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Mergers & Acquisitions

Understanding the M&A Process

This page outlines the valuation and merger or acquisition process. It lists the basic steps necessary and includes sample documents and resources typically used to execute the phases. It is not intended to replace qualified legal and financial advice.

Step 1: Find Suitors or Candidates

If you are interested in selling your agency, finding a buyer might be as simple as approaching a friendly competitor to begin a dialogue about a merger or sale. You could also ask carrier representatives for a lead on a potential suitor. The biggest downside to such a direct approach is that most sellers want to maintain a high degree of anonymity while they vet the opportunities, not risking the possibility of clients or carriers getting wind of the deliberations prematurely. For buyers, the direct approach can be more effective since anonymity isn’t usually an issue. Prospecting for acquisition candidates is not unlike prospecting for large commercial clients. It is the same type of relationship sale with a long sales cycle. Start with a pre-approach letter and begin a drip marketing process.

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Step 2: Value the Agency and Negotiate and Offer

  • Project adjusted cash flow under your ownership: The value of an insurance agency is rooted primarily in the discretionary cash flow that can be generated by the book of business under your management. In most cases, additional value from tangible net worth is incidental. After executing a confidentiality agreement and collecting initial documents and information, you will attempt to estimate cash flow under your management. Minimum necessary documents include income and expense statement and balance sheet, preferably for the past three years. You will be “normalizing” income and expense stream, adjusting the extraordinary and unnecessary to reflect its true economic value. Do not attempt to verify information or conduct extensive due diligence efforts until you have an agreement in principle on purchase terms.
  • Determine risk factors: As with any asset purchase, the value of a going concern is best expressed as equal to or less than the present value of future cash flows from the asset. This is calculated by applying a discount/capitalization rate or risk factor to the adjusted pretax profit. Calculating the discount or risk factor rate is a very subjective process wherein you make qualitative judgments about the riskiness of the acquisition. However, most agencies with average attributes will fall in the range of the risk-free treasury bill rate plus between 10 and 20 percentage points.
  • Conduct multiple valuation methods: Typically, agency appraisers will calculate value using a number of valuation methods. You should calculate value using various pessimistic, optimistic and most-likely scenarios. You will also add any tangible net worth and subtract 30 to 60 days working capital.
  • Negotiate the deal: The value to you based on your estimated discounted pro forma cash flow should be your top price. Other factors that can affect price include payment terms, hold-backs based on retention or earn-outs based on growth and tax implications. Generally speaking, the more risk the seller assumes after sale, the higher the price. In contrast, all cash deals are almost always discounted. Also, there are special tax implications if seller is a C-corp. Once you have an agreement in principle, you should get it on paper in the form of a letter of intent. While not binding, the agreement can prevent a seller from shopping your deal and make sure all parties have a shared understanding of terms and any contingencies to which the deal is subject

Step 3: Conduct Due Diligence

Due diligence is the process of validating assumptions made during the valuation process as well as identifying elements that will be the subject of representations and warranties in the purchase agreement. Proper due diligence is time-consuming and should only be initiated after a tentative agreement is negotiated and letter of intent executed.

Step 4: Secure Closing Agreements

These are legal documents that should not be created without qualified legal advice.

Step 5: Create a Transition Plan

The hardest part of an acquisition and merger is integrating the organizations. It is imperative that you identify expectations of all parties and identify all actions necessary to implement the transition after the deal is closed.