Jan, 2003 – Do Multiples Sound Too Good to be True?

Valuing Your Insurance Distribution Business:
If the multiples you are hearing about sound to good to be true, they probably are!
By, Mathew Klossner
You may have read an article recently where an industry consultant quoted current
valuation multiples for acquisitions at 8 times EBITDA (Earnings before Interest, Taxes,
Depreciation, and Amortization). Or maybe you heard through the grapevine that an
Agency owner across town sold for 2.5 times revenues. Beware! Rumors of various
multiples for sales are being tossed around more often than a football on a Sunday
afternoon.
By quoting these valuation multiples, industry consultants and other experts are doing
everyone a huge disservice. Misinformation can lead Agency ownerís to have an inflated
view of their Firmís value and can cause serious disappointment if they decide to sell
their business. There are a number of factors that affect the value of an insurance
distribution business and as such, the multiples they are worth. This article will discuss a
few significant ones:
• Asset vs. Stock deal: The biggest value differentiator is the form of Corporation
for which the business was established. All things being equal, ìCî Corporations
are worth less than ìSî Corporations and Limited Liability Corporations
(ìLLCísî).
The primary reasons for this is that the owners of C Corporations need to sell their
stock in order to realize capital gains treatment on the sale, while the owners of S
Corporations and LLCís may sell the assets and realize favorable capital gains
treatment. On the other side of the transaction, Buyers are generally averse to
acquiring stock for two reasons: (1) Buyers want to avoid exposure to undisclosed
liabilities and (2) stock deals do not allow buyers to capitalize on the lucrative tax
benefit associated with the amortization of goodwill. Consequently, a C
corporation ownerís desire to sell stock, directly conflicts with a Buyerís desire to
purchase assets. Ultimately, the Seller will need to realize a lower gross purchase
price to compensate the Buyer for the foregone tax benefit associated with an
asset deal and, the Seller will generally be required to provide indemnification to
the Buyer for undisclosed liabilities for a period of time subsequent to the
transaction.
• Deal Structure: An overwhelming majority of transactions include an earn-out
or contingency component. Because future payments may be based on
achieving/maintaining some level of performance, it is illogical to include the
aggregate potential of such payments in a discussion of the price of the deal.
Some consultants try to include maximum potential aggregate payments along
with historical revenues in order to provide the illusion of a high multiple for a
deal. Their hope is that this ìfuzzy mathî will entice potential sellers to contact
them. The reality of most transactions is that contingent payments are not present
value payments and the risks associated with the future unknown is not taken into
account when a basic simple multiple is quoted. Generally, the actual purchase
price has a much lower implied/realized multiple than the overly optimistic
multiple that was quoted for the transaction.
• Value of Balance Sheet: Some articles fail to mention the value of the balance
sheet when describing a transaction, while others have a footnote indicating that
quoted averages include the value of the balance sheet. Generally, the value of
the balance sheet, known as the tangible net worth, increases (if positive) or
decreases (if negative) the value of the ongoing business dollar for dollar. Failure
to extract the value of the balance sheet out of quoted deals, often leads to false
indicators of value. To illustrate the great injustice of quoting an average without
extracting the value of the balance sheet from the calculation, letís assume three
deals, where all transactions have a gross purchase price of $800 and acquire an
annual revenue stream of $500. All three transactions were quoted to have sold at
1.6 times revenues. However, for this illustration, each deal assumes a different
tangible balance sheet. The first deal assumed in the purchase price $250 in
value. The second assumed $100 in value. Finally, the third assumed $50 in
additional liabilities. By extracting the value of the assumed tangible balance
sheet, you will see that the actual revenue multiple of these three deals is different
than the 1.6 multiple that was quoted. Obviously, any principal who was basing
their estate planning on the 1.6 quote would be mislead.
Deal
Quoted
Multiple
Gross
Price Revenues
Balance
Sheet
Actual
Multiple
A 1.6 $800 $500 $250 1.1
B 1.6 $800 $500 $100 1.4
C 1.6 $800 $500 ($50) 1.7
Type of Business- Wholesaler vs. Retailer- Wholesalers (including MGAís, Program
Administrators, E&S Brokers, etcÖ) have an entirely different business model(s) than
Retail Brokers. Wholesalers have to share a piece of the commission revenue with the
Retail Broker. Because of this revenue sharing process Wholesalerís margins are
generally thinner, and they must operate more efficiently than Retail Brokers in order to
get to the same level of profitability.
Another issue relating to Wholesalers is ownership of expirations. Retail Agencies have a
relationship with a client who is an end user of insurance. Wholesalers generally only
have a relationship with a Broker, and donít actually own the expirations. This lack of
ownership will generally be viewed by a Buyer as more risky.
Because of these and a few other key business aspects (concentration of markets, loss
experience, etc.), wholesale type operations will generally have a lower average value per
net retained revenue dollar than a retail insurance operation. If you are a Wholesaler you
would be ill-advised to use retail multiples in your estate planning process.
Overall, beware of cocktail party chatter and misinformation. Most deals that are done
today are announced without describing the terms of the transaction. Read and listen to
third party price chatter with a skeptical mind, because as you have most likely already
realized, if it sounds too good to be true, it probably is.
Matt Klossner is Senior Vice President in charge of Mystic Capital Advisors Group,
LLCís Northeast operation. He is based in New York City and focuses on all aspects of
the insurance distribution channel. He can be reached at 212-251-0251 or via e-mail
at mklossner@mysticcapital.com.