Did you know that all $20 million firms are not worth the same? Whether you think you are worth 2x or 3x revenue (or maybe even more), the reality is you are only worth a multiple of your profitability or EBITDA (Earnings Before Interest Tax Depreciation and Amortization)—not a multiple of revenue.
So what are you really worth? Do you even know? It is likely you are worth much less internally than externally, and in our experience, the primary reason is because many agency owners run their firm as if it were a non-profit.
We are seeing that the valuation gap between internal value and external value as a driving force in the industry right now. It appears to be one of the main reasons so many firms are selling. The gap exists because of outdated or archaic valuation methodologies and the fact that most firms operate at a depressed EBITDA margin. An improvement in both areas is important to close the gap enough to make independence more palatable.
Most firms have a document process for valuing their stock internally. It is typically outlined in their shareholder agreement. Some firms have a set formula that sets the price. It is either revenue or EBITDA based. Sometimes it could be a multi-year average. Whether it is 6.5x EBITDA (pro forma or actual?) or 2x revenue, a formulaic approach to valuation may not adequately take into consideration any changes in the market. Value should be fluid, not static. A 6x EBITDA multiple may have made sense 10 years ago but the market has since changed. If a partner is set to retire soon, is he or she going to be satisfied with a depressed multiple because your firm decided on a formula 15 years ago that is no longer relevant?
Some firms get a fair market valuation from an independent third party. Firms with an Employee Stock Ownership Plan (ESOP) are required to get an independent valuation on an annual basis to ensure impartiality and that the valuation takes into consideration changes in external valuations and public broker trading multiples. We believe this is the most accurate way to calculate value. Publicly traded multiple and market comparables are utilized to calculate a valuation that is more in line with external valuations.
Agency owners should consider takeing a step back and think about why they are giving away the value of their firm. The average agency operated at a 17% EBITDA margin in 2014. The top 25% of firms operated at a 27% margin. The major difference—producer compensation. Do you
have a minimum account threshold for which producers do not receive renewal commission for accounts under the threshold? Do you require a new business minimum of $75,000-$100,000 that is required to keep producer status and your standard renewal commission?
In our experience, too often, firms are afraid to reduce producer compensation for fear they might leave. Over the years agencies have brought in resources like claims specialists, loss control, wellness coordinators, actuaries, etc. This is often a necessary part of staying competitive in a changing marketplace. However, most firms don’t “charge” the producers for these resources. The result is a continually eroding profit margin and inherently a depressed valuation.
Ultimately, the inferior profit margin eliminates the ability to perpetuate. It magnifies the difference between internal value and external value. In the end, shareholders will not be willing to sell for a substantial discount to external value. Internal stakeholders also will not be willing to buy equity if profitability and cash flow does not support the value expected by the exiting owners. The end result is a weak internal market and the decision to sell to secure external value.
In our opinon, ownership needs to take action and take control of their future. An external sale can still be a consideration but give yourself the choice.
Every month, for the rest of the year, I expect to lead with “the market continues to be extremely active.” There were 21 announced deals in April, which brings our year-to-date total to 117. That is five above the four-month total last year. We also know there are a few major buyers who are sandbagging their announcements. We expect those to come in the next few months and our growth year-over-year will suddenly be more substantial.
AssuredPartners continued its torrid pace in 2015 with four April deals. Their annual total is now nine. Arthur J. Gallagher completed one domestic transaction in April bringing their total to six transactions. Hub International completed three in April, bringing them into a second place tie with six total domestic transactions for the year.
A total of 15 (13%) have been employee benefits only firms. The industry continues to search for a more consultative approach to deal with the ever-changing health care environment.
The coming summer months will likely bring our anticipated vacation lag, but activity will continue to match the season’s temperatures. Buyers are still very active and we are seeing quality sellers coming to the table.
Keep an eye on firms larger than $20 million in revenue. They are likely about to start falling at a faster pace than we have ever seen.