Our proprietary data shows that in transactions where the purchase price is between $5 million and $6 million, the ability to understand and effectively negotiate the critical issues commonly found in all brokerage transactions can swing the purchase price, up or down, by as much as $1.2 million. In other words, the difference between a poorly negotiated transaction and a well-negotiated transaction can be as much as $2.4 million.

Most owners do not realize that the subtle moves made by both buyer and seller during a given transaction can have an exponential impact on the final purchase price. To drive this point home, the following describes the sale of the same insurance broker with two very different outcomes.

Scenario One

In this first scenario, the seller makes the decision to sell the company and decides to enter into negotiations with a buyer that has previously approached the seller about a possible transaction. With the help of his business attorney and accountant, he quickly receives an offer for 6.3-times the agency's EBITDA of $800,000, amounting to a purchase price of a little over $5 million.

EBITDA is earnings before interest, taxes, dividends and amortization. The $800,000 was adjusted to normalize the owner's salary. In other words, it is common for owners of privately held companies to include all or most of the company's profits as salary, resulting in very little EBITDA. Therefore an adjustment of owner's salary is necessary to provide a better understanding of the company's actual performance.

It should be noted that in this scenario the seller only approaches one buyer an approach surprisingly common in many transactions.

The first table (flagged, “Offer On The Table”) summarizes the transaction assumptions.

Pleased with the offer, the seller allows the buyer to perform the necessary due diligence. Upon completion of due diligence, the buyer advises the seller that further adjustments to EBITDA need to be made before closing the transaction, which will directly impact purchase price.

The buyer points out, for example, that the agency is currently paying below market rent with a lease that is shortly up for renewal, and that a small portion of its EBITDA was derived from revenue that the buyer believes is non-recurring.

As a result, the buyer reduces the pro forma EBITDA by $150,000 to $650,000, which results in an adjusted purchase price of $4.1 million significantly lower than the first offer.

The seller now has two options: continue with the deal or find another buyer.

The seller is concerned, and rightly so, that another buyer will most likely make the same adjustments as the first buyer, resulting in a similar purchase price. In addition, the seller realizes there is no guarantee that another buyer will even materialize let alone make an offer similar to that of the first buyer.

In this particular case, the seller decides to continue with the current buyer.

Just before signing the purchase agreement, the seller's attorney informs the seller that the net proceeds at the closing of the transaction will be $200,000 less then originally expected (See table flagged, “First Offer Adjusted”). This is due to the working capital requirement required by the buyer before taking over the business. Typically, a buyer will require working capital essentially cash on hand to pay for day-to-day expenses to be equal to anywhere from one to two months of expenses.

With the prospect of a $3.9 million payment only weeks away, the seller may find it difficult to terminate the transaction over $200,000.

Thus, the seller agrees to the final condition, signs the necessary documents and closes the deal a few weeks later. After the closing, the seller and his attorney and accountant go out for a celebratory lunch, congratulating one another; after all it was a good deal. Or was it?

As mentioned earlier, during a transaction, subtle moves made by both buyer and seller have an exponential impact on final purchase price. In this case, the seller's lack of adequate representation and inability to effectively understand the issues of the transaction before any negotiations took place put the ball in the buyer's court a significant disadvantage for the seller.

Scenario Two

In this scenario, the same seller engages a financial adviser experienced in insurance brokerage M&A transactions.

Rather than approach one buyer, the adviser counsels the seller to approach multiple buyers on a discrete, confidential and highly controlled basis. Before approaching any buyers, the adviser carefully reviews the seller's financials and builds defendable pro forma financial statements.

The accompanying table flagged, “Adviser Vets The Books” illustrates the changes made to EBITDA, which include:

• Normalizing executive salary.
• Adding back the salaries of two new producers who are not yet profitable and who would have no impact on trailing 12-month revenues if terminated.
• Below market rent expense on expiring lease.
• Discretionary dues, subscriptions and contributions that will not recur.
• Discretionary country club fees.
• A portion of automobile, travel and entertainment expense that will no longer be reimbursable under the new owner's policy.

During the process the seller receives offers from four qualified buyers. For the sake of simplicity we will focus on only two of the four offers.

In addition, we will assume that the offers are for all cash guaranteed at closing. In reality, offers generally include cash, notes or stock, or a combination of all three. (See related sidebar on this page.)

Buyer X offers to buy the agency for 6.2-times pro forma EBITDA and Buyer Y offers to pay 6.5-times pro forma EBITDA. The seller's adviser vets both offers thoroughly, and finds that although Buyer Y's offer appears much higher, it is actually equal to that of Buyer X's in terms of net proceeds to the seller. This is a result of Buyer Y requiring working capital equal to 60 days and of expenses, whereas Buyer X only requires 30 days of working capital.

Through careful negotiations the seller's adviser uses Buyer Y's offer of 6.5-times to push Buyer X's offer higher. After a tough negotiation process, Buyer X finally agrees to top Buyer Y's offer, offering a multiple of 6.6-times. In addition, they have agreed to a 30-day working capital requirement, which will require only a $50,000 balance sheet adjustment at closing. The specifics are summarized on the accompanying table, flagged, “A New Deal.”

At this point, the seller and buyer will generally sign a non-binding letter of intent stipulating broad terms of the transaction. The letter of intent will typically indicate that the consummation of the transaction will be subject to the buyer's completion of successful due diligence. The seller agrees to a 30-day lock-up period allowing Buyer Y to perform due diligence and to refrain from negotiations with other potential buyers. Assuming the seller's adviser has done a thorough job up front, it will be very difficult for the buyer to come back and dramatically change the offer, as was the case in Scenario One.

Upon completion of due diligence, both parties work to draft and sign a purchase agreement another part of the M&A process that entails a lengthy discussion. A few weeks later, the parties close the deal and the same type of congratulatory lunch is held.

recap

Both scenarios ended with the seller successfully closing a transaction, but the difference in net proceeds to the seller between scenarios is dramatic, given that both involved the sale of the same broker. (See the final table flagged, “Don't Leave $ On The Table.”)

In the scenarios above, we touched upon only a few of the issues that can dramatically alter value in the sale of an insurance brokerage. It is important for the seller to understand all of the issues which will have either a negative or positive impact on ultimate net proceeds to the seller.

In addition, it is just as important to employ a market-clearing process whereby the most qualified buyers with the most qualified offers are brought to the table. Although working with one buyer can lead to a good deal, it is unlikely the best deal.

Michael Fletcher is a vice president for Hales & Company, an investment banking firm specializing in financial services. He may be reached at [email protected].

Flag: Worth Noting

Dont Expect 100 Percent Cash

In the accompanying article, in our deal scenarios, we assumed that all-cash payments were guaranteed at closing. In reality, however, offers typically can include some combination of cash, notes or stock.

Guaranteed payments at closing usually range between 30 percent and 90 percent of the purchase price, with the remainder of the consideration to be paid through an earn-out. An earn-out is an agreement that the seller will obtain additional future compensation based on the business achieving certain future financial goals.

Also, the guaranteed portion of the purchase price does not always mean an all-cash payment at closing; rather it may be paid in installments under a note.

The analysis and negotiations of these issues alone warrant lengthy discussions.

Reproduced from National Underwriter Edition, April 15, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.