It is tough out there!
Companies demand higher volume, offer lower commissions and limit or withdraw from the region. Natural disasters almost seem common place. Legislative actions reform health care, Workers’ Compensation and auto insurance. Profit margins are dropping.
The average agent or broker may feel that they are a mere cork bobbing on the ocean. If a firm is not growing it will disappear. Many agents need to consider some action in order to survive.
The first step needs to be to work on internal growth. This usually begins with hiring new producers. Finding a good producer, however, is difficult and hiring a bad producer is costly. It may be better to initially use leverage with your existing operation. Use telemarketers or other sales techniques to attract new clients. Expand the pie and sell new coverages and additional lines to exiting clients. Try to free up the time of the owners and other producers so they can focus on sales by using experienced Account Managers.
The next step is to look for external solutions. If an owner is close to retirement or does not enjoy the responsibilities of being an owner, then it may make sense for them to sell the agency. It will require planning and time. The actual sales process typically takes around one year. Also, to maximize their equity, sellers usually need to work for two to five years to ease the transition of ownership.
If an owner would like to remain in the business for several more years and enjoys being an owner, then there are three more options to explore. They can: 1) form an association or cluster with other agencies, 2) merge with another agency, or 3) acquire another agency or book of business.
In these turbulent times, many agents are not sure what is the best solution to their woes. There are clear differences between merging versus clustering, versus acquiring. There is no one correct answer, each situation will have its own proper course. It is important, however, to be well informed about all the options that are out there.
A cluster is a group of agents and brokers forming a joint venture or association to market and place their individual books of business as part of a larger book. The objectives in forming clusters include:
Developing more clout and improved profit sharing agreements with markets due to volume consolidation.
Generate economies of scale due because of better utilization of existing facilities, overhead expenses, automation and personnel.
Create a potential market for a future buy-out when an owner wants to sell.
Create a new platform to design and launch new products, new lines of business and additional services.
While achieving one or more of these objectives, each cluster member can maintain independent ownership of their accounts or agency. Clusters can take many forms. They range from all cluster members housed in one office and the members share the staff, to each cluster member maintains their own office and staff. For smaller agents, the advantage of clustering can be summarized in one word — survival.
Pros and Cons of Clusters
One major concern with clusters or associations is the lack of commitment. The clustering versus merger option can be compared to living together versus marriage: you are partners, but there is no real commitment.
When a cluster member leaves with their book of business, a void is created with markets, shared expenses, or shared personnel. This could be fatal to a small cluster. It is important that all members share a common vision for the cluster and are willing to put in the time to make it succeed. The proper screening of members and creative cluster contracts can mitigate problems of uncooperative members or prevent members from leaving.
A cluster is typically an organization managed by a committee of owners. Each owner has his or her own ideas – often a rigid set of ideas – established from having been a sole owner for many years. Cluster members need to operate as a team with a few leaders in order to be successful. Unless each participant is willing to place the ultimate executive authority with a few individuals, there is often an inability to develop basic functional goals and implement decisions.
Accounting needs to be centralized. Each participating firm may have different operational efficiencies. Accurate expense allocations are important to determine an equitable cost sharing of expenses so the more efficient firms don’t bear a disproportionate amount of the costs.
A cluster may not be able to obtain the extra influence with carriers unless one or more of its participants already have an existing preferred relationship. An insurance company will have to approve of each participating firm in the cluster before agreeing to establish a relationship with and a new contract in the name of the cluster. Often, those firms desiring to cluster have small books of business or existing placement problems.
Insurance companies are, naturally, aware of this threat of adverse selection. Most insurance companies would rather deal with merged organizations versus cluster groups. Clusters need to work with the companies while in the formation stage and share the cluster business plan and member screening process.
Sometimes a cluster can be used as a prelude to a future merger. It is a good idea because it will allow the two firms to get to know each other before a formal joining of forces. If it does not work out, the separation will not be as traumatic because a cluster is easier to dissolve than a merged entity. For some owners, however, the initial commitment is important, so this two-step approach may not be desired. .
THE MERGER OPTION
Associations or clusters, when properly organized are a good option. The dilemma is that many are not properly organized because of some of the reasons already discussed. Since clusters often fail to fulfill the expectations of owners, we often recommend that firms consider merging as the alternative to clustering. When properly structured, a merger will bring in more benefits than clustering.
Mergers usually have some of the same objectives as a cluster (i.e., more clout with carriers, economies of scale, better market for buy-outs, more production and management talent, etc.). Markets are more likely to contract with a “merged” entity rather than a cluster due to its more permanent nature.
Merged firms are fully committed to operate as a larger, stronger and unified entity. Stockowners still enjoy the advantages of ownership in the entity, but not of their book of business.
Avoiding the Pitfalls
Bringing together different firms into a single operation will be tested by cultural differences between the original businesses. The personalities of the owners need to properly mesh and all parties need to share a common vision for the new entity.
Strengths must compliment weaknesses. Weakness should not be compounded. On paper, a good match would be between a predominantly sales-oriented firm and a firm focusing primarily on servicing existing accounts. However, the management priorities will differ and may result in conflicts among owners. Creating a simple strategic business plan for the new entity before final merger will help the partners work in concert with each other.
Compensation to the owners is usually a difficult issue and needs to be equitably established. When owners are equally compensated, resentment occurs if one owner does not do their fair share of the work. Compensation to the owners should be based on contribution to the firm using three components: production, management contribution and ownership percentage. We have articles and worksheets on owner compensation, if you need more information.
Some owners perform better by themselves and would rather not have additional partners. Also, some agencies are well established and only need to add a little more volume. For these two groups the acquisition of a book of business or an agency might make sense. Growth by acquisition can be a very valuable tool but only when part of an effective strategic marketing plan, including finding a “compatible” book and ensuring the transaction is well planned and structured.
The first step is to evaluate the book of business. Does it fit in well or compliment the agency’s existing book? Was the selling producer heavily involved with the clients? Find out how the book of business was produced and serviced. The buyer must make sure that their agency can properly service and maintain the accounts. Otherwise, the acquisition will be a “wasting asset.” Often the seller will need to assist for a few years in order to ensure a smooth transition with the clients and markets.
Will the acquisition also include other producers, CSRs or support staff? If so, they must fit into the buyer’s existing culture. Just like with mergers, cultural differences between firms can create morale and other problems. Avoid being forced to retain employees, make sure continued employment is at the buyer’s discretion.
Next, what should you pay for an acquisition? Study the cash flow and the risk involved. Do not pay based on a multiple of commissions. Many buyers believe that they will not lose money when they base the purchase price on retention and calculate the value using a multiple of commissions. This approach ignores risk and the expenses associated with the acquisition. Purchase price must be based on the true profitability of the acquisition and the risk of that profit continuing.
The profit margin, the terms of the pay-out, risk and retention level are directly related to the ability of the buyer to make a profit on the acquisition and must all be analyzed together. If too much is paid, too fast, a buyer will never break even on the deal! Keep in mind the cost in hiring professionals to value the business and assist in the transaction could save many dollars more if the deal was not properly structured or the price was too high.
A FINAL THOUGHT The distribution system for insurance is constantly evolving because of events outside of the control of the agency owner. Many agencies will need to consider restructuring the way they do business in order to survive. Whether an owner decides to merge, join a cluster or acquire, all alternatives and issues should be carefully evaluated.
COMMON ESSENTIAL ELEMENTS Clusters, mergers and acquisitions are very different yet the keys to their success are the same. The following steps should be applied to increase the likelihood of successful mergers, clusters or acquisitions:
Analyze your current situation. Can you grow internally? Should you sell? Does a cluster, merger or acquisition make sense for you? You should review each option in parallel to understand which option is best for you.
Do an extensive search for potential partners. Networking often works best. Hire a professional who can do the search while maintaining your confidentiality.
Carefully evaluate each potential partner to ensure that personalities, corporate cultures and long term goals are compatible. Take the time to know them and their families. Remember – business partners spend more time together than married couples!
Do extensive due diligence. Make sure all information is exchanged…all closets should be opened and all skeletons removed. Check on references and talk to company representatives. Review the client files and computer database.
Hire qualified professionals (CPAs, attorneys and consultants) to review financials, value the businesses, structure the deal, assist with the review process, provide advice on legal and tax issues and prepare proper documentation.
Draw up a mutually agreed to Letter of Intent outlining general terms of the transaction. This will become the basis of the formal professionally prepared purchase/merger/cluster legal agreement.
Establish and agree on a compensation plan for stockholders based on ownership, production and management responsibilities. Establish the travel/entertainment and auto policy for owners and producers.
Design a plan on what the new entity will look like before any transaction is complete. What changes will be made to management, facilities, staff, operations, and automation? What synergies are created that can be exploited.
Understand the impact the transaction will have on your carriers. Evaluate if there needs to be a consolidation of markets and/or if a new market should be sought out and added.
Discuss the retirement plan of any owners within five years of retirement. The approach to the buy-out should be drafted.
Draw up buy/sell agreements between shareholders in the event of death, disability or retirement. Cluster members can draft a contingent buy-sell agreement with one or more of the other members.
About the Authors.
Bill Schoeffler and Catherine Oak are partners in the international consulting firm, Oak & Associates, based in Northern California. The firm specializes in financial and management consulting for independent insurance agents and brokers, including valuations, mergers acquisitions, clusters, sales and marketing planning as well as perpetuation planning. They can be reached at (707) 936-6565 or by e-mail at email@example.com. Visit their new web site athttp://www.oakandassociates.com