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Debunking Valuation “MULTIPLES”
Ever wonder why you couldn’t go the wrong way on a one-way street if your eventual goal lies at the other end? It may be the shortest route from point A to point B, but the dangers of this direct route usually outweigh the risks.
Similarly, it is easy as pie to take a dollar value established for an agency and convert it to a multiple of anything your choosing. But trying to apply an arbitrary multiple to express the value of an agency is as risky as going the wrong way on a one-way street. It “might” work – or it might kill you!
Regardless of how often the appraisers in our industry try to correct this misconception, we continue to encounter agents who try to oversimplify the value of their or other agencies in terms of Multiples (of commission, of revenue, of earnings, of EBITDA).
We try to explain that you can’t define the value of any agency or book of business using a common multiple any more than trying to come up with a common dollar value for a house by multiplying its square footage by a consistent number. By using the same multiple of square footage, a house in run-down condition will generate an overly generous value while a custom house of the same square footage would generate a much lower value than justified by its condition.
Similarly, you can’t or shouldn’t define the value of any agency by any ‘rule of thumb’ multiple even if those multiples properly translated the defined value of the specific agencies applicable to those transactions.
I have spent an entire career debunking the myth of “multiples” (of anything) as a way of fairly determining the value of insurance businesses (and most other businesses, by the way). It is always easy to express a value in terms of a multiple as a point of convenience on the back end of a transaction. However, the reality is that any prudent buyer is going to calculate the potential earnings that derive from the existing business based on the trending of that business into the future. Whether formally through a valuation or informally through some spreadsheet calculations, the valuer is going to determine whether or not an acquired agency will throw off sufficient cash-flow and earnings to pay for itself. What sense does it make to buy an agency if it’s NOT going to eventually pay for itself? And if it takes too long to return a buyer’s investment, why buy it at all?
A buyer would be foolish to pay 2X revenue or 5X EBIDTA or any other form of cost basis for a business without identifying what the prospective earnings (after taxes) will be over an “acceptable” period of time – that is the amount of future earnings the buyer is willing to give up in order to acquire the business. The reason he is willing to give up some future earnings is to have the long term financial benefit of the business and the additional income it will accrue from economies of scale enjoyed in the acquisition.
Is it greedy for a buyer to purchase a business for one year of the business earnings? Is it unrealistic for a seller to believe that a buyer will give up the value of his earnings for an inordinate number of years just to buy the business in the first place? Somewhere between ‘greed’ and ‘unrealistic expectations’ lies the correct value of the business, what a willing buyer and willing seller agree to exchange in order to transfer ownership of the future earnings of that business. The key is to understand how much those future earnings will be (estimated based on known history and expected future growth and expenses) given the circumstances of the purchase. That is what a valuation is supposed to accomplish – identify the future earnings potential of the business under the circumstances of the specific transaction.
This is how we calculate value including that of the selling agency in the valuation that you have been sent. It is not magic or arbitrary. We calculate the historical growth and review the actual expense load of the business. We project the future growth based on historical perspective (and the expectations of the association that we recommended) and deduct the expenses that would transfer to the Buyer with the book of business. The tax load is calculated and the Net Earnings are cast for the next five years. We then calculate the Risk Factors that are associated with the achievement of that business flow and “discount” the value by a discount rate built on that risk rate (15% in this case).
The result is a dollar amount for value of the Seller. And that’s why there are three calculations in the valuation, one if the selling agency is maintained in house, one if it is sold without further involvement or participation and one (applicable to Seller’s transaction) that involves a takeover of the agency with on-going association that will result in mutual continued benefit at both organizations. You can certainly take any of those three values and convert them back to a multiple of revenues, EBITDA or a multiple of the number of chairs in the building – but understand that those multiples are simply a matter of convenience for expression of the value, not an accurate representation of the value of agencies that would differ from the Selling Agency or from the Buyer. That’s why the Buyer may have been accurately offered 3X for his agency and declined. The offer may have been fair from the potential buyer’s standpoint but the agency owner recognized that the intrinsic as well as future earnings potential of his agency makes even a 3X offer unsatisfactory compared to his own future earnings potential in the business.
When acting as an Expert Witness on agency valuation, I often use the example of two agencies, side-by-side, each with $1 Million of revenue from the same type of business (PL, CL, etc.). The first was $3 MM five years ago and is manned by owner and staff in their 60’s and 70’s with a client base of the same ages. The second is owned by a couple of 30 yr. old’s. Their staff is in their 20’s and 30’s. They started five years ago from scratch and have built their business to $1 MM in revenue in five years. Would you pay the same multiple for both? This simple example illustrates the danger of any form of multiple formulas for the calculation of value of an agency. Whether you use my valuation or your own calculations, please be prudent in your identification of value of the Seller Agency in order to avoid ‘cheating’ either the buyer or the seller. The best transaction is one in which a valued asset is purchased for a price that is a fair representation of the future earnings of the business over a reasonable period of time (defined by each of buyer and seller and compared). If my suspicion is correct (and I’ve been doing this for a long time), the value of the Selling Agency is as expressed in our valuation.
Whether you use Agency Consulting Group, Inc., another firm or choose to do it yourself, make sure you step through the exercise of identifying the after-tax earnings that you could enjoy if you purchased another agency or book of business. Identify how long you would be willing to give up those earnings in order to regain the investment that you are spending to get the agency. The amount derived from this exercise is the appropriate maximum value you should establish for the agency in question. Then – and only then – should you redefine that dollar amount back to a simplistic multiple (of whatever you feel is important) as an expression of a value multiple. A retiring seller may want to boast to friends what type of multiple he got for his agency without ever telling them how much he actually received.