Planning Ahead: How to Retire from a Lifetime’s Work

A common problem with agency owners that are considering retirement is that some individuals in their 60’s and beyond have devoted their lives to the job of running their businesses, often at the expense of personal enjoyment. They may find it difficult to distinguish between their lives at work and their non-professional lives. For some, the end of work equals the end of a meaningful part of their lives. They are not sure what they would do if they did not go to work. Thus, there is a lot of emotion involved in implementing a perpetuation/retirement plan.

A number of owners know they need to do something about perpetuation. Some know they may need to sell the agency, especially if they do not have good internal candidates for carrying the agency forward. While some may have candidates in mind, many of these “candidates” are not the types of individuals that the owners should trust to take over their management and production responsibilities. Nor should the retiring owners rest their retirement income on these individuals’ ability to pay. Family members can complicate the whole situation. Just because they are family does not mean they can take over and properly run the business, especially if they have no insurance background.

Key employees usually do not have the money for the purchase of the owners’ stock. Without strong skills, they may not be able to run the agency profitably. Even with promises to pay off the owner over time with the agency’s money, the lack of an entrepreneurial spirit can cause a lack of cash flow despite growth.

Retiring owners that fall into these scenarios may have a difficult time selling their agency. Often a merger is easier, as they may not be required to give up all management control and retire right away. Time can help people prepare for the transition into retirement.

Valuation and terms today
Valuating the agency in preparation for a sale, whether internal or external, presents additional problems. Individuals who are over 60 probably bought books of business and/or the existing agency from retiring principals for multiples of revenue in the 1.5 to 2.0 range over the years.

Today it is rare for an agency to receive a sale price of 1.5 times revenues or above, unless the agency offers the buyer some unique items, such as special niches or markets, great producers, a desirable location, or a stable, very profitable book generating a profit margin in excess of 30 percent.

Even less likely are terms for a fixed price under five years, which was more common decades ago. Most aging principals do not want the risk of a retention purchase or the thought of a long-term buy-out, especially if they are told they cannot stay very long after the purchase.

One way to reduce the risk of a retention purchase is by having a floor negotiated in a deal, for example, the floor could be 75 percent of the agreed earnout value. Or the risky portions of the book/commissions could be paid for based on retention, rather than the whole book. Retention deals are often done today without interest being paid on top of the purchase price and without these floors.

Contingents and interest income should also be incorporated into the value of the buy-out, not just a multiple of commissions. These are revenues that increase the bottom-line and should be paid for in a deal.

Selling assets versus stock
If the agency is a “C” Corporation, buyers can only write-off an acquisition if they buy assets versus stock. In this case, the goal of the seller conflicts with the buyer’s goals. If the agency’s assets are sold rather than stock of the corporation, under today’s tax law the seller may be hit with a double tax. He or she would first have the proceeds taxed corporately and the balance taxed at the individual capital gains level.

The impact of this double tax could be reduced through a deferred compensation plan established in advance. Changing to an “S” corporation will keep any increase in value after the switch to an “S” from being double taxed. A valuation should be done at the time of the change, so the value can be established if ever questioned by the IRS. The “S” corporate tax rate when selling a business fully kicks in 10 years after the change from a “C” corporation. Contact a qualified CPA prior to making this change to make sure it fits with the agency’s situation.

If an owner is close to retirement another option can be to make the sale a merger first, with an agreement in place that after the firms merge, the retiring owner will sell the stock at some negotiated point. The price may even be pre-set based on the merger value or at a price negotiated by the parties. In this way, the sale of stock will be at the capital gains rate, avoiding the “double tax” rate that an asset sale of the “C” corporation would have generated. Care must be taken so that the IRS cannot consider that the merger was done to avoid paying taxes.

Identification of priorities
In any sale, it is necessary to identify what is important to the seller. Do they want to stay on? Do they want a private office to go to for a number of years? What role do they want to play, if any? What is fair compensation for the work performed? Which key employees need to be kept (especially family members who might need an ownership interest)? This wish list should be created well before the list of qualified buyers is developed.

This list is usually more important than determining the price. If the book or firm is a good one, there is usually not a problem finding a party that will pay the seller a fair market value.

It’s a seller’s market
Today it is a seller’s market, even though agency values are still somewhat conservative. Values today are typically in the 0.9 to 1.4 times revenue range.

Despite today’s lower profit margins, prices of insurance agencies may be driven up by the lack of supply of good agencies for sale. The demand has traditionally been caused by the insurance companies’ pressure on independent agencies to have more and more volume with them. Many new deals today are done for strategic reasons, such as adding new lines or getting new staff.

The current hard market may make a seller want to wait until they feel they are at their peak, which also has an effect on supply. There is less motivation to sell when principals are finally making money, as compared to the lean years and years of soft market pricing.

When preparing for a sale, a number of qualified buyers should be determined. Those potential buyers can then be prioritized with respect to their compatibility with the seller and how closely they match the seller’s wish list. Prospective buyers should then be approached one at a time.

An owner that is not quite ready to sell may want to have a contingent buy/sell agreement with an agency in the same city that is respected by the owner. This will buy some time for the seller to develop an effective perpetuation plan.

If family is involved in the business the owner may want to consider options to lessen estate and/or gift taxes. A Grantor Retained Annuity Trust (GRAT) is an excellent vehicle for perpetuation whenfamily members are involved.

The GRAT makes the payments deductible to the corporation, as long as the seller stays alive during the buy-out, usually over period of ten years. Some of these options allow an owner to “freeze” the value of the stock until it is passed on to the children.

Summary
A good consultant will help owners plan the appropriate steps for retirement and should help make the process as painless as possible.

If an external sale instead of internal perpetuation becomes the right avenue, the key is to find a compatible party, unless the owner only cares about taking his or her money up front and running.

Most owners will want assurance that the new owners are taking good care of their employees and clients. After all, the sale of their agency is the sale of a lifetime’s work.

There will always be a greater fool—one that might pay more for an agency than an astute buyer would. However, if all of the money is not received up front, or if the owner cares about the treatment of the clients and future employment of his/her employees, the owner will want to make sure that the buyer is fair and astute.

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 national and international insurance agencies, including valuations, mergers, acquisitions, clusters, sales and marketing planning, as well as perpetuation planning. For more information, call (707) 935-6565, e-mail catoak@sonic.net, or visit www.oakandassociates.com/catoak/.