The employee benefit advising industry had a record-setting year of agency mergers and acquisitions in 2017, as independent data from consulting firm OPTIS Partners show benefit brokerages accounted for 174 transactions — a nearly 90% increase from 2016.
But, what makes for a strong brokerage valuation and a successful sale at the onset? It starts with a record of stable recent growth, say several industry consultants with decades of sales experience between them. That record is buoyed by seller motivation, revenue diversification and a business model that looks beyond the traditional sales approach.
The first thing a prospective buyer is going to look for is a history of proven, strong growth and a positive outlook for the future. Noting that the market fluctuates in often uncontrollable ways, a general rule of thumb is to monitor new business a percentage of prior year commissions and fees, says Tommy McDonald, vice president at leading M&A consultancy MarshBerry.
McDonald recommends targeting 20% new business as a percentage of prior year growth, but adds that 10%-15% is closer to the typical brokerage’s output. “If you can produce 10% organic growth regardless of the market cycle, the economic impact or the retention impact on your business, that’s a good metric to aspire toward,” says McDonald.
As a marker for valuation, a brokerage should establish the company’s adjusted free cash flow by analyzing the profit and loss statements of the past three years, says Jack Kwicien, an agency consultant who has facilitated dozens of sales through his company, Daymark Advisors. Ideally, he says, this process would include quarterly or even monthly P&L statements, “to understand the seasonality of revenue and expenses.”
BMost valuations would include the owner’s compensation and remove any “preference items,” such as multiple cars, residencies, even housekeeper expenses and college tuition that often get run through the business, Kwicien says. Any type of expense that the company buyer would not continue gets added back into the adjusted free cash flow of the company. For example, if a brokerage spent $100,000 on a new CRM product, about $90,000 would be added back, as that CRM’s yearly maintenance should only be about $10,000 going forward.
Ideally, Kwicien says, buyers are looking to acquire a business with at least a 10% compounded annual growth rate in terms of topline revenue as well as a 20%-30% cash flow margin. Anything north of 30% would put the seller at the high end of the range of valuations. In today’s market, he says, that would be anywhere from five and a half to seven times adjusted free cash flow.
However, regardless of how a book of business looks on paper, a buyer would be remiss to discount the qualitative factors that come with an acquisition. And that starts with the seller’s motivation for offloading their company.
There’s a lot of psychology that goes into a sale, says consultant Wendy Keneipp of Q4intelligence, including the owner’s leadership style and how they’ll behave during an earn-out period. For example, are they burned out and not driven to maintain the business, or are they excited and motivated?
“If you’re going to count on the owners to be in there and run the agency for the next two or three years, that’s where I would really focus a lot of attention,” says Keneipp. “What is their ability to move that agency forward, rather than just let it sit and stagnate?”
If the business is stagnating, it might indicate a distress sale due to something like a health setback for the seller, adds Kwicien. Most buyers will be looking for the agency owner to stay on at least one to three years to facilitate an orderly transition and keep clients, he says.
Therefore, Kwicien says, due diligence would include a strategy session with the seller about their personal motivations: Why are they selling? How long do they plan to stay around post-transaction? Do they have family members who want to stay in the business? Do they have health issues? How old are they?
“The emotional sides of things in the transaction are equally as important as the financial considerations,” Kwicien says, adding that they are the precursors that drive the construct of the terms of the sale agreement.
Also see: “Looking to be acquired? Start here.”
Alera Group, a national benefit and P&C brokerage that formed in December 2016 when 24 independent companies united, is looking to acquire as many as 40 additional companies. More than half a dozen joined in 2017. CEO Alan Levitz says the first thing he looks for in a potential acquisition is a cultural fit.
“We spent nearly two years planning and defining our culture, and are protective of what we have built,” says Levitz. “Our culture is an intentional and significant component of the success we experienced as we brought the original 24 firms together. We are looking for new partners that want to collaborate with our existing partners to continually improve the client experience across the entire organization.”
A less volatile book
Beyond a lack of personal motivation in the owner or a cultural misalignment, another risk for the buyer would be acquiring a brokerage with too many eggs in one or two baskets. Having a couple of clients make up a large percentage of revenue, around 5%-12%, is a big risk, says MarshBerry’s McDonald.
Daymark’s Kwicien agrees, citing a recent transaction where a client had 67% of its total revenue coming from only five companies. The deal still went through, he says, but it affected the value of the business.
“If you’re on the buyer side of that equation, you’re concerned about the concentration of business in a handful of clients and the potential for loss,” says Kwicien.
Moving away from a lot of individual and small business accounts and toward up-market companies would also indicate a less volatile book of business, says Q4intelligence’s Keneipp, as it tends to be more difficult for larger companies to switch benefit brokers, creating more stability for the existing broker of record.
Another key indicator of stability is diversification of age in a benefit advisory’s staff. In this people-driven business, buying a company with a lot of employees looking to retire in the next five or even 10 years will impact the valuation, says McDonald. “That’s obviously an impact in value relative to one that has a firm that’s built a bench of people that can support it into perpetuity,” he says.
While Keneipp says this industry doesn’t tend to have a lot of bloat in internal staff makeup, it doesn’t hurt to take a look at staff compensation and structure to improve cash flow, says McDonald. Also, he adds, producer contracts should be clear as to who owns their individual books of business: the company or the producer themselves?
In addition to producer and key employee agreements, other essential documents that should be reviewed with the assistance of a lawyer include: financial reports (with an emphasis on loans and debts), all insurance carrier contracts, compensation and bonus arrangements, other vendor contracts for things such as software, and the operating agreement for the business (is it an LLC, C Corp, Subchapter S Corp, etc.), says Kwicien.
Beyond traditional sales
With an eye toward the future and how valuations may change over time, buyers should look at how much control the agency has over its revenue stream. For example, Keneipp says, are they still completely dependent on dwindling carrier commissions and bonuses, or have they moved into a more fee-based compensation model structured more around consulting?
Brokerages need a well-defined approach to pricing additional services such as HR consulting, data analytics consulting, compliance services and technology implementation, so that they’re not just doing it as part of their traditional brokerage fee, McDonald adds.
This changing business model means the quality of non-sales talent is also increasingly important, says McDonald. “In this business today, having expertise and focus on data analytics, population health management, compliance and HRIS technology is very important,” he says.
Owning propriety technology is a benefit as well, says Kwicien. As is a team brimming with demonstrated thought leadership that enables brokerages to generate new business revenue through non-traditional sources, such as seminar selling, adds McDonald.
While Kwicien, Keneipp and McDonald all agree that agency owners should always run their businesses as if it’s already for sale, getting them to the point of true sell-ability typically takes from about 30 to 90 days.
But, Kwicien cautions, the end transaction is never about price, but rather the final terms of the agreement. For example, a $10 million valuation with $4 million in cash at closing and a five-year earn out issuing $1.2 million per year contingent on business performance is not as good for the seller as $6 million in cash at closing and $1 million per year for four years that is not contingent on business performance. The former, he notes, would put 60% of the risk on the seller.
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