectiveness of staff should dramatically improve.

Summary

Retirement may be the most emotional decision many agency owners ever make. It is more a personal decision than a business decision. To maximize your agency's value, enhance its future, and ease the transition, begin planning your agency's perpetuation at least five years before you want to retire. This does not mean to start thinking about a plan five years before retirement. It means to actively begin preparing for your retirement. Planning and making commitments about such an emotional decision is difficult. Agency owners rationalize that they don't want to make commitments five years out because it is quite likely that they'll change their mind and they don't want to limit their options. With an open mind, focus and perhaps some outside assistance, a perpetuation plan can be developed without limiting an owner's options. Planning your retirement then can increase or at least keep your agency from losing value, ease the transition, maintain your options and make your decision much simpler when its time to retire.