My June column addressed many of the causes of poor agency valuations–and apparently struck a chord with readers. Most of the e-mails I received asked for more information regarding why working capital is so important to an agency's value. This month, I will explain why.
Think of an agency's value in terms of “what is being bought.” At a minimum, the buyer purchases the seller's customer files (or expirations). Depending on what is bought, other assets may include employees and company contracts. The value of every business purchased is the sum of its parts, and the more effectively the parts work together, the more valuable the business. Working capital plays an important role in this process.
Think of an agency as a machine. A key part of every machine is lubricating oil, a small component that plays a pivotal role in the effectiveness of the bigger parts. In the service industry, working capital is the lubricating oil that affects the big picture. Without adequate working capital, agencies don't run efficiently and can even break down, which may result in bankruptcy. An engine can run with inadequate oil, but with each revolution, it wears out a little.
The same holds true for an agency with inadequate working capital. It can run for a while, but each new sale compromises its longevity. Unfortunately for many agency owners, the wear and tear is so gradual it isn't recognized until it's too late, and the agency eventually “breaks down.”
Working capital is aptly named. It works 24 hours a day, seven days a week. It's not used for acquisitions or erecting buildings–that's investment capital. It's used to pay expenses and cover emergencies. Covering expenses comes first in a growing business, and working capital is used to pay those expenses. When an agency hires people for expansion, it has to pay them before they make their first sale, and that money comes from working capital. Without adequate working capital, the money has to come from somewhere–like the owner's paycheck.
Working capital is also like a short-term savings account that enables a business to pay for investments such as people and automation. What are the benefits of adequate working capital?
–It allows an agency to take advantage of opportunities. For instance, many agencies hire people only when they need them, rather than when they find them. Sufficient working capital gives owners the luxury of bringing an exceptional talent on board when one becomes available.
–It fosters strategic growth, because banks like to lend money to agencies with adequate working capital.
–It affords the opportunity to buy equipment quickly. (If you were to ask New Orleans agents with and without adequate working capital how they fared after Hurricane Katrina, I'm sure you'd find the ones with adequate working capital weathered the crisis much better.)
–It enables an agency–with proper documentation and if it so chooses–to give key accounts more time to pay. (I'm not a fan of this practice, but it exists. When it is vital to accommodate an important client, adequate working capital can make it possible to do so.)
In theory, the aforementioned moves can pay off quickly. Take away adequate working capital, and an agency's ability to take advantage of these opportunities is severely limited.
An agency with adequate working capital clearly has a competitive advantage. With plenty of working capital, agencies can grow quickly. Meanwhile the risk that an unexpected event will cripple them is reduced. Many agency owners don't understand the importance of adequate working capital, perhaps because they have never had it or experienced its benefits. They have survived without it but have not enjoyed the prosperity it can bring.
Working capital can even affect basic agency operations. Some agencies have difficulty making payroll because the agency owner doesn't understand the importance of working capital. This occurs fairly often when agencies make acquisitions but don't get working capital from the seller. If a seller can't provide working capital, the selling price of the agency should be discounted. Expenses come first, and buyers may not have the money to pay their bills if they don't have adequate working capital. I've known many agency owners who thought their acquisitions looked successful; but because they didn't address working capital in the acquisition agreement, they experienced many sleepless nights.
It generally is considered adequate for an acquired agency to have 30 days of working capital, unless the agency being purchased has excess bad debt, an excessive number of clients who pay late or a specialty in a risky industry, like trucking. One could argue that direct-bill personal-lines business requires less than a 30-day reserve, but I haven't seen this proved.
Buyers shouldn't pay extra for a 30-day cushion, but many do–usually because they don't know any better or consider the additional cost a small price to pay for peace of mind. If a buyer purchases an agency that has more than 30 days of working capital, it will have to pay a premium, but 30 days' worth should be considered standard.
A machine would not be considered whole if it had any missing parts, so why try to run an agency without a major component like working capital?
Chris Burand is president of Burand & Associates LLC, an agency consulting firm. Readers may contact Chris at (719) 485-3868 or at [email protected].
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