Jan, 2011 – Perpetuation Is Easy – Isn’t It?

THE BELOW ARTICLE WAS PUBLISHED IN THE JANUARY, 2011 ROUGH NOTES MAGAZINE

AGENCY FINANCIAL MANAGEMENT

PERPETUATING IS EASY — ISN’T IT?

Several factors to consider

By Robin C. Frost, ACA

The population is aging and the United States is expecting to see a significant rise in the
number of retired people in the coming years, which raises the question: Have you
considered your retirement plan lately?

Instead of the infamous “Joe the plumber,” let us consider the case of Joe the insurance
agent. Joe is 59 years old. He had been planning his retirement well, but lately things have
started to look a little dicey. Joe thought his retirement savings were safely invested, but
they took a bath during the economic downturn. He is left with less-than-anticipated
retirement funds and he is seriously worried about the future. Sound familiar?
So what can Joe do? Perhaps it is time to focus on the one asset that is under his control—
his agency. As advisors in the insurance industry, agency owners often ask us what they
should be doing to prepare for the perpetuation of their agency. The answer is simple: Start
planning now.

Leveraged buyouts
First, let’s remember that a perpetuation is a sale of the business. If it is an internal
perpetuation, it is the sale to a team of investors who currently work within the agency,
which is effectively a leveraged buyout (LBO). It is either funded by a bank loan or, more
often than not, via seller financing (i.e., the seller acts as the lender, with the cash flow of
the business being tapped to fund the purchase over a period of time). LBOs generally
strike fear into most investors, given their high rate of failure, and a perpetuation should be
treated with similar caution. Whether the perpetuation is financed by an external group or
via the seller, ultimately the agency’s cash flow will be the only source for repayment, which
adds greater emphasis on ensuring the future success of the company for all parties.

The buyout group
Back to Joe. The first question he needs to ask himself is, “Who is the buyout group?” This
is probably the most crucial step in the process. In many cases, it may be clear. In Joe’s
case, his son, Joe Jr., will eventually take over. Sounds simple, but if Joe is viewing the
situation with an objective eye, he has to ask some tough questions, starting with whether
his son has the right mix of talents.

Sales talent is always key, but management talent is critical too. Will Joe Jr. have the
support of all the staff? Will he be able to retain employees? As was previously mentioned,
it is critical to both sides that the new ownership succeeds. The worst-case scenario for a
retiring principal who has financed the perpetuation is that the agency fails: the new
owner(s) cannot make the purchase payments, and the retired owner regains control of an
agency which is a shell of its former self. So, once again, although the buyout group may be
obvious, will it actually be able to deliver? If not, should an alternative buyout group be
sought?

Valuation
Having considered his strengths and weaknesses, Joe has decided that Joe Jr. is up to the
task of running the agency, and that he has a willingness to buy it in the future. The next
fundamental question is—what is a fair price for the transfer of ownership?

The fair value for the agency needs to be determined and the valuation method should be
part of the perpetuation agreement. Value is often based upon a multiple of earnings,
typically based on earnings before interest, taxation, depreciation and amortization
(EBITDA), but this valuation may be translated into a multiple of revenues.

Let’s consider the case of Joe’s agency. Unlike his retirement funds, Joe has managed his
agency’s balance sheet conservatively, and the company is in solid shape, in an “in trust”
position with good liquidity. Chart 1 above summarizes the earnings valuation.

So Joe and Joe Jr. may choose to prescribe a valuation of 6x EBITDA or may prefer 1.67 x
revenues. Whichever is agreeable to both, this will add certainty to the valuation and avoid
any future argument. However, the downside to this approach may be that the prescribed
methodology or multiple that is normal market practice at the time of drawing up the
agreement may not be so when the company actually perpetuates.

Retirement needs
The majority of agency sales are structured to include an initial down payment with a
schedule of future earnout payments based on meeting certain performance targets. In the
case of a perpetuation, significantly more of the purchase price is made via the future
earnout payments, usually spread over a longer period to accommodate the new
ownership. Joe needs to consider what cash flows from the perpetuation will fit his
retirement needs. The critical issue here, though, is taxation.

Joe needs to be aware of what the actual cash receipts will be to him on an after-tax basis.
The company may be subject to double taxation on the sale of assets (for example, if it is
organized as a Subchapter C corporation, and it sells its assets), which would significantly
reduce the actual cash received by Joe. He may need to consider filing an election to
convert to a Subchapter S corporation (S Corp), which would remove the double taxation
threat; but he should be aware that in most cases there is a 10-year period before the
conversion benefits are fully realized, so is Joe happy to wait another 10 years before retiring?

A further issue relates to the timing of the capital gains tax on the earnout payments. Given
that the consideration for the agency is spread over time, Joe may simply pay capital gains
tax as each payment is received, or alternatively he may prefer to pay the whole amount
upfront. You may ask, why on earth would he want to pay the government ahead of time?
Well if there are anticipated tax rate changes, it may be beneficial to pay at the lower rate.
However, there is a downside to paying the tax upfront, in that if Joe were not to receive the
entirety of the consideration upon which his tax estimate was based, his recoupment would
be severely limited by capital loss tax regulations.

Sensitivity analysis
So we have considered Joe’s needs in structuring the financial terms of the transaction, but
we should also consider this from Joe Jr.’s perspective. There is, of course, the issue of
whether Joe Jr. can afford to fund any initial down payment that Joe may need. Then
looking to the future payout schedule, Joe Jr. will be paying for the acquisition out of the
future profits of the agency. Running different scenarios may quickly show that the expected
cash flows will not cover the costs.

In the case of Joe, he will need the full value paid at the time of transfer, so Joe Jr. needs to
go to the outside credit market to fund the purchase. Joe Jr. is able to borrow funds at 5.5%
from the bank, provided he pays the first $500,000, which by itself may be a large stumbling
block. In considering the future after-tax cash flows of the agency, Joe Jr. has assumed no
growth and a 40% tax rate, which for illustrative purposes here has been reduced to 35% to
allow for the deductibility of the interest expense. Chart 2 above shows scenarios for
borrowing the money.

So as things stand, Joe Jr. will have a problem. First, he has the significant question as to
whether or not he will be able to afford the $500,000 down payment when the agency
perpetuates. Then for the earnout payments, the questions that need to be asked include:
What level of growth will be enough to cover the shortfall? Will it be possible to meet this
shortfall via expense cuts or via growth of the top line? Alternatively, should the valuation be
reduced to facilitate the process? As can be seen, the sensitivity analysis from the buyer’s
side is critical in the whole planning process. What initially seems like a great plan could be
worthless if the buying group won’t be able to fund it. At the end of day, the ideal
perpetuation plan should be challenging to the buyer group but not so challenging as to be
unachievable.

Due diligence
A further issue to consider for the future is due diligence. Over these last few years, Joe Jr.
has really gotten to know how the company works and by the time it comes to perpetuate,
he will know it inside and out, so he suggests that some costs could be saved by not
conducting a formal due diligence. Although well intentioned, Joe Jr. could easily be
creating future problems for himself.

A third-party view of a company can identify issues which, while known by all parties, had
not been considered a risk and that could have an impact on the fair valuation of the
company. It can be thought of as analogous to buying your friend’s house. Although your
friend has maintained the house well and you trust him or her, you would be unlikely to go
ahead without an inspection by a qualified individual. The use of an outside professional to
review makes all sides feel more comfortable and reduces the possibility of unforeseen
problems emerging and causing a strain in the relationship later on.

Conclusion
For any perpetuation agreement to work it must be fair to all sides, and all parties should be
involved in the negotiation of the agreement. Once completed, there must be buy-in from all
sides for it to succeed. The use of a qualified agency advisor to assist in the perpetuation
plan can often facilitate this process, as well as being able to perform the valuation and run
the sensitivity testing scenarios to stress the plan and assess whether or not it can be
workable.

The author
Robin Frost is a vice president of Mystic Capital Advisors Group, LLC, a national mergers
and acquisition advisory firm that focuses exclusively on the insurance industry.